for years, regulation – capital requirement in particular – has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk. It is to be expected that financial institutions would maximise returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators.
Pointer from Tyler Cowen.
The diagnosis of regulatory arbitrage is correct. However, the prescription of better regulation needs to take into account the fact that all centrally planned incentive systems degrade over time. That is, over time, regulated institutions will find weaknesses in the system and come up with ways to maximize risk within the letter of the law.
That is why I argue for “spirit of the law” regulation. This is a very unpopular idea. But I think that if the government protects an institution, with deposit insurance for example, then executives should be liable for a collapse regardless of whether the risks they took met the letter of the law. And I think that prison should be the punishment. You don’t want executives to assume that as long as their portfolios meet the letter of the law they need not worry about risk-taking.