1、Journal of Banking and FinanceRevised Draft: June 21, 2001USING DEFERRED COMPENSATION TO STRENGTHEN THE ETHICS OFFINANCIAL REGULATION*Edward J. Kane Cleary Professor in FinanceBoston CollegeABSTRACTDefects in the corporate governance of government-owned enterprises temptopportunistic officials to br
2、each duties of public stewardship. Corporate-governancetheory suggests that incentive-based deferred compensation could intensify the force thatcommon-law duties actually exert on regulatory managers. In principle, a forfeitablefund of deferred compensation could be combined with provisions for meas
3、uring,verifying, and rewarding multiperiod performance to make top regulators accountable formaximizing the long-run net social benefits their enterprise produces. Becausegovernment deposit-insurance enterprises are purveyors of credit enhancements forwhich private substitute and reinsurance markets
4、 exist, their performance could bemeasured accurately enough to make employment contracts for deposit-insurance CEOs apromising place to experiment with this kind of accountability reform.JEL Classification Codes: G2, G3, H4, K2Keywords: Ethics; Government Compensation; Financial Regulation; Deposit
5、 Insurance* For valuable comments on an earlier draft, the author wishes to thank Robert Eisenbeis, James Moser,Larry Wall, and two anonymous referees. Edward J. Kane, Finance Department, 330 Fulton Hall, Boston College, Chestnut Hill, MA 02467, (617)552-3986, fax (617) 553-0431, edward.kanebc.edu.2
6、Regulation and ethics are terms of art. Regulation consists of setting rules (inLatin, regula) and enforcing them. Enforcement entails monitoring and compellingregulatee conformance. External enforcement is sometimes characterized as supervisionand may be assigned to parties whose interests differ s
7、ubstantially from those of therulemakers. It is convenient to define “ethics” of regulation etymologically asoccupational standards of performance that are imbedded in the customary ways of doingthings that one may observe today in the community of actual supervisors and regulators(cf. Jackall, 1998
8、). These practical standards tell us how to expect conflicts of interestinherent in particular regulatory duties to be resolved.In modern societies, a financial institution is an organization that produces funds-management, informational, and transactional products for a base of customers withwhom i
9、t seeks to maintain a repeat-business relationship. Back-office elements of thisbusiness may be characterized as an information and dealmaking factory. Each dealobligates the counterparties to exchange a mix of information, cash, and service flowstoday and at specified future dates. To reliably valu
10、e their side of potential deals,financial institutions gather, verify, and process information about the investment projectsand creditworthiness of their counterparties. Through their capital structure andcontracting instruments, institutions transmit accounting and other kinds of informationabout h
11、ow existing deals allocate risk across their firms explicit and implicitstakeholders.The proximate goal of any financial regulator is to constrain the behavior of clientfinancial institutions. Regulatory constraints supplement subtler limits that are set bysocial norms and by competitors in the mark
12、ets in which institutions compete.3To set bounds on the behavior of a financial firm requires regulatory officials tofocus on its information flows and dealmaking activity. To establish even limited controlover a universe of individual regulatees, financial regulators have to establish protocolsfor
13、disclosure, truth-telling, promise-making, promise-keeping, and conciliation.Particularly because of externalities associated with financial institutions role in acountrys payments system, most societies assign government financial regulators threemajor tasks:(1) to limit risks of fraud, discriminat
14、ion and contract nonperformance infinancial transactions;(2) to operate a safety net designed to virtually eliminate risks of fire-sale lossesassociated with financial-institution insolvencies and unjustified customerruns; and(3) to operate the fraud controls and safety net honorably and at minimumo
15、pportunity cost to taxpayers.These services offer benefits in confidence and convenience to regulated firms and totheir customers. Minimizing the opportunity costs of producing regulatory benefitsentails marginal-cost pricing for all services performed specifically for particularconstituencies and b
16、alancing increases in uncompensated current expenditures onenforcement and compliance against the decreases such expenditures might induce in theprojected costs of future financial messes and crises. The optimal balance may bedefined as the equilibrium tradeoff that would obtain if it were possible
17、to align theincentives of regulators perfectly with those of taxpayers.4In choosing and operating a framework of rules and bureaucratic enforcement, theCEO of any regulatory enterprise faces three potential incentive conflicts. First, societyusually assigns more than one mission to each regulatory e
18、nterprise. These separatemissions may and sometimes do conflict with one another, allowing regulators to choosewhich ones to prioritize (Wall and Eisenbeis, 1999). Second, parties who might beharmed by a regulators conscientious efforts to fulfill its social mission may be expectedto find ways to re
19、taliate against the personal and bureaucratic interests of the CEO.Especially when a problem is not yet publicly recognized, a regulators short-terminterests may be better served by a strategy of regulatory forbearance and coverup.Third, among top regulators job turnover is high. The brevity of a CE
20、Os expected termof office implies a decisionmaking horizon that would on average overvalue the near-term effects of policy strategies and may do so ever more heavily the longer a CEO staysin office. No one should suppose that political pressures for shortsighted policies can beneutralized merely by
21、giving top office holders the option of serving a lengthy term inoffice. 1It is convenient to analyze these incentive conflicts in a principal-agentframework. The ultimate principals are voter-taxpayers, for whom elected politicians andprivate and governmental regulatory agents act as fiduciaries or
22、 “public stewards” (Bearand Maldonado-Bear, 1993). Under common law, fiduciaries owe their principals dutiesof competence, loyalty, and care. These ethical duties oblige top regulators to exercise ahigh degree of vigilance and to strive energetically and fairly to protect their principalsinterests.
23、Personnel screens, conflict-of-interest rules, and the need to enlist collusive1 For example, in the U.S., Governors of the Federal Reserve System are appointed to staggered 14-yearterms. Nevertheless, it is rare for Governors to serve out a whole term. In fact, those whose terms do5partners limit t
24、he kinds of corruption we observe (Rose-Ackerman, 1979). However,coordination costs and federal law effectively insulate regulatory CEOs and boards fromthe threat of taxpayer lawsuits for engaging in negligent, deceptive, or manipulativebehavior that arguably breaches these duties.Ideally, the emplo
25、yment contracts under which top regulators function should bedesigned to minimize the costs generated by their agency relationship (Jensen andMeckling, 1976). An ideal contract would contain provisions measuring, verifying, andrewarding performance in ways that would render regulators fully accounta
26、ble totaxpayers for maximizing the net social benefits their decisions produce.This paper begins by reviewing how financial regulators create value and howdefects in the corporate governance of government-owned enterprises tempt regulators tobreach their duties of public stewardship. Subsequent sect
27、ions explain how taxpayerscould benefit from drawing on corporate-governance theory to intensify the incentiveforce that common-law duties actually exert on regulatory officials.I. Why External Regulators that Create Value in External Finance areTempted to Distribute Regulatory Benefits Opportunisti
28、callyAs information and deal-making factories, financial institutions create value bysupplying services that lower the costs that surplus and deficit spending units incur innegotiating and executing financial contracts. In intermediating flows of informationbetween actual and potential counterpartie
29、s, a financial institution not only collects,verifies, and analyzes information, it also moves the information it processes overinternal and external communications networks. To keep its customers satisfied, anexpire have often been appointed to serve only a fractional term.6institutions services mu
30、st be efficiently performed and the accuracy, security, andconfidentiality of its information exchanges must be credibly maintained.All modern societies regulate financial institutions and they do this forcompelling reasons. Regulatory services generate net social value when they enhancetransactiona
31、l convenience and customer confidence in low-cost ways. Acting as trustedand disinterested outside parties, beneficent teams of private and governmental financialregulators can minimize coordination costs by: overseeing the accuracy andconfidentiality of information flows to customers, harmonizing i
32、nterfirm and networktransactions, standardizing contracting protocols, and guaranteeing contract performance.Although complying and monitoring compliance with specific restrictions is acostly process, regulation is on balance a valuable product because it generates aggregatebenefits for society and/
33、or for the industry being regulated and these benefits exceed theircosts. It is the net benefits -and not the services themselves- that customers andinstitutions value.It is instructive to view financial services as a product that is supplied jointly byfinancial institutions and their regulators. Th
34、is jointness in production means thatinternational trade in financial services empowers customers to choose not just betweendomestic and foreign suppliers of financial products, but also between host-country andhome-country systems of regulation. In financial services, customer choice focuses notjus
35、t on the stand-alone capacity of the institutions with which the customer formallydeals, but also on differences in the cost and quality of the supervisory and guaranteeservices on which informationally disadvantaged customers rely in assessing the liquidityand safety of the products selected. The v
36、alue that regulated institutions can fairly7attribute to the services of a given regulatory enterprise depend on the mix of purposes itsregulatory CEO pursues and on the efficiency with which its managers accumulate anddeploy enterprise resources. Of course, a regulators resources include the value
37、ofwhatever implicit and explicit government guarantees the enterprise can command.Regulatory RelationshipsLike the financial-services business itself, financial regulation is a relationshipbusiness. Regulated institutions and their regulators contract to do a range of repeatbusiness with each other
38、for an indeterminate time. Although clients exert discipline onhigh-cost regulators by migrating their business to other producers of regulatory services,regulatory activity need not always be efficient in the short run. Neither party canrecontract either moment to moment or transaction to transacti
39、on. If either side wishes todissolve the relationship, it must absorb a substantial switching cost.Public-choice theory emphasizes that regulation is not always intended to besocially benign. In particular, a regulators ability to support and enforce cartel-likebehavior among its clients subjects it
40、 to constant political pressure to produce subsidiesand use its coordination powers to generate monopoly profits for incumbent institutions.Figure One diagrams the contradictory pressures under which governmentregulators must operate. On the supply side of each regulatory relationship, regulatorstra
41、de benefits to client “regulatees“ for engaging in conforming behaviors and threaten topenalize nonconforming activity. Although regulatory services generate a mix of public,bureaucratic, and private benefits, officials are reluctant to acknowledge that incentiveconflicts influence their policy deci
42、sions. This reluctance leads officials to employ “spin8doctors“ whose job is to credibly misinform taxpayer-voters about what is at stake inproposals to make changes either in financial rules or in enforcement practices.On the demand side of the relationship, regulatees seek to influence regulators
43、tomake favorable adjustments in the net burden or subsidy that the regulatory frameworkgenerates. Although channels of taxpayer influence (such as an independent press andlegislative oversight) are intended to promote the public interest, they may be subvertedto intensify the incentive conflicts tha
44、t make it hard for regulators to straightforwardlyserve the public good. As in the U.S. savings-and-loan mess, self-seeking sectoralpressure on politicians and regulators often aggravates incentive conflicts. Firmscomparative advantage in building and exercising clout helps to explain why in practic
45、econsumer interests are often subordinated to producer interests (Stigler, 1971; Pelzman,1976; Rose-Ackerman, 1979; Becker, 1983).Opportunistic Behavior and its ControlEthical norms of truth-telling, fair dealing, and promise-keeping express asimultaneous obligation to render good that is due to oth
46、ers and to avoid evil that wouldharm them. The force of this conception turns on the difficult-to-define italicized words.To operationalize the task of verifying violations of social norms, economists havedeveloped the simpler concept of opportunism. An agent is said to be perfectlyopportunistic if
47、its choice of actions is based exclusively on its self-interest and is notinfluenced at all by a desire to respect social norms (Magill and Quinzii, 1996, p. 14).We may define a perfectly opportunistic regulator as one who would honor taxpayerinterests only when it is in its self-interest to do so a
48、nd would exploit any advantages thenonobservability and nonverifiability of its actions and character create.9How much value a regulator creates and how beneficently this value is distributeddepends on the incentives under which institutional managers and top regulators operate.These incentives vary
49、 across types of firms, across societies, and from era to era. Inprinciple, regulatees are bound to offer hidden or laundered side payments to regulatoryofficials to tempt them to use their certification, coordination, and guarantee services insocially non-neutral ways. When these offers succeed, institutions may engage in thetype of “crony capitalism“ for which Indonesia has become the poster child. In suchcases, the public interest to a greater or lesser degree is sold out by venal regulators.Speaking of the U.S., Auchincloss (1966, p. 9) observes: “So completely is it taken f
