Ethical Failures in Regulating and Supervising: The Pursuit of Safety Net Subsidies

Abstract

This paper traces the financial institution crisis of 2007-2008 to a breakdown in the incentives of regulators, supervisors, managers, and investors to perform adequate due diligence on securitized investments. Investors allowed their trust in the reputations of credit rating firms and the giant financial firms that manufactured highly rated tranches of securitized loan pools to blind them to the casino ethics of these firms' managers and line employees. Government credit allocation schemes generate incentive conflicts that undermine the effectiveness of government supervision and eventually produce financial crisis. In 2007-2008, technological change and regulatory competition led incentive conflicted supervisors to outsource much of their due discipline to credit rating firms and accountants. This outsourcing encouraged institutions to leverage and securitize their loans in ways that pushed credit risks on poorly underwritten loans into hidden corners where supervisors and credit ratings firms were not obliged to look for them and failed to discern the dangers posed until it was too late.