Chapter

Incentives versus Rules

Kern Alexander, Rahul Dhumale and John Eatwell

in Global Governance of Financial Systems

Published in print September 2005 | ISBN: 9780195166989
Published online September 2007 | e-ISBN: 9780199783861 | DOI: http://dx.doi.org/10.1093/acprof:oso/9780195166989.003.0008
 Incentives versus Rules

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This chapter considers the role of market discipline and whether it can be relied upon as the only tool of financial regulation. It argues that if this is true, there needs to be at minimum an incentive-compatible framework in place a priori. The chapter begins by briefly considering the “incentive problem” in regulation using a principal-agent framework. It then considers the design of an incentive-compatible regulatory system that encourages prudent behavior and efficient financial intermediation. The discussion continues by assessing the nature of the tradeoff between incentive- and rule-based regulation by analyzing the interaction between regulatory and agency incentives. The chapter concludes by considering the challenges in designing appropriate incentive mechanisms to regulate financial markets through market discipline.

Keywords: market discipline; financial regulation; incentive-based regulation; rule-based regulation; financial markets; incentives

Chapter.  4282 words. 

Subjects: Financial Markets

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