Incentive Compatibility: A Study On The Construction Of An Effective Banking Supervision Mechanism In China

Since 1990s, the ideology of banking regulation and supervision has progressed on the roads of achieving the balance of market failure and the intervention failure as well as improving the efficiency of regulation, which is the trend of the theory of banking regulation. Under the current framework of banking regulation, the global or regional financial crises do not disappear and even become more severe. Then, the banking regulatory and supervisory authorities and the international organizations are obligated to rethink the efficiency of the current arrangements seriously. The regulators in China face even more challenges due to the complex domestic financial situations and how to build an effective banking regulation mechanism is their and researchers'major concern. The theoretical analysis in this paper puts forwards how to measure the rules of effective banking regulation and builds an systematic theoretic framework with the advanced methods, which is a contribution to the theory of effective banking regulation. While, we raise the suggestions of how to build the effective banking regulation framework in China, which is beneficial to the level of the authorities, the sustainable economic developments, the capabilities of resisting the potential financial risks and the protections of the interests of the consumers. We think the research findings in this paper embody great meanings for carrying out the scientific development thoughts and improving the socialism harmonious societies enterprises. The functional perspectives, the theory of objective regulation and the benefit-cost analysis of banking regulation are the three main reprehensive theories. However, the current 3 main theories about effective banking supervision all have some limits. The functional supervision theory and the aim-based supervision theory focused on the design of supervision structure (organizational structure), but the choice of supervision structure depend on the development of financial system, political and economic system and cultural tradition and many other factors, so the theoretical analysis can not provide common conclusions, and it's also difficult to realize these conclusions. As for the other theory—the cost-profit analysis of supervision, it's a good way to think about the problem, but as it's difficult to calculate the cost and benefit of supervision, this theory is not so operational. So this paper argues that to discuss the effectiveness of supervision system, it's necessary to analyze the mechanism design problem. And this paper uses the theory and analysis framework of information economics and institutional economics, suggests that the incentive compatibility of the stakeholders of supervision should be the cretieria of the effectiveness of supervision.In the Principle-Agent framework, the incentive problem is in fact the problem for the principle to design a mechanism to reduce the posibility that the agent might choose the way that against the aim of maximum interests under the asymetric information. The key point of incentive mechanism is, how the principle can make the agent behave according the aim of principle. Since 1980's, the incentive theory absorbed into the regulatory economics and there emerged a incentive regulation theory. This theory put the regulation problem under the principle-agent framework with asymetric information, its framework and analytical methods are very useful for the problem of effective banking supervision. Because financial transaction incluedes a complicate structure of explicit and implicit contracts between banks and consumers, banks and supervisors, supervisors and publics, so the supervision system can be seen as a series of implicit contracts between banks and supervisors and publics. So the relations among the subjects in the supervision structure can be seen as the principle-agent relations. There are two key incentive problems for the supervision system, one is how to design a more incentive compatable framework of supervision and make the banks to operate more prudencial, and the other is how to make the supervisors more effective. This thesis make two incentive models for the banking institution and the supervisor to analyze these two problems, and draw these conclusions: the main cause of the supervision failure is that the incentive distortion and incentive insufficiency under the serious asymetric information, this will cause the increasing of supervision cost and the welfare losses. So it's necessary to design incentive compatible supervision mechanism between the supervisors and financial institutions and between the supervisors and the publics to realize the effective supervision. The so called incentive compatible supervision mechanism is the mechanism which can make the principles and agents in the supervision structure have the same aims and make the same efforts to control the financial risks.The specific instruments of banking supervision can be divided to Preventive Regulation and Protetive Regulation. The key content of Preventive Regulation is capital regulation. As the basic framework of capital regulation for international banking system, the Basel Capital Accord emphasized that the capital regulation should depend on the combination of market mechanism and internal management, emphasized the importance of the intra-promotion of supervisors and banking institutions, so it reflected the principles of incentive compatibility. The PCA of banking capital regulation gave more autonomous rights to the banks on the risk management, also reflected the principles of incentive compatibility. So the evolution of capital regulation showed the trend of incentive compatible supervision in the field of preventive regulation. On the other hand, the deposit insurance system is a key componant of protective regulation, it played an important role to maintain the stability of financial system, but it has moral hazard problems. To reduce this moral hazard, it's necessary to design an incentive compatible mechanism. At the operational level, the risk-based fee rate of deposit inssurence, the market constraint instruments like partial deposit insurence and the MODIS all reflected the principles of incentive compatibility. o the evolution of deposit insurence system showed the trend of incentive compatible supervision in the field of protective regulation.The experiences of the governance of banking supervision reflected the principles of the incentives on the supervisor and provided useful implications for us. In the process of reforming the regulatory system, the UK government enforced the regulatory authority's incentives and obligations. The FSMA 2000 built a mechanism preventing the FSA abuse its power. The internal structure reflects the ideal of incentive rule. By employee discipline, clear regulatory criteria, strengthening internal control, effective performance evaluation methods, FSA's governance improves. One of the most feature of US regulatory system is its dependence on the healthy law system, which enhances the authority of the regulator on the one hand and raises the incentives of the regulator on the other hand. To keep the balance of the regulation, the quantity methods, and information openness are also characteristic of the US regulation. Of course, there is no one rule for all countries, while by the experiences of UK and US, we can conclude some principles of effective incentive methods, including the incentive rules for regulator, i.e., independence, liabilities, transparences and morals, the framework for incentive regulator, i.e. the arrangements of the authorities and the internal structure, the external situations for effective incentive regulator, i.e. the level of market economy, the governance of a country an the law system.Since the establishment of the CBRC, some principles of incentive compatible supervision has been shown in the process of the construction of of an effective supervision system in China. But in present day, the key problems which reduce the effectiveness of supervision system still exist, the problem of incentive incompatibility still not be resolved, the independency of supervisory institution hasn't achieved, the cost of supervision is still high, the moral hazard still undermined the efficiency of supervision system, and there is still no effective regulation for the supervisors. So it's necessary to construct an incentive compatible supervision system based on the current situation of China's banking supervision and the foreign experiences. Specifically, we should improve the incentive compatibility at 3 levels: the preventive regulation level, the protective regulation level and the internal regulation level. Firstly, it's necessary to realize the the incentive compatibility in the preventive regulation through introducing the differenciate regulaiton, and combining the regulation with the banks'internal management, increasing the function of market constraint. Secondly, it's necessary to realize the the incentive compatibility in the protective regulation through establishing sientific deposit insurence system, the lender of last Resort system and quiting system. And finally, it's necessary to realize the the incentive compatibility in the regulation operation mechanism through effective incentive-constraint mechanism, process-controling system, evaluation mechanism and the system of responsibility.