12 banking standards – such as Basel Core Principles, BCPs - helps in limiting financial crises at the national level (see for example Demirgüç-Kunt, Detragiache and Tressel 2008; Demirgüç-Kunt and Detragiache 2011).

# **_Symptomatic treatment vs.  underlying incentive distortions_**

Most regulations of course affect incentives in one way or the other. Indeed, the recent regulatory reforms at the global level as well as those at the country level have included measures aimed at reducing the role of systemically important financial institutions, improving compensation policies, reducing the role of credit ratings, fill in various data and information gaps, all of which go some way towards addressing the weaknesses highlighted by the crisis (World Bank, 2012). But, as pointed out by Čihák, Demirgüç-Kunt, Martínez Pería, and Mohseni-Cheraghlou (2012) based on a detailed analysis of the World Bank’s bank regulation and supervision survey, the regulatory responses to the crisis at the individual country level have been slow and in most areas gradual at best. The crisis did not trigger a major change in national regulatory and supervisory frameworks. While some measures adopted in the crisis (such as improvements in resolution regimes in some countries) are encouraging, others (such as extension of blanket guarantees, and increase coverage of deposit insurance schemes) are likely to be less so. The survey results suggest that there is substantial room for further improving the regulatory and supervisory frameworks as well as private incentives to monitor risk-taking.

Addressing incentive problems with regulations has been far from trivial. For one, many regulations provide only a symptomatic treatment. For example, ceilings on credit growth have been used to slow down credit growth in some countries. This measure is aimed at the symptom—rapid credit growth—without addressing the underlying incentive issue, which is the incentive of commercial bank managers and shareholders to boost profits by rapidly expanding credit portfolio, without sufficient regard to risk. If regulations address the symptoms but not these underlying issues, the result may be just another, sometimes even more problematic issue. In many countries experimenting with credit ceilings, the result was a growth in unregulated activities. Hence, addressing one incentive issue by a new regulation often leads to creating incentive breakdowns elsewhere.

Another important argument for putting incentive issues front and center is that the regulation-based approach is reactive and tends to get overtaken by events. For example, at the global level, Basel II was created when the shortcomings in Basel I became apparent, and Basel III is being put in place after shortcomings in Basel II became apparent. Risk weights, which play a central role in these frameworks, should ideally change with the evolution of risks. For example, capital requirements should in principle take into account the codependence of financial institutions (see e.g. Acharya 2011). But these can change quite preventing, detecting, and paying for losses at financial institutions. Basel II forces signatory countries to reopen safety-net bargaining across affected sectors.