The best way to control risks is the market incentive to do so. For the market to work, there must be adequate information transparency, and an adequate pay (or penalty) structure that causes the private sector or market to regulate itself. For example, excessive bonuses may have caused the Barings management to overlook the risks assumed by Leeson. Low pay for internal auditors relative to dealers may prevent them from raising the alarm bell. Internal audit committees of financial institutions should signify that they have considered the implications for the risk preferences of key personnel of their pay structures. It is now better recognized that a robust financial infrastructure is also a form of regulator on market participant behaviour. Modern financial infrastructure, such as automated payment systems, impose on market participants certain minimum standards of performance, such as time compliance in payments. Failure of one participant to perform would immediately expose the participant to market discipline. There is therefore peer pressure on market participants to comply with the standards demanded by international payment systems. Costs of Regulation Regulation is not without costs. The US estimates that regulation costs the consumer roughly 7% of GDP annually, both directly or indirectly. Bank regulation can be likened to deposit insurance - the higher the regulation and safety, the higher the insurance premium. One theory suggests that banks can elect to be one of three categories: super-safe banks, safe or normal. Super-safe banks are only allowed to hold super-safe assets, but in return have 100% deposit insurance.
BIS Review 124/2007  1