Compliance Moral Hazard and the Backfiring Mandate

A new paper from Johns Hopkins and University of Chicago researchers tackles a critical problem in financial compliance: how competing banks can effectively share information about risky customers without undermining each other's incentives. The authors identify three key frictions that distinguish this setting: compliance moral hazard (where banks shirk due diligence if they can free-ride on others' reports), adversarial adaptation (where criminals adjust to evade detection), and information destruction through intervention (where taking action on a tip destroys the evidence).

To solve this, they develop the Temporal Value Assignment (TVA) mechanism, which uses a strictly proper scoring rule on discounted verified outcomes to reward truthful reporting. In simulations using a synthetic AML benchmark, TVA achieves substantially higher welfare than either autarky (no sharing) or mandated sharing without proper incentive design. Crucially, the paper shows that poorly designed mandates can actually reduce welfare below autarky, a 'backfiring' result with direct implications for financial regulators and policymakers.