Academic journal article Atlantic Economic Journal

Can the European Community Afford to Neglect the Need for More Accountable Safety-Net Management?

Academic journal article Atlantic Economic Journal

Can the European Community Afford to Neglect the Need for More Accountable Safety-Net Management?

Article excerpt

Financial-institution supervision combines a capacity to observe fluctuations in balance-sheet values ("vision") with a capacity to influence managerial actions ("control") and an incentive system that governs the pursuit and exercise of these capacities. Even when portfolios and attendant risks are concentrated within a single country, it is difficult to establish a combination of adequate oversight of institutional balance sheets, adequate authority to intervene in timely fashion, and bureaucratic incentives to detect and resolve insolvent institutions in ways that adequately protect taxpayer interests. As a result, individual countries solve this contracting problem in different ways.

For this reason, sincere efforts to integrate the financial markets of individual countries must also integrate national safety nets. Safety nets are instruments for preventing and resolving financial crises. Crisis prevention and crisis management entail a right to take over insolvent financial institutions. Efforts to assess the viability of troubled institutions and to assign fair values to stakeholder claims against failing firms are rife with incentive conflict.

As European institutions and markets book more and more cross-border business, the potential for conflict grows. This is because some or all of the bill for one country's regulatory mistakes or gambles can be presented to citizens of other countries. Gaps in the jurisdiction of national regulators and supervisors can break the link between efforts to control bank and nonbank risk-taking and the allocation of losses that taxpayers might accrue in financial-institution failures.

To keep the discussion concrete, this paper focuses on potential cross-country abuse of nation-based systems of explicit deposit insurance. However, it should be understood that this is merely the tip of a global safety-net iceberg and that past abuses of the U.S. safety net have exploited accountability breakdowns that extend de facto forms of safety-net support for institutions and instruments that reach far beyond the limits of de jure coverages. The major problem of modern financial regulation is to restore economic logic to the de jure and de facto coverage of country safety nets. In the U.S., claims on banks that are not deposits and claims on institutions that are not banks (e.g., government-sponsored enterprises, mutual funds, and even hedge funds) have managed to extract de facto safety-net support.

The social norms on which the regulatory systems of European countries are built typically weaken regulators' capacity and incentives to intervene strongly and promptly at systemically important banks. Differences in these norms make the effort to coordinate vision, control, and incentives across countries an especially thorny problem. Cross-border activity expands opportunities for insolvent banks (and incentive-conflicted government officials) to hide losses and concentrations in risk exposure from supervisors in home and/or host countries. To lessen this danger, information-sharing arrangements between national regulatory bodies have been expanding as well, but unfortunately at a much slower pace [Dermine, 2003; G. Garcia and M. Nieto, 2005; Schoenmaker and Oosterloo, 2006; Schiller, 2003].

But being able to monitor bank risk exposures is only part of the cross-border coordination problem. Differences in regulatory authority, instruments, and goals must also be reconciled and imbedded into a cross-border architecture of democratic accountability. Cross-border accountability and emergency tax-collecting capacity mean that whoever manages a multinational safety net must be accountable to the taxpayers of whatever countries supply the risk capital safety-net managers can call upon to bail out insolvent institutions in catastrophic circumstances. Because nation-based regulators focus primarily on effects that fall on their own citizens, the costs of banking insolvency in one country could easily spill over onto the accounts of taxpayers in partner countries Wives, 2001]. …

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