The cat-and-mouse between national governments and their banks

The basic elements of international rules aimed at preventing financial instability need to emerge from upcoming financial summits. The nature of these rules is an open question.

Designing a new financial order can be interpreted as a principal-agent problem. The principal – the politician – sets the rules and incentives but cannot observe the behaviour of the agents – the financial institutions – including their efforts and their options to avoid following the rules. As we know from principal-agent theory, it is a complicated task to write the rules.

Credible abolition of bailouts

In the long run, a bankruptcy procedure for financial institutions in which the national governments credibly commit themselves not to bail out their banks if the worst case comes should be introduced. An important element of such a rule is that, in the case of failure, the owners of the bank will lose their capital and its managers will be replaced by the regulator. Due to the pervasive impact of a bank failure on the banking system and on the general public, however, it would be extremely difficult to make such a no-bail-out rule credible.

Absent a credible rule, banks will expect future assistance. Then, today’s financial crisis will soon be forgotten and a cycle of pathological learning will start again. Thus, ten or twenty years from now, governments will be in the same position as they found themselves when the financial crisis erupted in 2008. In any case, central banks and governments should be aware that without such a credible no-bail-out rule, commercial banks will view governments’ massive injections of liquidity and immense fiscal rescue packages as part of a strategic game. In order to prevent such a cat-and-mouse game, governments must write a sustainable principle-agent contract. This problem will, of course, be aggravated if banks are partly owned by the government – such as Germany’s “state” banks, which experienced extraordinary losses in the crisis.

Completing insulating the banking system from the failure of an individual bank would of course solve this dilemma, but the interconnectedness of the banking system makes such a proposal incredibly difficult, if not impossible. Yet another solution would be national supervision so efficiently organised that financial crises are prevented and national governments never find themselves in an indefensible position vis-à-vis their banks. Historical experience suggests that this is hard to achieve.

The difficulty of international coordination

International spillovers are typical for the financial industry and in a financial crisis. Consequently, some international agreement on rules against financial instability is necessary. The credibility of national no-bail-out clauses depends on financial regulation being insulated from political pressures. For instance, international financial rules should aim to prevent bubbles arising from the fact that national rules allow “artificial financing” of over-spending (over-consumption; over-investment) or if a financial bubble has no basis in real savings (as was the case of the US housing market). A country’s no-bail-out rule has no credibility if it fails in its surveillance of its banking industry in order to temporarily reap higher benefits.

Supervisory cooperation within the International Stability Forum, similar to cooperation between competition authorities, might make national no-bail-out clauses more credible. Such cooperation is not a strong form of commitment, but greater measures are unlikely to be adopted. Proposals for countries to compensate others when their supervision failures result in crisis – the polluter-pays-principle for financial disruptions – are unlikely to happen (Siebert 2009). Countries are reluctant to cede sovereignty in such an important area. For similar reasons, it is improbable that countries could agree on some form of a dispute settlement mechanism resembling that of the WTO.

The IMF is equally ill-equipped to make a no-bail-out rule credible. Admittedly, this Bretton Woods institution represents an international forum where finance ministers and central bankers meet and where they can exchange views. It is also no question that the IMF can help those countries that experience balance of payments or currency problems as a consequence of financial crises. However, the IMF has no sanctions at its disposal to stop national banking systems from running into trouble.

To do so, the IMF would need strong sanctions against the financial “polluter”. Governments are unlikely to cede sovereignty in the area of prudential supervision, including concrete sanctions, to an international body like the IMF. Consequently, the IMF is not in a position to apply the polluter-pays-principle when a country starts a financial bubble that artificially leads to national over-consumption and over-investment. Another crucial aspect is that any bail out will have to be backed by national tax money; states are unwilling to cede sovereignty in this realm. Thus, the IMF cannot play the role of the world’s economy chief regulator.

Finally, the credibility of a no-bail-out clause would depend on the position of central banks. In the bonanza of national political rescue plans and the ensuing enthusiasm for anti-recession programs in the autumn of 2008, central banks must be on their guard that these activities do not erode their positions of independence, which were produced by past politics. It would indeed be a historic irony of rule-setting if the financial crisis would serve to politicise again the money-supply process.

The punch line is that national governments must do their utmost in order to improve the efficiency of their regulation. If nations fail in their supervision, governments will find themselves in the same situation as they did in the fall of 2008 – they will have no other option than to bail out their banks.

References

Siebert, H. (2009). Rules for the Global Economy. Princeton University Press: Princeton.