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GAPS IN THE FABRIC ______ NATIONAL SAFETY NETS

By Valerie Lawrence,2014-05-13 20:40
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GAPS IN THE FABRIC ______ NATIONAL SAFETY NETS

    October 29, 2007

    INCENTIVE CONFLICT IN CENTRAL-BANK RESPONSES TO SECTORAL *TURMOIL IN FINANCIAL HUB COUNTRIES

    Edward J. Kane

    Boston College

    ABSTRACT

     National safety nets are imbedded in country-specific regulatory cultures that

    encompass contradictory goals of nationalistic welfare maximization, merciful treatment

    of distressed institutions, and bureaucratic blame avoidance. Focusing on this goal

    conflict, this paper develops two hypotheses. First, in times of financial-sector stress,

    political pressure is bound to increase the incentive force of the second and third goals at

    the expense of the first. Second, gaps and distortions in cross-country connections

    between national safety nets require improvisational responses from de facto hegemonic

    regulators. Reinforced by reputational concerns, the hegemons‟ goal conflicts dispose

    them to react to cross-country evidence of incipient financial-institution insolvencies in short-sighted ways. During the commercial-paper and interbank turmoil of summer 2007,

    de facto hegemons used repurchase agreements to transfer taxpayer fundsimplicitly but

    in large measureto several of the particular institutions whose imprudence in

    originating, pricing, and securitizing poorly underwritten loans led to the turmoil in the

    first place. The precedent established by these transfers promises to exacerbate the depth,

    breadth, and duration of future instances of financial-institution insolvency by confirming

    that institutions that underinvest in due diligence can expect taxpayers to protect them

    from much of the adverse consequences.

     * The author wishes to thank Ramon P. DeGennaro, Robert A. Eisenbeis, Richard Herring, James Moser,

    and James Thomson for comments that greatly improved the paper.

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    INCENTIVE CONFLICT IN CENTRAL-BANK RESPONSES TO SECTORAL

    TURMOIL IN FINANCIAL HUB COUNTRIES

    Political concern for the safety of a particular enterprise or economic sector increases both with its clout and with the extent to which its failure might generate

    negative externalities that harm voters and so-called “innocent parties” that cannot

    directly influence the tradeoffs its managers make. Implicitly or explicitly, most

    governments maintain a safety net for banks and selected other firms. This net combines

    measures that restrict the risky positions that protected institutions assume in the first

    place with measures that limit the damage that customers, employees, creditors, and

    stockholders suffer when and if disaster ensues. Managers of protected institutions may

    be likened to a team of high-wire artists. They deliberately throw themselves into risky

    positions and, when things turn out badly, a messy multiparty disaster can ensue.

    Section I of the paper identifies the conceptual components of a national safety net and describes the incomplete ways that the nets of financial-center countries are joined

    today. Section II introduces the idea that national regulatory cultures exist and embrace

    conflicting norms. Section III develops the hypothesis that financial turmoil alters the

    preference ordering that regulatory cultures assign to conflicting regulatory norms. In

    times of turmoil, the incentive force exercised by norms that foster truth-telling and

    accountability for efficient and distributionally defensible loss control declines sharply,

    while the influence of competing nationalistic and blame-minimization norms intensifies.

    For the leaders of the hegemonic global regulatory community (especially the Fed and

    the European Central Bank), the absence of an established procedure for sharing losses

    that might be imbedded in the accounts of large multinational institutions increases the

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    depth of their exposure to a personal and bureaucratic reputational disaster. To reduce this exposure, policymakers in these countries can use central-bank lending to shift some of the worrisome losses to national taxpayers by directly and indirectly subsidizing

    troubled financial markets and institutions that lie within their purview whenever it

    appears that financial-institution insolvencies may be widespread. Officials‟ reputational

    concerns and limited policy options combine to create a disposition to over-react to

    multinational financial stress (such as that observed during the 2007 subprime turmoil). In the US, this disposition implies that having a corporate subsidiary with primary-dealer status opens a channel through which a few deeply troubled foreign conglomerates and

    domestic nonbanks can plan to extract substantial subsidies by engaging in repurchase

    agreements with the Fed.

    Current market turmoil may be attributed to the market‟s simultaneous

    reassessment and repricing of the downside risks inherent in securitization vehicles that outsourced the due-diligence phase of the underwriting process to credit-scoring models

    and credit-rating organizations. For example, trading in the riskiest slice of the ABX

    index of bonds backed by home loans made in the second half of 2006 slid to a new low

    of 18 cents by late October, while the TABX index (which proxies the assets underlying

    collateralized debt obligations) has also continued to slide.

    The reassessment and repricing clogged the pipeline of unfinished securitizations, particularly for institutions and conduits that originated or packaged the riskiest loans or securitization structures. In addition, the repricing undermined the solvency of highly leveraged institutions (such as structured investment vehicles) that had routinely short-funded a risky portfolio.

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    Although using central-bank resources to relieve insolvency-driven shortages of liquidity at troubled institutions keeps markets running more smoothly in the short run, it

    generates adverse long-run consequences by allowing institutions to reap rewards in

    proportion to the imprudence they showed in originating, pricing, and securitizing poorly

    underwritten loans. Accommodating their needs threatens to exacerbate the depth,

    breadth, and duration of future instances of financial-institution insolvency by

    encouraging these and other institutions to underinvest in due diligence in the future.

    Section IV explains that, to offset short-run pressure on central banks to give troubled

    institutions a break, it is important to require officials to follow market-mimicking

    procedures in curing so-called liquidity shortages and to justify and account explicitly for

    the value and distribution of the subsidies their last-resort lending generates.

    I. Understanding National Safety Nets and How Weakly They are Linked

    Financial stability is often defined by contraposition: as the absence of widespread liquidity and solvency crises. An enterprise experiences a liquidity crisis

    when it finds it difficult and/or inordinately expensive to refinance its debt or to meet

    other obligations as they come due. A liquidity squeeze is usually rooted in an

    overleveraged balance sheet or an unsupportable business plan. In other cases, lending

    institutions should be able to recognize a firms legitimate credit needs. However, when

    financial institutions in a given nation or region undergo serious liquidity crises of their

    own, their ability to support the liquidity needs of viable customers can be temporarily

    disrupted.

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The desirability of preventing the dissolution of fundamentally healthy firms creates a

    logical case for the existence of private or governmental lenders of last resort (Thornton,

    1802; Bagehot, 1873).

    A troubled firm falls into insolvency when the discounted value of its

    accumulated and projected losses exceeds its capacity to absorb these losses. For an

    individual nation, a corporate insolvency crisis amounts to a tsunami of individual-firm

    red ink. A financial tsunami occurs when losses passed into the accounts of at least one

    systemically important financial-services firm or sector overwhelm its enterprise-

    contributed capital and are perceived to be spilling rapidly into the balance sheets of

    various counterparties. The crisis is propagated by the political and economic efforts of

    potential loss-bearers to shift their contractual exposure to the tidal wave of losses onto

    less-wary parties, especially ordinary taxpayers.

     A nation‟s financial safety net has three goals: (1) avoiding liquidity and

    insolvency crises; (2) identifying and alleviating temporary liquidity shortages (i.e.,

    “disorderly markets”); and (3) mitigating the effects of both isolated and widespread

    insolvencies when they surface. The fabric of the net combines arrangements intended to

    detect and contain developing financial-institution problems with politically feasible

    arrangements for absorbing and distributing losses protected institutions might incur.

    This paper argues that, whereas national safety nets in hub countries may be likened to a

    relatively sturdy nylon mesh, the fabric connecting these nets is tissue-thin. For safety-

    net managers, the cross-country tissue fails to establish global accountability for the

    knock-on economic effects of the policies they follow. Without such accountability,

    national authorities are free to maximize a myopic and self-determined welfare function

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that they need not worry about revealing or defending ex post. Given so much discretion,

    global safety-net support is unlikely to be allocated in distributionally defensible or cost-

    effective ways either within or across nations (cf. Todd, 2002).

    Systemic risk concerns the chance of a system breakdown or devolution.

    Breakdowns may come from damage that spreads contagiously from one part of a

    network to another or from the disintegration of one or more network connections.

    Within a country, systemic risk expresses the danger is that a wave of insolvencies will

    suddenly interfere with payments and credit flows between regions and major institutions.

    In a global context, systemic risk is the risk that losses embodied in one nation‟s wave of

    insolvencies will batter firms and households located on foreign financial shores. By

    expanding opportunities for transferring local risks across countries at low cost,

    globalization helps to reduce the concentration of idiosyncratic risks in individual nations.

    But at the same time, intrafirm and hub-and-spoke linkages between the financial-

    services firms and markets of individual nations provide opaque channels through which

    the destructive energy unleashed by one country‟s liquidity shortage or insolvency crisis and its speed of transmission to other countries might actually be amplified.

    Regulatory lags in adapting to cross-country securitization has left the tissue

    connecting national safety nets dangerously thin. National markets for interbank loans

    and financing customer needs are integrating faster through intrafirm and hub-and-spoke

    linkages than arrangements for mitigating the consequences of cross-country shocks. By

    default, responsibility for managing global crisis pressures falls upon a handful of

    incentive-conflicted national regulatory institutions and cross-country lenders of last

    resort. To understand how these pivotal institutions might interact in different kinds of

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global crises, one must recognize that inconsistent constraints and incentives are built

    into the norms that govern the political and regulatory cultures within which their

    managers operate.

    Components of National Nets

    Modern finance theory emphasizes that financial-institution customers and safety-

    net managers must control incentives for opportunistic behavior by financial-institution

    managers, owners, and borrowers (Jensen and Meckling, 1976; Diamond, 1984; La Porta,

    Lopez-de-Silanes, Shleifer, and Vishny, 1998). Managerial opportunism has three

    intertwined roots:

    1. Monitoring costs: difficulties outsiders face in obtaining reliable information

    about unfavorable developments and observing adverse actions by institution

    managers, including recklessness, negligence, incompetence, fraud, and self-

    dealing;

    2. Policing costs: difficulties outsiders face in adequately analyzing and

    responding to whatever information its monitoring activity uncovers;

    3. Coordination costs: difficulties customers and national safety-net managers

    face in coordinating collective action.

    Safety nets centralize the functions of monitoring, analyzing, and responding to

    evidence about institutional performance. Ideally, this outsourcing of due diligence helps

    financial institutions to maintain customer confidence by solving three coordination

    problems: avoiding redundant monitoring expense; standardizing contracting protocols;

    and timing and calibrating disciplinary action. When its incentives are aligned with

    society‟s needs, a conscientious monitor-enforcer will make it unprofitable for

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institutions to misrepresent their economic condition to customers and to pursue profit-

    making opportunities that unfairly exploit their informational advantages.

    Viewed as a bureaucratic structure, a safety net has three components: (1) financial-

    institution regulators and monitors; (2) lenders of last resort; and (3) regimes for

    financing safety-net activities and allocating the losses imbedded in insolvent enterprises.

    This architecture is supported by a social contract whose counterparties are major sectors

    of a nation‟s political, regulatory, and economic communities. In principle, the contract

    has three segments:

    1. Subcontracts that define and assign supervisory responsibilities for preventing

    and resolving disruptive financial-institution insolvencies;

    2. Subcontracts that define a range of tax-transfer techniques for financing this

    supervisory activity and whatever losses it fails to prevent;

    3. Subcontracts that dictate the political and economic incentives under which

    such safety-net operators discharge their responsibilities.

    Tissue Connecting National Nets in Open Economies

    Regulators in hub countries are well aware of the need to stretch the span of their

    safety nets to match the span of the markets and institutions under their purview.

    However, they lack the authority to tax or compensate foreign entities directly as global

    stability might require. The connections forged to date focus mainly on guarding against

    crises in good times and hardly at all on how to deal with crises when they occur

    (Eisenbeis and Kaufman, 2005).

    Two world-spanning portfolio institutions were established in 1944 at Bretton

    Woods: the International Monetary Fund (IMF) and the World Bank. Unlike the “Fund”

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which can operate somewhat like a bank, the “Bank” operates as a fund that cannot

    provide timely crisis assistance. The European Central Bank (ECB) is an important and

    more recent regional portfolio institution. Its monetary-policy activities span the markets

    of Euro-area countries.

    National safety nets are also linked by a series of less-comprehensive international

    financial organizations. These bridging organizations are of two types: (1) portfolio

    institutions to which member countries have contributed funds that their managers invest in particular kinds of assets and (2) intergovernmental and self-regulatory forums for

    coordination (such as the Financial Stability Forum and Financial Stability Institute) that serve primarily to debate, evaluate, and secure agreement on rules and standards for

    overseeing cross-border business in a club-like atmosphere.

    At least six worldwide coordinating forums deserve mention: the World Trade

    Organization (WTO), the Bank for International Settlements (BIS), the International

    Organization of Securities Commissions (IOSCO), the International Association of

    Insurance Supervisors (IAIS), and the International Association of Swaps Dealers

    (IASD).

    Functioning within the BIS, the Basel Committee on Banking Supervision (BCBS)

    leads the way in formulating cross-country standards for banks. Regionally, the

    European Commission develops economic policy guidelines for European Union (EU)

    countries. These last two forums have developed the principle that primary responsibility

    for the solvency of multinational financial conglomerates lies with home-country

    regulators.

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    Arguably, only the BIS, the ECB, and the IMF establish financial and regulatory

    tissue that meaningfully connects the supervisory activities and fiscal resources that

    constitute financial nets in different countries. These three institutions seek to persuade

    individual countries to identify and adopt improved safety-net arrangements. However,

    only the ECB can truly create money and is able to react promptly enough to assist

    troubled institutions and markets when they fall into distress.

    Because none of these institutions has the authority to levy taxes at will, their

    managers cannot overtly allocate losses in crisis circumstances. Whatever subsidized

    crisis assistance these entities can supply must flow through some form of last-resort

    lending.

    This paper makes three points:

    1. The global net enlarges the web of multiparty contractual duties and

    obligations facing managers of national nets. The links concern the

    deployment of implicit government guarantees and subsidized lender-of-

    last-resort credit facilities.

    2. Central-bank repurchase agreements have evolved into a particularly

    opaque substitute for discount-window lending.

    3. The absence of a global tax-transfer mechanism for resolving the

    insolvency of multinational conglomerates is apt to call forth an

    inflationary oversupply of subsidized last-resort lending from central banks

    in financial hub countries when substantial multinational shocks first

    emerge.

    II. Incentive Conflicts Built into National Regulatory Cultures

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