October 29, 2007
INCENTIVE CONFLICT IN CENTRAL-BANK RESPONSES TO SECTORAL *TURMOIL IN FINANCIAL HUB COUNTRIES
Edward J. Kane
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 funds—implicitly but
in large measure—to 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.
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
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.
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 firm‟s 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
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
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
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
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
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-
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
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”
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
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
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
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
II. Incentive Conflicts Built into National Regulatory Cultures