31 July 2011

Who Will Be Telling the Truth: Greece, the EFSB, or National Regulators?

Recently the EU set up the European Systemic Risk Board (ESRB). Ok, this is kind of old news (the enacting legislation went into effect in December 2010). Why am I writing about it now?

Well, just the other day EU leaders put together another rescue package that included guarantees and lose-sharing with banks (a partial default). In all of the discussion surrounding the future shape of a sustainable system of EU government financing (here or here for example) there has been little discussion of the need for good information about what is really going on.

In research I'm currently putting together (and mentioned in previous posts) I've found that in order for policymakers to actually choose the level of bank (and I suppose government debt) guarantees that they want they need good information about economic fundamentals (not a huge surprise). But there is a good chance that the ESRB won't be able to give good information. Or more precisely, any information they give will get confused.

Let me hypothesise: Conflicting information is often bad information. Regulators give conflicting information if they have conflicting preferences (see here).

The ESRB is going to be providing information about the health of the financial sector. Well, so are lots of others. There are numerous financial stability boards, regulators, etc. in Europe also providing information. All of these agencies are run by people who (likely) have different preferences from each other and from European decision-makers.

Lets make some assumptions:

  • European decision-makers (presidents, PM, chancellors, and the Commission) want a stable European financial sector at the lowest possible cost.

  • Some national regulators/stability boards, etc. want stable national financial sectors at the lowest possible cost to the country.

  • Other national regulators/stability boards, etc. want to provide accurate information regardless of the policy consequences.

  • Lets not make any assumptions about the ESRB's preferences right now.

Thinking about the Greek debt crisis example: National interest focused regulators want to maintain the stability of their country's banking sector. These regulators likely want to present their country in the best light possible: "our banks aren't that exposed to the Greek debt problem." Hopefully, they can reassure investors and depositors to continue putting money into their country's banks. Painting a rosy picture has the added benefit of making high European guarantees seem like a good idea to European decision-makers (we can regain market confidence by saying we'll cover everything, but the problem isn't too bad so we won't have to actually cover much of anything!).

Accurate information focused regulators will provide good information regardless of the market's and the European response.

Ok, so where am I going with this?

The problem for European decision-makers (like anyone in a signalling game) is to decide which is which. This can be pretty tricky since in reality most regulators likely will be a bit of both. Regulators may want to provide accurate information, but they also don't want to trigger crises by revealing how bad things are. This is probably true of any ESRB.

European decision-makers need good information to make the policy decisions they want. However, when there are many regulators, financial stability boards, and their own ESRB giving them information, all with their own preferences, who can they believe?

This is a key issue to resolve if the EU wants to create a sustainable financial architecture. I also need to think about it more. . .

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