The ECB's Reason for the Irish Taxpayer Footing the Bill is Wrong!

Lorenzo Bini-Smaghi, a member of the executive board of the European Central Bank, wrote a column in the Financial Times in which he argued that Irish taxpayers should not complain about being required to foot the bill for the Irish banking crisis.

In making his argument, he reveals that the ECB prefers to selectively adhere to the FDR Framework that has been the foundation for the global financial markets for the last 75+ years.

Please recall that under the FDR Framework, financial markets combine the philosophy of disclosure with the principle of caveat emptor [buyer beware].

• It is the responsibility of the government and its regulators to be ensure that all useful, relevant information is made accessible to all market participants in an appropriate, timely manner.  

• It is the responsibility of the market participants, including the regulators, to do their homework as they know that it is buyer beware when they make an investment or guarantee deposits.

Mr. Bini-Smaghi observes

...In the years before the crisis several countries, like Ireland and the UK, took decisions aimed at ensuring a more benign environment for their financial sectors. These included favourable taxation for banks, and less stringent self-regulation, rather than thorough inspections and reports.

In short, the regulators in these countries committed two sins under the FDR Framework.  First, they acted as gatekeepers that prevented access to all the useful, relevant information on their banks.  Second, they did not do their homework using this information and therefore misrepresented to other market participants what this information would have shown was going on.  This misrepresentation distorted the capital allocation decisions of the other market participants.

He then observes that

As a result, their banks grew larger and more profitable, increasing leverage and lending to risky sectors such as real estate.

... In principle, the costs of restructuring these banks should mainly be passed on to shareholders and managers, and thus subsequently on to bondholders. 

Mr. Bini-Smaghi describes exactly how the costs of restructuring are handled under the FDR Framework.  100% of the time the costs of restructuring are borne first by the shareholders and then by the unsecured bondholders.  With access to all the useful, relevant information, investors accept these losses as a potential outcome of making an investment and do not expect to be bailed out.

Under the FDR Framework, taxpayers should never have more than minimum involvement in absorbing losses from the failure of a bank.  Unlike other investors, governments cannot easily sell their investment - the deposit guarantee - as the risk of the bank changes.  The way a government "sells" its investment is by resolving the bank.  It is up to the regulators to protect the taxpayer and step in and resolve the bank before the loss absorbing capacity of the shareholders and unsecured bondholders is exhausted.

However, Mr. Bini-Smaghi would like to make an exception and selectively move away from how losses are borne under the FDR Framework.

Only in a systemic crisis should taxpayers be involved. The question is, how should we judge if a crisis is truly systemic, and therefore whether taxpayers should rightly bear some of the costs of resolving the situation?

... [When] discretion is exercised at the national level in applying common EU regulations, and also when implementing prudential supervision. The taxpayers’ incentive to vote for a tougher, hands-on approach is also weakened if their bank’s liabilities are held abroad, and therefore the burden of adjustment can be shifted to non-residents.

If the decision on whether a crisis is systemic or not is in the hands of the authorities of the country where the troubled banks are located, their authorities will have an incentive to underestimate the systemic dimension of the crisis, and thus shift the burden to other European taxpayers.  

However, those other countries will rightly consider that, as long as supervision remains national and accountable to the taxpayers of the country with indebted banks, those taxpayers should, in the first instance, assume responsibility for any failures.

Mr. Bini-Smaghi thinks the home nation's taxpayers should absorb the losses ahead of non-home nation investors because it was the failure of the home nation's regulators to prevent these losses in the first place or to provide the useful, relevant information so that investors could have avoided investing in these banks and incurring losses.

His argument conveniently leaves out the fact that no-one forced the investors to invest in the failing banks.  They invested despite the fact that they did not have access to all the useful, relevant information.  They invested despite the fact that the home nation regulators announced a more hands off policy.  They invested knowing that it is a buyer beware market and they would have to absorb any losses on their investment.

... One way to reduce the burden on taxpayers arising from these perverse incentives is to minimise the degree of discretion enjoyed by national regulators. 

Ultimately this would mean the integration of independent prudential supervision at the European, or at least euro area, level – to match the way burdens are shared when a systemic crisis strikes. 

Such a move may seem politically unpalatable, as taxpayers around the eurozone fear having to bail out the banks in other countries. But these taxpayers would at least have the assurance that banks in different countries would henceforth be subject to uniform and independent supervision, and that there would be no incentive to tolerate excessive risk-taking by individual nations. 

Actually, there is a better solution that does not have perverse incentives, that does not force taxpayers around the eurozone to bail out the banks in other countries and would not require integration of the prudential supervision function in each country.

The better solution is to enforce every aspect of the FDR Framework.

What this would mean is that each country's banking regulators would have to give up their monopoly on all the useful, relevant information.  By making this information accessible to all market participants in an appropriate, timely manner, no longer would capital allocation be distorted by the inability of market participants, including the regulators in other countries, to properly analyze the risk of an investment in a bank, structured finance security or country.

It would also mean that investors absorb losses again.

Recent events have shown that, as long as the accountability of supervisors to taxpayers is primarily a national affair, and discretion in the implementation of national financial regulations and supervision is allowed, then there is a high risk that taxpayers will foot most of the bill. They should not complain when it actually happens.

What recent events have shown is that regulators are willing to set aside how losses are absorbed under the FDR Framework based global financial system and instead stick the taxpayer with the bill.  This is the ultimate in privatizing the gains and socializing the losses.