Can the European Community Afford to Neglect the Need for More Accountable Safety-Net Management?

As financial institutions and markets transact more and more cross-border business, gaps and flaws in national safety nets become more consequential. Because citizens of host (home) countries may be made to pay for mistakes made in the home (host) country, Basel’s lead-regulator paradigm violates the principle of democratic accountability. Because important differences exist in policymaking authority, instruments, and goals, banking supervisors need to improve their ability to monitor and mitigate the consequences of defects in one another’s performance. A straightforward way to enhance both capacities would be to establish opportunities for public trading in debt obligations and reinsurance derivatives issued by country-level deposit-insurance entities. (JEL F36) Financial-institution supervision combines a capacity to observe fluctuations in balance-sheet values (Bvision’’) with a capacity to influence managerial actions (Bcontrol’’) and an incentive system that governs the pursuit and exercise of these capacities. Even when portfolios and attendant risks are concentrated within a single country, it is difficult to establish a combination of adequate oversight of institutional balance sheets, adequate authority to intervene in timely fashion, and bureaucratic incentives to detect and resolve insolvent institutions in ways that adequately protect taxpayer interests. As a result, individual countries solve this contracting problem in different ways. For this reason, sincere efforts to integrate the financial markets of individual countries must also integrate national safety nets. Safety nets are instruments for preventing and resolving financial crises. Crisis prevention and crisis management entail a right to take over insolvent financial institutions. Efforts to assess the viability of troubled institutions and to assign fair values to stakeholder claims against failing firms are rife with incentive conflict. As European institutions and markets book more and more cross-border business, the potential for conflict grows. This is because some or all of the bill for one country’s regulatory mistakes or gambles can be presented to citizens of other countries. Gaps in the jurisdiction of national regulators and supervisors can break the link between efforts to control bank and nonbank risk-taking and the allocation of losses that taxpayers might accrue in financial-institution failures. Atlantic Economic Journal (2006)34:127Y144 * IAES 2006 DOI: 10.1007/s11293-006-9000-7 *Boston CollegeVU.S.A. Presidential address presented at the Sixtieth International Atlantic Economic Conference, October 6Y9, 2005, New York, New York. This paper extends and refocuses analysis first presented in Kane (2003) and (2005). The author wishes to thank Richard C. Aspinwall, Bill Bergman, and Mark Flannery for helpful criticisms of an earlier draft.