The Systemic Risk Board: A return to the EMS

By: Casper de Vries

The ECB watchers’ conference is an enjoyable yearly event where one can shoot from the hip at unfounded central bank speak and where academic paradigms find their demise in the monetary reality of the day. For many years the ECB’s two pillar strategy has gone down the academic drain, while the FED and its band of pseudo general equilibrium inflation targeters looked much better. But the credit crisis changed the roles. The ECB’s two pillars strategy with its information on money and credit is today credited for early warning of bubbles in the making. By contrast, both the FED and the Bank of England are scorned for having missed the asset inflation big time due to their focus on consumer inflation. 

 

Does this mean that the ECB this year come away unscathed? Not entirely, as the third leg that is being added to the ECB still feels quite uncomfortable. At this year’s conference Lucas Papademos, the vice president of the ECB, introduced just a tad too smoothly what may be called a smorgasbord of risk oversight. The problems for the newly created Systemic Risk Board are numerous.

 

To start with, governor Papademos quietly admitted that the ECB does not yet have a clear concept of systemic risk and is still searching for the proper instruments to tame the undefined beast. The ECB is to be commended for its openness on the issue and can be partially exonerated for its Rawlsian veil of ignorance. Institutions like the IMF are also groping in the dark. Nor did academia close ranks and provide a readymade definition of the concept of systemic risk, though many proposals are floating around. It is like the time before Celsius introduced his temperature scale.

 

Network externalities within a payment system imply that the stability of the system hinges on the stability of the majority of banks. The system is fragile, as it is as strong as its weakest banks. But why was Barings bank not systemically important, while Northern Rock, AIG and Lehman Brothers were? Is it the connectedness between different banks, where some fulfill a center role while others are just peripheral? Is it a signaling effect whereby some bank’s status is taken as a representative for the sector as a whole?

 

There is definitely a need for an operational definition of systemic risk. One such definition could be a natural extension of the individual bank’s Value at Risk measure to the system’s level. Alternatively, a measure that focuses on the weakest link principle would calculate the probability of failure of the worst capitalized bank. A measure like the number of expected bank failures, conditional on one bank failing, would bring the systemic interdependencies between banks to the fore. All such measures would rely on using multivariate extreme value theory to be able to calculate the unexpected, deep into the tail events. It would also be useful to have some indicators that signal a rise in systemic risk such as consumer price and asset inflation, monetary expansion, withering credit standards and exorbitant remuneration schemes. Finally, once it is clear what the definition of systemic risk is, instruments like capital requirements, dynamic provisioning, diversification, duration matching, liquidity and leverage ratios have to be devised to contain systemic risk

The second problem for the ECB is that if it were to serve the two goals, price stability and financial stability, the two goals may at times conflict. Which goal should receive priority? Arguably, in the long run sound monetary policy is the best guarantee for financial stability. For the ECB to be able to serve two masters, at least one other instrument next to the interest rate is required. For the same reason the goals may conflict, the instruments will also counteract. The trick is to identify an instrument that steers financial stability, but does never correlate perfectly negatively with the interest rate that steers price stability.

 

The biggest problem, though, is the fact that the board only has an advisory role to national supervisors and regulators. This setup goes back to the making of the Maastricht treaty: Thanks to intensive lobbying by local central bankers, who feared to become the proverbial firemen on the electrically powered British locomotives, the supervisory role originally allocated to the ECB was dropped. But as the crisis with Fortis has shown, memorandums of understanding between decentralized supervisors that should have sealed the mutual cooperation in a crisis situation, turned out to be the perfect pretext for inaction and miscommunication. We learned the hard way that there can be no European banking system without an EMU bailout budget, as no local finance minister is willing to pay for the problems next door. So perhaps indeed as long as we don’t have a union in the true meaning of the word, it is better that we don’t lift supervision of our national heroes to the EMU level.

 

So what should be the role of a Systemic Risk Board if it has no clear goal, no instruments and may only give advice? This is like an ECB that cannot set the interest rate, but has to advice national central banks on the interest rate that they should set. Pretty much a return to the days of the EMS it looks like. At the time local central banks were well advised to follow the lead of the Buba, but often acted otherwise. As national interests prevail in a crisis, the advice is likely not heeded when it is most needed.

 

The best thing the board can probably do is to collect information on the aggregate exposures of the banking system and disseminate this to the market. After all the only reason for having a financial sector is to bridge the information divide between investors and borrowers. At the same time asymmetric information is a problem in the financial sector that sometimes creates systemic risk. Providing information can at least help to partly overcome the divide. Perhaps the best the ECB could do, is to renounce its advisory role until it receives temporary budgetary powers and a clear ranking of the two goals. For the time being it seems best to concentrate on collecting and providing information. Then it is up to local central bankers and politicians to act or not to act.

 

Casper G. de Vries is professor at the Erasmus School of Economics, Erasmus University Rotterdam.

 

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