23 November 2012

Eijffinger/Nijskens: Banking union and ambiguity - Dare to go further

This column argues that the ECB should exert 'constructive ambiguity' in its supervision. This strategy would lead banks to behave more safely on their own by holding more liquid reserves and having a higher capital ratio.

Constructive ambiguity

To establish an incentive-compatible supervisory and resolution system it is important that the ECB is sufficiently credible. This credibility facilitates building confidence in regulation and thus helps the ECB in carrying out its new supervisory task. It may be difficult to maintain this credibility if the ECB’s reputation is impaired by mistakes or spill overs from monetary policy.

The authors suggest a solution: the ECB should adhere to a policy of ‘constructive ambiguity’ ex ante. This can serve as a solution to forbearance. In a liquidity provision context (though this can also be applied to early intervention measures) constructive ambiguity means that the ECB can commit to a mixed strategy. Never bailing out is too costly and therefore not credible, while always bailing out leads to obvious moral hazard problems. This strategy leads banks to behave more safely on their own by holding more liquid reserves and having a higher capital ratio.

Why adhere to ambiguity?

Adhering to ambiguity gives the ECB the possibility to retain discretion until the moment that assistance is necessary, thereby providing banks with the incentive to behave prudently. To see how this works, consider two polar cases. If the ECB states that all banks will always be assisted, banks take too much risk. On the other hand, if the ECB announces it will never bail out any bank, banks become risk averse and relinquish their function of risk and maturity transformation. Therefore, by being ambiguous ex ante, the ECB can induce banks to take the appropriate amount of risk.

An important prerequisite for ambiguity is that the ECB has a sound reputation and is credible. As the ECB is an independent, reputable institution it is reasonable to assume that it is also credible; this means it is able to pursue constructive ambiguity. However, some caution has to be exerted. Too much uncertainty about assistance can lead to risk-averse behaviour, e.g. flight to safety, and can intensify panics. Careful expectations management is therefore needed, leading to a tradeoff between ambiguity and transparency. To make this ambiguity strategy democratically sound, the ECB should be accountable to the European Parliament.

Conclusions

The European Commision’s proposal assigns to the ECB the task of systemic bank supervision, and ultimately the responsibility for bank supervision in the whole eurozone. It also suggests new micro-prudential early intervention powers for the ECB.

Several components are missing from this picture. First, the ECB can never supervise all 6,000 banks in the Eurozone. Non-systemic banks should be supervised by national supervisors in a harmonised framework which is set up by the European Banking Authority. Second, supervision must be separated from monetary policy to avoid conflicts of interest. Furthermore, European-wide deposit insurance and resolution funds have to be created. This is an important political issue as many Member States, but mainly Germany, will not accept the ECB as supervisory authority while resolution is funded at the national level.

Will ambiguity be applied?

Finally and perhaps most importantly, how will the ECB assume its supervisory task? Will ambiguity be applied? Until now, Mario Draghi, president of the ECB, does the utmost to be as clear and transparent as possible, and no sign of ambiguity is to be seen in the liquidity domain. Perhaps this will change when the ECB is also responsible for supervision and is able to impose more conditionality on banks receiving assistance. Adhering to constructive ambiguity can then give banks the appropriate risk-taking incentives.

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