15 September 2016

IMF: Supervisory incentives in a banking union

This International Monetary Fund‘s (IMF) paper develops a simple model to analyze supervisory incentives and bank behavior. In the model, levered banks protected by limited liability invest in portfolios that are too risky from a social welfare perspective.

Local supervisors are tasked with the day to day job of monitoring banks and identifying which have risky portfolios and are poorly capitalized, but the regulatory actions associated with identifying such banks are under the control of a central supervisor who may have different objectives.

Authors first show that the threat of regulatory intervention provides discipline against moral hazard by causing some banks to adjust their investment decisions and choose safer portfolios than they would otherwise. In equilibrium, however, there will be banks (the least capitalized ones) for which moral hazard is stronger than regulatory discipline. These will not comply with regulatory standards and will instead stick with their preferred portfolios, even at the risk of being intervened and losing the returns from their investments.

In their framework, under centralization, the local supervisor’s incentives to collect information decrease relative to when she operates under full independence. The reason is that the information she collects might be used by the center to take actions that she dislikes.

This agency conflict can lead to less information being collected and, as a result, worse quality portfolios on aggregate despite the higher regulatory standards.

Their analysis highlights the benefits and challenges of “hub-and-spokes” regulatory frameworks, such as the newly established Single Supervisory Mechanism (SSM) in the eurozone.

Authors show that, to the extent that local agencies are perceived as softer than a central supervisor, centralization is likely to raise supervisory standards and deal with the perceived laxness and unwillingness to intervene that preceded the recent crisis. However, they also argue that, to the extent that the parties in charge of information collection and implementation continue to have different objectives, absent corrective mechanisms, the tougher standards may in fact lead to even greater risk taking and consequently an increased chance of systemic problems. Further, the agency problems at the source of this issue are larger the laxer the local supervisor. Hence, the problem may be the most severe exactly for those cases that could in principle benefit the most from centralized supervision.

The design of the SSM implicitly takes into account these risks. First, the ECB retains the right to take any bank in the eurozone under direct supervision. In their model, this would act as a threat to the local supervisor and increase its payoff from exerting effort. Second, the new design puts all locally systemic banks under direct ECB supervision. This likely minimizes the difference between the local and central supervisors’ utility functions. Indeed, banks that are locally systemic but not systemic for the eurozone as a whole are those for which views are most likely to differ. The fact that all euro level systemic banks also are under direct supervision has a similar effect, since these are the banks for which the externality from failure is likely to be valued differently by local and central supervisors. Third, internal governance practices such as having ECB employees heading on-site inspection teams and rotating staff of different nationality on these teams contributes to limit conflicts.

Full working paper

© International Monetary Fund