20 December 2012

Gersbach/Brunnermeier: True independence for the ECB - Triggering power; no more, no less

This column argues that the ECB's current role undermines its independence. What Europe needs is a new Restructuring Authority in which the ECB has the power to restructure banks as it sees fit, but under a system with two authorities, reducing undue forbearance.

A necessary step to reduce undue forbearance is to establish a workable resolution regime for financial institutions. Such a regime should follow common rules and be handled by a “Restructuring Authority”, separate from the ECB, using funds from industry and government to recapitalise banks when the system is endangered.

Operational separation between the ECB and the Restructuring Authority, however, is not sufficient in itself to ensure central bank independence because the Restructuring Authority may opt for undue forbearance.

A policy framework is needed that would reconcile the need to keep the ECB separate from bank-restructuring activities with its need to have a say in them. We propose a setting in which both the ECB and the Restructuring Authority:

(i) initiate bank restructuring on their own (that is, ‘triggering power’); and

(ii) have access to the relevant information about the financial status of the banks (that is, ‘information power’).

Besides triggering power, the ECB and the Restructuring Authority must have access to the same information about banks’ financial health because, otherwise, they cannot convincingly establish whether bank restructuring is needed (even if a violation of regulatory rules is proven). As banking supervision will be partially entrusted to the ECB, the ECB will have some triggering power and easier access to information. However, the policy framework outlined in this column does not depend on whether eurozone banking supervision will be shifted fully towards the ECB or not.

Once the restructuring of banks in financial distress has been initiated, the details of the restructuring plan would be left to the Restructuring Authority, following pre-established principles. The losses caused should first be borne by the shareholders, and then by the creditors. Viable parts of the bank should be sold and other parts restructured or closed. Affected banks could also be recapitalised. The necessary funds would be provided by the industry and the fiscal authorities funding the Restructuring Authority.

Allowing two authorities to initiate a bank restructuring process would yield two immediate benefits:

• Undue forbearance declines in a diarchic system (in which there are two authorities). For the ECB, there are incentives to trigger restructuring early, as inactivity may cause capital losses and higher inflation in the intermediate term. These, in turn, could harm the central bankers’ reputation and would threaten their independence. However, the ECB also faces difficult tradeoffs when deciding whether to trigger the restructuring of weak banks to whom, in the past, it has lent funds against collateral that might be of less value today. Thus, it would be essential to grant triggering power to two institutions instead of one.

• Granting the ECB the right to initiate the process would also motivate the Restructuring Authority to act, as it would certainly prefer to keep the initiative. The ECB’s reputation would suffer from being forced into action continuously. Ideally, the ECB’s threat to act would be sufficient to reduce undue forbearance from the Restructuring Authority. If, however, the ECB decides to act and requires a restructuring, it is important to make this single-handed move from the ECB public, but only with a delay (e.g. 6-12 months).

Overall, the authors expect such a diarchic organisation to strengthen the eurozone banking systems. It would also help ensure the ECB’s independence. Otherwise, the ECB would remain subservient to the fiscal authority (‘fiscal dominance’) and/or the financial industry (‘financial dominance’). The authors further expect this diarchic organisation to enhance the credibility of the ‘no-bailout principle’.

Of course, the coordination of these two institutions in the diarchy will be a central factor in assuring optimal functioning. In particular, it is important that the two decision-making bodies have the opportunity to undertake such coordination themselves, before one of them triggers restructuring.

Moreover, the capital providers’ rights should be protected. This can be achieved by decision-making rules in which votes are weighted according to the capital shares of Member States.

Full article

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