Many people blame financial supervisors for their part in the credit crisis. Supervisors have failed to understand complex financial products, to spot excessive leverage and risk-taking, to predict the effect of incentive pay on the behavior of bank executives and to correctly assess the systemic risks of asset price bubbles. As a result, they haven’t fulfilled their public duty, which is to safeguard financial stability.
In their defense one can say that many others – in the financial press and in the academic community – have also been surprised by the timing and depth of the crisis, although it was not their primary job to spot the dangers. Calls for tighter regulation and supervision should therefore recognize that mistakes, ignorance and incompetence can never be completed eradicated. But the least we can try to do is to get the incentives right.
Ideally, financial supervisors should act as a restraining force towards the financial institutions they supervise. Yet in the European context, with its patchwork of national supervisors, supervisors have a strong incentive to stimulate financial growth, in order to defend and expand their supervisory territory. In the Netherlands, the central bank’s eagerness to allow financial institutions to grow and expand internationally has now created a major headache for the public purse. This headache results from a divergence between institutional self-interest and the public interest.
Public choice theory recognizes that public institutions, including financial supervisors, do not automatically act in the public interest. Instead, they may try to advance their own institutional self-interests by seeking an increase in the power, reputation, prestige or size of their bureaucracies. This human tendency explains why in the past European supervisors have been so reluctant to allow acquisitions of “their” banks by foreign players. After a foreign takeover, the consolidated supervision of the holding transfers to the foreign supervisor. The domestic supervisor is demoted to subcontractor. It also explains why supervisors support the creation of national financial champions and welcome their empire-building activities abroad. The larger their banks grow, the more difficult a foreign take-over will be and the likelier that supervision remains at home. Consolidated supervision of international financial conglomerates also adds power and prestige to supervisors and allows them to punch above their weight among peers.
Institutional self-interest clashes with the public interest for three reasons. First, the creation of national champions with large international operations may put the public finances at risk, when these institutions outgrow the size of their home country. This “Iceland” effect is by now well-known and applies to a number of European countries, including the Netherlands. The state’s risk exposure is stronger when banks attract foreign deposits through branches, which fall under the domestic deposit guarantee scheme. Second, the creation of national champions may reduce domestic competition in financial services. Third, national champions increase the risk of regulatory capture. Regulatory capture exists when a supervisor becomes too dependent on the supervised financial institution and starts identifying with and acting in the interest of the financial institution. As a result, the regulatory duties may be compromised.
Self-interested behavior by supervisors is more likely in countries where the home market is small and serviced by a few potential take-over candidates, whose transfer into foreign ownership would raise existential fears with the home supervisor. Developments in the Dutch financial sector fit the public choice perspective surprisingly well. Since the early 1990s Dutch financial institutions have been allowed to merge. This has led to the emergence of two financial conglomerates with sizable activities outside the Benelux countries: ING (through the merger of NMB, Postbank and Nationale Nederlanden) and ABN-AMRO. Both are based in the Netherlands, which makes the Dutch central bank responsible for consolidated supervision. The complex nature of these international financial institutions offers plenty of supervisory work, of a sort which is more challenging than supervising parochial savings banks.
The ABN-AMRO take-over by the Consortium in 2007 stripped the Dutch central bank of its consolidated supervision of ABN-AMRO’s Dutch, US, Brazilian and Italian activities. Prior to the take-over, central bank president Wellink advocated a merger between ING and ABN-AMRO. This alternative would have been in the central bank’s institutional self-interest. A merger between ING and ABN-AMRO would have kept Wellink in charge of supervising one of the largest global financial institutions, which would have been virtually impregnable to a foreign take-over. But would it have been in the public interest?
The answer is no. Right now, the Dutch authorities have their hands full coping with ING. If Wellink’s dream would have come true, the ING headache would have turned into an ING/ABN-AMRO nightmare, as the troubled assets of ABN-AMRO’s former US and wholesale activities would have been added to ING’s toxic portfolio. The Dutch taxpayer was extremely lucky that these assets have been sold off just in time to Bank of America and RBS and that Wellink’s vision failed.
Financial supervisors are not perfect. They make mistakes and will continue to do so. But the least the public may expect is that they act in the public interest, by keeping an eye on their country’s exposure to financial risk and by having a sound view on financial stability and what it implies for the make-up of the financial sector. In this regard Wellink has served his country poorly. The Dutch central bank has over the years supported policies aimed at increasing the size of Dutch financial institutions and has neglected the build-up of the state’s exposure to the branch activities of its international banks. How much faith can the Dutch public still have in a financial supervisor who believes that bigger is better?