Donato Masciandaro

The ‘Draghi Law’ on Banking Evolution

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Donato Masciandaro

America24, 25 gennaio 2014, 23:45

Weak banks should be allowed to disappear, with benefits to financial stability and at no cost for citizens. This is the message that European Central Bank (ECB) President Mario Draghi sent yesterday. It is a bell tolling for bankers, on one hand, and politicians—national and European ones—on the other.

Yesterday, President Draghi returned to the the opportunity—as well as the duty—for fragile banks to exit the market, in the context of wider reflections on financial stability in Europe.

From the moment the Union decided to explicitly invest the ECB with the responsibility for banking supervision, the financial stability question assumed a strong relevance within our central bank, with absolutely unprecedented and peculiar consequences for its role, at least when one looks at the main industrialized nations’ central banks as a group.

In fact, beginning this year, the ECB will have to fulfill two very different tasks: as the monetary policy authority, it will have to continue seeking monetary stability; as the banking supervising authority, it will have to take care of financial stability.

How delicate the task is can be evinced by comparison with the American central bank, the Fed, which manages monetary policy with a dual mandate of protecting both monetary stability and growth, plus recently increased powers on banking supervision.

The plurality of goals makes the work of an American central banker—today Ben Bernanke, tomorrow Janet Yellen—easier: he/she can use a higher level of freedom to gain concrete personal advantages. In a way, the specific interests of politicians, or of regular bankers, are easier to satisfy, and in another it is easier to hide potential errors or omissions in the management of the different policies.

The work of the ECB will be harder than that required today of the Japanese central bank, Bank of Japan, which just like the ECB has inflation as a priority, but it is not heavily involved in supervision. The same can be said when thinking about the British central Bank, Bank of England, the recent return of which to the realm of full banking supervision responsibilities has in fact weakened the relevance of stability as the polar star of monetary policy.

Hence, Draghi’s mission is not so simple: how can he maintain the protection of monetary stability as a primary goal and at the same time also grant the protection of financial stability? The only way to achieve it is to act within the two policies with different timing and modalities in order to maximize the probability that actions in the two realms are synergic with each other or at least neutral, therefore reducing the risk of conflicts. To travel down such a road, the ECB wants to take the right first step—namely the reliability of banking budgets.

Reliable budgets are the indispensable bastion for having a healthy and regular functioning of banking and financial markets. Thus, by protecting the premises of financial stability at a corporate level, one ensures, at the same time, efficiency in the transmission mechanism of monetary policy, on which the effectiveness of the pursuit of monetary stability depends. One hand virtuously washes the other.

Yet, in order to obtain reliable banking budgets, at least two tools are necessary: transparency and resolution rules. The ECB president insisted that the main objective of the beginning of supervision functions is having maximum transparency in banking budgets. It is worth emphasizing that in order to avert systemic crises—or exit them once they occur—opacity and ambiguity in the risk level embedded in each bank’s portfolio must be avoided.

Scandinavian and Japanese lessons (respectively in a positive and a negative way) have taught us that everyone should be able to tell weak banks from strong ones, in terms, again, of budget reliability. I would not include in the “good” lessons column those coming from the United States, where the distinction between good and bad banks has been made by giving the rank of banks to intermediaries which previously were not, with all the relative risks of moral hazard, as well as of latent or postponed costs for the community.

But the distinction between “strong and weak” banks is only useful if weak banks can disappear without costs for taxpayers or the economic system as a whole. The great crisis was precisely this: the socialization of damages caused by an excess of banking deregulation, financed by an excess of liquidity. In order for weak banks to disappear there must be an effective set of structural regulations.

President Draghi reminded us of the importance of involving private entities—not to be mistaken with deposit holders—in the payment of costs for banking weakness (bail in), as well as of the mandatory role of the national banking resolution rules and, in a future perspective, European ones. The challenge for banking reliability can be won only if resolution rules are credible.

Draghi’s bell on weak banks’ mortality must be listened to, at least by two great actors in the financial scenario: bankers, who (especially the big ones) are used to thinking of themselves as immortal, for reasons of size or nationality, and, at the same time, politicians, who have the systematic temptation to use, or promise to use, the right defibrillators when a bank is about to, or should, die, as specific interests, either electoral or personal ones, are stronger then the general ones.

If, in the next few months, national, and European, politicians are not credible in terms of resolution rules, the mission of the ECB of conjugating in the best way possible monetary and banking policies will not be difficult. It will be mission impossible.

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