31 July 2011

Who Will Be Telling the Truth: Greece, the EFSB, or National Regulators?

Recently the EU set up the European Systemic Risk Board (ESRB). Ok, this is kind of old news (the enacting legislation went into effect in December 2010). Why am I writing about it now?

Well, just the other day EU leaders put together another rescue package that included guarantees and lose-sharing with banks (a partial default). In all of the discussion surrounding the future shape of a sustainable system of EU government financing (here or here for example) there has been little discussion of the need for good information about what is really going on.

In research I'm currently putting together (and mentioned in previous posts) I've found that in order for policymakers to actually choose the level of bank (and I suppose government debt) guarantees that they want they need good information about economic fundamentals (not a huge surprise). But there is a good chance that the ESRB won't be able to give good information. Or more precisely, any information they give will get confused.

Let me hypothesise: Conflicting information is often bad information. Regulators give conflicting information if they have conflicting preferences (see here).

The ESRB is going to be providing information about the health of the financial sector. Well, so are lots of others. There are numerous financial stability boards, regulators, etc. in Europe also providing information. All of these agencies are run by people who (likely) have different preferences from each other and from European decision-makers.

Lets make some assumptions:

  • European decision-makers (presidents, PM, chancellors, and the Commission) want a stable European financial sector at the lowest possible cost.

  • Some national regulators/stability boards, etc. want stable national financial sectors at the lowest possible cost to the country.

  • Other national regulators/stability boards, etc. want to provide accurate information regardless of the policy consequences.

  • Lets not make any assumptions about the ESRB's preferences right now.

Thinking about the Greek debt crisis example: National interest focused regulators want to maintain the stability of their country's banking sector. These regulators likely want to present their country in the best light possible: "our banks aren't that exposed to the Greek debt problem." Hopefully, they can reassure investors and depositors to continue putting money into their country's banks. Painting a rosy picture has the added benefit of making high European guarantees seem like a good idea to European decision-makers (we can regain market confidence by saying we'll cover everything, but the problem isn't too bad so we won't have to actually cover much of anything!).

Accurate information focused regulators will provide good information regardless of the market's and the European response.

Ok, so where am I going with this?

The problem for European decision-makers (like anyone in a signalling game) is to decide which is which. This can be pretty tricky since in reality most regulators likely will be a bit of both. Regulators may want to provide accurate information, but they also don't want to trigger crises by revealing how bad things are. This is probably true of any ESRB.

European decision-makers need good information to make the policy decisions they want. However, when there are many regulators, financial stability boards, and their own ESRB giving them information, all with their own preferences, who can they believe?

This is a key issue to resolve if the EU wants to create a sustainable financial architecture. I also need to think about it more. . .

21 July 2011

Fake Apple Store, Real Hysteria.

The NY Times website recently published a story about "The Rise of the Fake Apple Store".

Um, there are "fake" Apple Stores everywhere, including in the US. There is even a "fake" store up the street from my Dad's house in Erie, Pennsylvania.

The real story isn't "Asians are Slavishly Copying American Creativity", but "Local Entrepreneurs Meet Demand for Apple Retail Experience when Apple Doesn't".

Basically, even in places where Apple doesn't set up shop like Erie, PA, Kunming, and Seoul (which I know also has plenty of Apple Store-like stores) there is still a latent demand for well designed modern places to try and buy Apple products. Look-a-like stores are just filling this demand. Since (all the ones I've ever been to) sell actual Apple products what is the harm in this?

However, the comments on both the NY Times site and at Slate (where it is largely reprinted) have largely picked up the "Slavish Asians" reading and become kind of hysterical about Chinese counterfeiting.

The NY Times article, based largely on one blog post the reporter read, doesn't actually give any evidence that the products sold at the look-a-like stores, even in Kunming, are fake.

I just don't see how selling real Apple products at a store that looks like an Apple Store is a bad thing either for Apple or for consumers, especially when the consumers live in areas without Apple Stores.

Korean Lessons for the US, Part 2: Look the Other Way, It's for the Economy

In the previous post I pointed to some of the ways that financial regulators in Korea and the US have credibly committed to bad regulation by making themselves bad at collecting financial market information. But there were two unresolved issues I'll cover now:

  1. Why would regulators want weak regulation?

  2. How did Korea get out of this problem?

Answer 1: Sure, there are lots of reasons why regulators would want to have weak regulation. There are the usual stories about crony capitalism, revolving doors, etc. Sure, there probably is something to these theories. But there is also something less sinister, but more problematic going on:

loose regulation might be good for the general economy in the short-term.

In fact, this is how US regulators have been talking about the issue (for example see this great article from the FT). The basic argument is that enforcing tight capital adequacy requirements, lending standards, etc., makes less money and credit available to lend to businesses, people, etc. When businesses and people have less credit they spend less, economy tanks.

In 1997 Korea the regulators wanted to keep the economy moving along by having banks keep lending to already highly indebted industrial conglomerates (chaebol). They would presumable use the borrowed money to keep building new factories and employing more people.

In present day America the regulators want basically the same thing.

This is where credibly committing to bad regulation comes in. If a country has tough regulations on the books--like the US's Dodd-Frank--or it looks like they could be new laws, banks might begin to slow down their lending. This is what the regulations require them to do. But if regulators can credible demonstrate that they won't be able to gather enough information to enforce the regulations, then banks can feel safe lending at the same rate.

Sure, crony capitalism is a bad reason for weak regulation, but is a desire to keep the economy moving along also bad? I guess for tomorrow it's not that bad. So, why not have weak regulation all the time? Why do we need to go through this dance of credibly committing to weak regulation? Well, the expansion of credit (more and more loans) isn't always a good thing, especially when it is unlikely to be be paid back (this is part of why regulations were created in the first place). Regulations should prevent bubbles.

The problem gets worse if banks don't have enough savings to cover the bad debts. As we've recently seen, these problems tend to snowball, and it is typically the government (and the public's money) that end up covering the bad debts (for more nuance on government responses see this book by Guillermo Rosas).

Is it bad or good to weaken regulation by credibly committing to not have enough information to actually regulate? Over the long run, it seems pretty bad.

How can we get regulators, who may not even have their jobs over the long-run, especially if the economy stays bad, to break their credible commitments to bad regulation?

This gets to the second question.

Answer 2: In Korea the IMF came in and forced them to change. Hm, I don't know how practical this lesson is for the US. What are the odds that the US will have to implement IMF loan conditions any time soon?

19 July 2011

Korean Lessons for the US, Part 1: Credibly Committing to Bad Regulation

It's always a good day when you notice your PhD research overlapping with what's going on in the news. PhD research might actually matter!

This happened to me when I was listening to a recent Fresh Air interview with NY Times reporter Louise Story about why the United States has prosecuted so few people involved in the financial crisis. A couple points caught my attention:

  • Regulatory agencies, especially the SEC, are understaffed. (not really news to most people interested in this stuff)
  • Since 2008 the Justice Department has officially allowed financial companies to defer prosecutions if they conduct their own investigation into alleged wrongdoing. (that's more like it)
  • The combined effect of understaffing and essentially outsourcing investigations to financial companies is that regulators are:

    • Losing the capacity to do their own investigations of financial institutions
    • Not going to even be able to critically evaluate the investigations given to them by the companies they are regulating.

She lists a number of other reasons for lax regulatory enforcement, but these points caught my attention. They reminded me of the 1997 Korean situation. (I'm shovelling through the Korea-end of a comparison of financial crisis in Korea and Ireland with Mícheál O'Keefe at the LSE.) In particular it reminded me of an argument we're trying to make regarding regulator capacity and information.

Long-story-short: if the financial sector is unhealthy (lots of non-performing loans, etc), but a regulator doesn't want regulations tightened they can obscure the information they give to policymakers. Put another way, making the economy seem good makes people feel like there is no need to impose new regulations.

I guess regulators could just lie about the state of the financial sector. But this has its problems, like being called to testify at a congressional investigation about why you lied. There is also the problem of credible commitments.

Question: How can you ensure that information remains bad overtime and in a way that is credibly signalled to financial markets?

Answer: make the regulator unable to collect good information. (I'll come back to this point in the next post.)

In pre-1997 Crisis Korea the Ministry of Finance and the Economy (the ministry of finance and financial regulator wrapped up in one) was able to do this through a complex web of understaffed regulatory departments (for background see a 2002 paper by Jin Wook Choi). Louise Story's reporting indicates some ways that US regulators can credibly commit to bad information and therefore weak regulation.

I'm sure you're all wondering about two unresolved questions. Why would a financial regulator prefer weak regulation and how did Korea solve this problem?

Well, I'll give my answers to these questions in the next post.