Centralization of financial regulation

A Public Choice Analysis for the European Union

Seminar Paper 2010 52 Pages

Economics - Monetary theory and policy


I. Table of Contents

II. List of abbreviations and definitions

III. List of figures

IV. List of tables

1. Introduction

2. Financial Regulation
2.1. Kinds of regulation
2.2. Regulatory competition
2.3. Thedilemmaofregulation
2.4. The role of regulation in the recent financial crisis
2.4.1. Regulation, incentives and amplifying effects
2.5. Consolidation
2.5.1. Regulatory approaches
2.5.2. International comparison

3. Centralizing regulation and supervision in Europe
3.1. EU institutions and positions
3.1.1. Subsidiarity in the EU treaties
3.1.2. Interests for centralization
3.1.3. Reform Proposals for the EU
3.2. Public Choice Analysis
3.2.1. Policy uniformity
3.2.2. Leviathan
3.2.3. Lobbying
3.2.4. Policy learning
3.2.5. Complementarities
3.2.6. Decision making
3.3. TheroleoftheECandthe ECB

4. The Council, Voters opinion and the risk of over-regulation
4.1. The Council and the political decision-making process
4.1.1. Decision making on EU level
4.1.2. Description ofdata
4.1.3. Application to EU Council decision-making
4. 2. Voter Irrationality and the risk of over-regulation

5. Conclusion

V. Bibliography

VI. Appendix

II. List ofabbreviations and definitions

illustration not visible in this excerpt

III. List offigures

Figure 1 - Interests of actors in EU decision-making processes

Figure 2 - Proposed Structure for EU regulation and supervision

Figure 3 - Country Specifity, Transaction costs and organizational structure

Figure 4 - Decision-making costs vs. external costs for different majority thresholds

Figure 5 - Agenda-setting power of EC bolsters centralization

IV. List oftables

Table 1 - International comparison of regulatory approaches

Table 2 - Structured approach to assess benefits of centralization

Table 3 - Results of Council decision using different Assessment Bases

Figures and tables in Appendix:


Table 4: Current studies on the effects of decentralization (p.34 -36)

Table 5: Overview of variables for the 27 EU Countries - Highest and lowest highlighted (p.37-38)

Table 6: Voting rights in EU Council (p.39)

Table 7: Calculation of Council decisions due to the three majority criteria (p.40)


Figure 6: Geographical overview ofpreferences for European or National level (p.41) Figure 7: Geographical overview ofpreferences for supervision or transparency (p.42)

1. Introduction

Financial regulation has played an unfavorable role in the financial crisis. Many reform proposals conclude from its failure that there is a need for more and tougher rules (Group30 2009). Consolidating existing regulatory bodies and a centralization of authorities seem to be the ubiquitous answer of many politicians1. In the European Union (EU), a reform proposal has gained support by the European parliament (EP) and the European Commission (EC), which would mean additional competences and staff for European bureaucracies. Because it would centralize large parts of regulation and supervision, political arguments focus on the allocation of competences and power2. However, it is not sure if the proposed changes would have any effect in preventing future crises.

The structure of this paper follows a systematic approach to demonstrate problems with this proposal. At first, I show in chapter 2 that the role of regulation and governments in the financial crisis is ambiguous. What is viewed as market failure was sometimes only a rational response to incentives set by regulation. It is often stated that markets did not work efficiently, and the obvious solution is to rely on governments and regulators to fix the problems. I check if international comparison provides support for consolidating regulatory bodies. In Chapter 3, I assess in detail the proposed EU reform that focuses on establishing new bureaucracies and implementing more rules. I will use a structured Public Choice approach to evaluate the reform proposal and assess special interests of involved political parties. Chapter 4 examines the role of the EU Council and voter preferences. Considerable power in the EU decision-making process rests with parties that support centralization and more regulation. With various approaches, it is tried to shed light on the position of the Council as the representation of member states. While European institutions might embrace additional power and competences, rational voters in the member states should oppose harmful, excessive regulation and centralization. However, a detailed analysis of government and voter preferences reveals that both are likely to have biased preferences in favor of too much regulation.

Decentralization and political competition might be the only way to prevent overregulation, which will constraint future growth. With this in mind, the obvious solution of more regulation, relying on bureaucracies and omnipotent governments, seems less advantageous. Moral hazard problems and misleading incentives, and inefficient capital requirements could be the real problem, not the quantity of market rules. Transparency and public disclosure of information might be superior to relying on some "competent authority"3 that single-handedly prevents future crises.

Reforms should be judged by their efficiency; they should neither follow the interest of the banking lobby, nor exploit voter ignorance to expand political power and influence.

2. Financial Regulation

Regulation and supervision has been at the heart of criticism after the recent financial and economic crisis. Several reform proposals have been made to "avoid" the next crises, which mostly focus on international cooperation and expanding the influence and power of regulatory agencies (Group30 2009; The De Larosière Group 2009). Slow progress with reforms is often blamed on the strong influence of the banking lobby, political self-interest or the international unwillingness to cooperate4. Thus, as all these problems involve collective decision-making, they can only be fully understood by adding a public choice perspective (Gadinis 2008). Developing optimal ideas of future regulation will not make much sense if political summits fail to implement the ideas. Disregarding the political level of the discussion will make unhelpful, but popular new regulations more probable.

In this chapter, I start with shortly outlining the role and types of regulation. I will structure and evaluate arguments concerning the desirability of competing systems, and try to exemplify what I call the dilemma of regulation. It is not possible to construct a perfect regulatory framework, and very often well-meant attempts can cause adverse effects. This can be seen in the ambiguous role of politics and regulation played in the financial crisis. A comparison of national systems with one or multiple regulatory bodies suggests that besides the discussion about centralization and fusion of supervisory bodies, organizational structure has only a minor influence on efficiency.

2. 1. Kinds of regulation

Financial regulation can be broadly divided into safety-and-soundness regulation and compliance. Safety-and-soundness regulation's fundamental purpose is to protect fixed-amount creditors from losing their funds, and to provide stability within the financial system. This is of central interest for this paper. Compliance regulation should protect individuals from unfair treatment and misleading advice5. A compliance issue in the crisis was "misstating and omitting key facts about a financial product tied to subprime mortgages"6 through Goldman Sachs. They have been sued by the US Government and private investors for this potentially criminal act. However, this is mainly a topic for criminologist and lawyers. When I use the term regulation, it encompasses the setting of rules and their supervision. Where necessary I will further discriminate between both. Instead of going into excessive details of single regulations, I rather try to portray the big picture.

2.2. Regulatory competition

Whereas for instance in the area of accounting significant international harmonization has been achieved, "countries financial laws remain characteristically heterogeneous" (Gadinis 2008, p.449). Sinn (2003a; 2003b) has repeatedly brought up arguments against this kind of policy competition. He argues that governments have imposed regulation to correct market failures due to asymmetric information and limited liability. This regulati]on has positive international policy externalities. "Systems competition" might however re-instate the initial market failure and lead to a race-to-the- bottom. However, empirical studies show that international competition can also trigger a "race-to- the-top" (Vaubel 2008a), and that there is a positive effect of policy competition on innovation (Bernholz and Vaubel 2004). Consequently, others have rejected Sinn's claims, and expressed a more positive view (Baltensperger 2003). I will treat benefits of centralization and consolidation in more detail later.

2.3. The dilemma of regulation

It is very easy for an economist to identify a problem, describe its causes and conclude that regulation should fix it. However, in the real life it seems like this is not the full story. Politicians and interest groups can try to misuse regulation to extract rents (Brennan and Buchanan 1984). This can lead to excessive and harmful regulation. There are other caveats of more and centralized regulation. As with all government failure, the problem is not primarily that regulators are either incompetent or lack knowledge. However, they have to work in an area of contradictory and conflicting interests. Stigler implied that "...as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefits" (Stigler 1971, p.3). Yandle concluded that regulation is often required ".as protection from competition, from technological change, and from losses that threaten profits and jobs" (Yandle 1983, p.13). Political representatives often push for exceptions for certain branches or companies that are situated in their constituency7. This does not imply that regulation is always a bad thing, but it does add additional complexity.

Problems with this regulatory capture have been classified in three categories: Interest group theories, Tollbooth theories and Principal-Agent Theories (Boehm 2007). Interest group theories focus on the influence of lobby groups on regulators and the costs of rent seeking activities, with a passive role of public agents. Tollbooth theories point to the possibility of public agents actively extracting rents from regulated industries through bribes and campaign contributions. Asymmetric information is the core of Principal-Agent theories. The fact that "firms have private information that is hard for citizens or their representatives to obtain" (Bó 2006) is indeed an issue that is hard to overcome.

Even if regulators only pursue the public interest, regulation can only be static while company behavior is dynamic.8 A reason for failing regulation is that the regulated circumvent it by changing their behavior. Offsetting behavior will counter the intended effects of regulation (Peltzman 2010). The "Peltzman effect" describes people reacting to a safety regulation by increasing other risky behavior. It is in the nature of markets to find a way to implement the most efficient solution. If this is to avoid regulation, it is often called regulatory arbitrage9. A popular answer has been to implement more and stricter rules. Regarding financial regulation, the public expectation for new regulation is no less than to prevent the next crisis. However, can governments and regulation really be expected to help?

2.4. The role of regulation in the recent financial crisis

2.4.1. Regulation, incentives and amplifying effects

Subjectivism cannot completely be avoided in an analysis of the financial crisis, and it is impossible to incorporate all aspects. Hellwig (2009) provides a coherent analysis ofthe crisis. The main points I want to outline are the adverse effects of often well-meant, but economically unsound policies and rules. U.S. policy, mostly through government-sponsored enterprises (GSE) like Freddie Mac and Fannie Mae, encouraged the provision of long-term variable-interest loans to certain groups9 10. Long before the crisis, studies concluded that "there is an inherent conflict between the GSE's status (...) and the government mission they are expected to perform" (Wallison and Ely 2000, p.6). While the risk of the massive expansion of these GSE's has not gone unnoticed11, the measure to spread mortgage risk worldwide was widely accepted in both academics and politics12. Even in the retrospective, "in principle, the securitization of such risks should be regarded as a good idea" (Hellwig 2009, p.134). This is why once the U.S. mortgage holders started to default, losses occurred at banks worldwide. There were three main factors in the run-up to the crisis I want to highlight.

The first is that politics interfered in the housing market and created an unstable equilibrium in the mortgage market. In the end, markets proved the impossibility of providing mortgages to people who cannot afford them. The second is, that it was a reaction to the U.S. Standards& Loans crisis in the 1980s that regulators and academics pushed for allowing commercial banks to invest in riskier assets, including MBS (Brumbaugh Jr and Litan 1989). While the actual effect of a "too-big-too- fail"-bank going bankrupt are debatable, the fear of it has prompted politicians and central banks to rescue these banks. The prospect to be bailed out provides wrong incentives for banks and leads to adverse effects. Obviously, if there is a reduced risk of going bankrupt, the tendency to endeavor in risky behavior increases. Overall, it does at least increase the number of banks that will be difficult to liquidate.

The third factor is that capital requirements were too low, too complicated and misleading (Vaubel 2010). The risk-adjusted capital requirements in Basel guidelines allowed banks to under­capitalize using regulatory gaps (Hellwig 2010). Market actors did rely on models using ratings and backward-looking data that were providing a misleading sense of security. Regulation encouraged and set incentives to buy MBS securities13. Not only were low-income households taking on unsustainable loans, but also the government quasi-guarantee lured private investors in the market14. Regulators and Supervisors failed to prevent banks from exploiting regulatory gaps. Once U.S. mortgage holders started to default, losses occurred at banks worldwide. Resolving Fannie Mae and Freddie Mac will costs U.S. taxpayers up to $400 billion, more than for all other failed American banks together. Misleading incentives or error rather than limited liability of managers and "sheer greed" of bankers are the most obvious reasons ( Hellwig 2009; Vaubel 2009).

In addition to these factors, several amplifying effects played a role in augmenting the crisis (not in causing it). Market participants took part in deals that they knew to be unsound, because markets closely resembled what Keynes had called a "beauty contest"15. "Irrational exuberance", "animal spirits" and "behavioral cascades" contributed to the widespread panic in the markets (Akerlof and Shiller 2010; Gintis 2009). The Interbank lending market collapsed because of newly introduced uncertainty in the market. Amplifying effects of the crisis can be seen as market failure. 2. 5. Consolidation

2.5.1. Regulatoryapproaches

Among the most common themes in reform proposals is the wish for consolidation in the "alphabet soup"16 of regulatory agencies. It is obvious that a lack of consolidation was at least not the only reason for failed regulation. (Fresh and Baily 2009) have structured regulatory approaches in three categories. The Integrated approach involves a single regulator overseeing all financial institutions and providing all kind of regulation. If safety-and-soundness and compliance regulation are separate it can be referred to as the Twin Peak approach. The Functional approach implies that institutions are supervised based on type of business. Challenges lie in the coordination between the functional regulators. Under the Institutional approach, the legal status of an institution defines its supervisor. It is less flexible, as institutions can seek regulatory arbitrage through changing their legal status and picking their most convenient regulator.

2.5.2. Internationalcomparison

illustration not visible in this excerpt

Table 1 - International comparison of regulatory approaches

Table 1 provides an overview of differences between international regulatory approaches17.

It is not the purpose of this table to explore in depth country characteristics, but to extract the relevant conclusions. It can be seen that regulatory systems vary broadly across nations, but there seems to be a trend towards the Twin Peak or Integrated approach. However, there seems to be no clear pattern for a preferred, "first-best", regulatory approach. Two countries that have mastered the crises quite successfully, and often ascribe that to their regulatory structure, are Canada and Australia. Both broadly adopted a Twin Peak approach. However, this is where the similarities stop.

The Canadian system has strong role for the federal states, although this is otherwise often blamed for inefficient regulatory competition. The Australian system is strongly based on principle- based regulation, which focuses more on outcomes than on rules. This involves intensive dialogue between regulators and regulated institutions, which on the other hand could be criticized as opening a gateway for lobbyists. The Australian example seems to favor principle-based regulation18. However, the UK had implemented this approach some years before the crisis, and was among the countries most severely affected. The overview suggests that there is not a single best regulatory approach. If countries adopt a Twin Peak or integrated approach seems not to affect regulatory outcomes as much as sound principles and effective coordination. It is possible that the same problems continue to exist with an Integrated or Twin-peak approach, only now within on organization instead of between different institutions. The functional and institutional approach might be problematic when business changes their field of business or their legal form quickly.

France has relied on a more functional approach, with three authorities responsible for different business types and a large role the Central Bank. The country was among the ones most severely hit by the crisis.

Empirically, a comparison of regulatory structures in 150 countries by Barth, Caprio, and Levine (2006) concludes that private monitoring is most important for supervision efficiency. Very often, blind faith into regulators is not justified more than waiting in "till angels govern". It fails to find a relation between regulatory structures or power of supervisors and the performance of the banking system. On the contrary, more government monitoring seems to "crowd out" (more efficient) private monitoring, because it leads to a false sense of security. In many cases, corruption, lobbyism and incompetency undermine even the most sophisticated regulatory approaches.

3. Centralizing regulation and supervision in Europe

Chapter II has highlighted the shortcomings and role of regulation in the crisis. Different regulatory approaches in various countries have not been clearly related to country performance in the crisis. Nonetheless, consolidation, merging existing agencies and introducing more rules are often viewed as the best solution to prevent future crises and are part of reform proposals for the EU. Subsequently, I will examine reform proposals and evaluate them using a structured framework. It considers the role of Subsidiarity, varying interests and decision-making rules.

3.1. EU institutions and positions

3.1.1. Subsidiarity in the EU treaties

Subsidiarity has always been a guiding principle for the European Union. The Single European Act (1986) stated, "The central authority should only act (...), if it achieves targets better than national governments would" (Ischia 2004, p.68). Since the Treaty on European Union (Maastricht 1993), it is officially established in European Law. The Treaty of Lisbon (2009) allows national parliaments to force the EC to review proposals, if they are considered incompatible with Subsidiarity. The official glossary of the European Union states that "decisions are taken as closely as possible to the citizen and that constant checks are made as to whether action at Community level is justified in the light of the possibilities available at national, regional or local level. (,..)"19 The actual enforcement of Subsidiarity is more complicated. On several issues, the EC has used loopholes in the treaties to centralize and enhance its influence (Ischia 2004). The preamble of the Lisbon treaty does mention "the process of creating an ever closer union (...) in accordance with the principle of Subsidiarity". However, Subsidiarity is not complementary to an "ever closer union". On the contrary, it implies a detailed cost-benefit analysis before centralizing any individual policy field.

3.1.2. Interests for centralization

Sometimes it is assumed that the primary objectives for European and National governments and bureaucracies are to expand their power. This is too simple. Other motives also have to be regarded in this framework. Figure 1 shows the most important institutions regarding centralization in Europe.

illustration not visible in this excerpt

Group I consists of the EC, the EP, and the EU Court. They all clearly support further centralization. The commission20 regards itself as the "guardian of the treaties", the parliament mainly consists of convinced Europeans, and the EU Court is often called an "engine of integration". Vaubel (2008; 1996) has shown that constitutional courts have an interest and play a significant role in enhancing centralization within a country. None of this does imply that these institutions do merely want to increase their power. People could also really be convinced that centralization is the right way to overcome problems. Through self-selection, these people are more likely to work in these institutions. Group II are the EU Council, National and State/local parliaments. They have a clear interest in preserving their competences. National Constitutional Courts have often (unsuccessfully) ruled against centralizing legislation. The incentives for group III, the National and State/local governments are ambiguous. While they are likely to want to preserve their status, the delegation of unpleasant tasks to the EU has more than once been an easy way to avoid voters' displeasure (Vaubel 2006; 1994). Whether a decision is made by real conviction or to increase power is not clearly distinguishable. The aims to help the public interest and the wish for an "ever-closer" EU often go along. Nonetheless, even good motives do not guarantee good results.

3.1.3. Reform Proposals for the EU

One of the most prominent reform proposals was the G30 project on financial reform chaired by Paul A. Volcker (Group30 2009). The proposal focuses on additional, consolidated supervision, more regulation, the central bank supervising financial stability, the independence of regulatory institutions, and somehow a better international coordination. The proposals exhibit wide skepticism about markets; the unfortunate role of the U.S. government, the FED, and Freddie Mac and Fannie Mae on the other hand is only shortly mentioned. A similar report focused on the EU has been prepared by the so-called "High level group", chaired by Jacques de Larosière21. It does not further analyze the causes for government failure. The role of international trade imbalances and artificially low central bank rates is mentioned, merging of commercial and investment banks has made the world "a more complex" (The De Larosière Group (DLG) 2009, p.62) place. The actual reform proposals consist mainly of more, stricter and consolidated regulation. Interestingly, it does explicitly highlight the EU interest for raising rival's costs. "The EU has a clear interest in promoting worldwide consistency of regulatory standards towards the high level benchmarks" (DLG 2009, p.60).

illustration not visible in this excerpt

Anyhow, the report does mention the need for better information exchange, and a way to handle and a possible liquidation of distressed banks. In rare honesty, it admits that, "it is inevitable that there will be failures (in regulation) from time to time" (DLG 2009, p.39). This does not stop the proposal from mainly relying on regulators to anticipate and prevent future crises. At the core of the proposal are two reforms: At first, "the Financial Stability Forum (FSF), (...), is put in charge of promoting the convergence of international financial regulation to the highest level benchmarks" (DLG 2009, p.61). Secondly, a European System of Financial Supervision (ESFS) and a European Systemic Risk Council (ESRC) should be installed in two stages.

illustration not visible in this excerpt

Figure 2 - Proposed Structure for EU regulation and supervision, compare (The De Larosière Group 2009, p.57)

At the key of the target structure is a new committee to oversee the "systemic-effects" of regulation, the ESRC. It cooperates with three new authorities: a European Banking Authority (EBA), a European Insurance Authority (EIA) and a European Securities Authority (ESA). These authorities are extensions of three existing committees. The three authorities "should be managed by (,..)the chairs of the nationalsupervisory authorities. The chairpersons and director generals (...) should be full-time independent professionals (...) (author note: "appointed") by the EC, the EP and the Council (...) for a period of 8 years "(DLG 2009, p.55). The most important additional competencies are legally binding mediation between national supervisors; the adoption of binding supervisory standards, and licensing and supervision of specific EU-wide institutions (e.g. Credit Rating Agencies). The role of national authorities would mainly diminish to executing central orders and being "responsible for the day-to-day supervision of firms" (DLG 2009, p.56).

The main effect of the ESRC is that the ECB would officially add financial stability to its targets. In addition, the role of the EC would increase the political influence on regulation. The French system was described earlier. It is strange that its structure closely resembles the proposed one. The performance of the French system in the crisis was not particularly outstanding. However, the European Commission has mainly welcomed the propositions.22, major changes are the proposed names of authorities23. The EC proposes the ESRC to be established through Article 95 of the EC Treaty. Voting rights in this board (simple majority voting) would be given to "the Governors of national central banks; the President and the vice-President of the ECB; a Member of the EC; the Chairpersons of the three European Supervisory Authorities". The Board can supposedly act against the interest of individual member states, as these" may not always coincide with (...) maintaining financial stability in the European Union as a whole." Two consultation rounds with involved parties have highlighted worries about the allocation of power in the proposal24. The new institution shall "take the measures necessary for the protection of the confidential nature of the warnings" which would lead to less instead of more openness.

The EP has further added strict supervision and regulation of private sector remuneration systems to the EC propositions25, including data about individual managers' salaries. This would shift considerable power and influence to the MEP's. Throughout the text, most difficult actions are delegated to "competent authorities". Why these authorities should have superior knowledge to other market participants is spared together with other complicated details.26 The main representative organ of the member states on this issue is the Economic and Financial Affairs Council (ECOFIN). In its statement it signals, "Agreement on the substance", so that the new authorities "can be operational from 1 January 2011"27. The authorities would receive power to ensure "harmonized rules" and a "common regulatory culture". In general, the Council gives priority to enhancing cooperation opposed to new central authorities28.

3. 2. PublicChoiceAnalysis

The proposals would mean a considerable shift of power and competencies from the member states to the EU. Common sense suggests that banks that operate on a European or worldwide scale should be supervised through a worldwide authority. Common rules should ensure a level playing field for all competitors. It has been shown that very often, the unintended effects of rules countervail against the (well-meant) intended effects. In the economic literature, centralizing political power was at first treated by the "First-Generation Theory of Fiscal Federalism" (Oates 2005, p.350). It was mainly concerned with the "assignment of functions to the different levels of government" (Oates 2005, p.352); maintaining the assumption of a benevolent government. The role of economists was mainly to determine market failures and let government agencies fix the failures. Public Choice literature brought the most important extension to this field by including the possibility of government failure (Frey 2009; Tullock 1967; Buchanan and Tullock 1962). The approach improved the consistency in economic analysis by assuming that all individuals maximize their own utility. Goals of public agents have be modeled as maximizing the size of their budget (Niskanen 1971), maximizing revenues that the public sector extracts from the economy (Brennan and Buchanan 1980), the chance of (re-) election (Artés and Viňuela 2007; Dreher and Vaubel 2004jSeabright 1996), and higher salaries and bigger staff (Vaubel 2006; Vaubel 1996).

Misperceptions about political processes do exist in both the public and parts of economics.

Not including Public Choice aspects will always lead to an incomplete analysis of any subject that involves collective decision-making. In the following, I rely on a framework by Ederveen, Gelauff, and Pelkmans (2008a), to provide a structured analysis of the problem of centralizing regulation. Table 2 provides a broad overview of the revised framework.

illustration not visible in this excerpt

Table 2 - Structured approach to assess benefits of centralization

3.2.1. Policy uniformity

Preference matching

Even if governments maximize the welfare of their constituencies, problems with centralization can arise. A central government will most likely pursue a uniform policy in all jurisdictions, as it is politically very difficult to provide different amounts of a public good in different locations (Oates 2005). If information is costly, the local governments will have superior information of local circumstances. De Tocqueville wrote that centralized "legislation cannot adapt itself to the exigencies and the customs of the population, which is a great cause of trouble and misery" (Tocqueville 1863, p.163). Oates' (1972) de-centralization theorem states, that decentralization can always increase welfare if differences in preferences exist.

Preferences about financial regulation vary strongly across European Countries. Survey results that I show in more detail later confirm these. Problems occur for rules and supervision. The Basel requirements are an example for the attempt to establish common regulation. Differing preferences and conflicts are exemplified by the discussion between largely equity-dependent American companies and European companies that rely more on debt. A common (worldwide) supervision would in addition significantly suffer from information constraints. The sheer amount of computing and intellectual capacity required is enormous. While common rules could still rely on the market to process information, supervision requires an agency to solely cope with that. Overwhelming evidence indicates the superiority of groups and markets over central agencies in decision-making (Surowiecki 2004).


Policy decisions of one state can lead to positive or negative externalities in other states. By forming bigger groups or through centralization, the internalization of externalities is theoretically possible. Central government can try to compensate or penalize local governments to achieve a pareto- superior outcome (Oates 2005). A regulation level that is too low in one country may cause external effects in other countries. Failing banks in one country might damage the reputation of banks everywhere. Therefore, it is one target of regulators to maintain market confidence.29 Common regulation like Basel II can cause external effects. If one bank suffers credit losses and losses part of their equity capital, it is forced to reduce lending, including lending to other banks. This partly caused the process that led to the breakdown of the interbank lending-market. Very often advocates of centralization merely point to the costs of externalities and assume that the problem will be solved. However, the practical implementation always lags behind the theoretical optimum. Assessing externalities and implementing correction measures is always extremely difficult and not necessarily better than the original result.


1 http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//TEXT+REPORT+A7-2010-0205+0+DOC+XML+V0//EN

2 http://www.euractiv.de/finanzplatz-europa/artikel/klinz-fdp-staaten-mssen-scheinheiligkeit-aufgeben-003336,


3 http://www.europarl.europa.eu/news/expert/infopress_page/042-77983-186-07-28-907-20100706IPR77978-05-07-2010- 2010-false/default_de.htm

4 http://www.spiegel.de/wirtschaft/unternehmen/0,1518,658139,00.html

5 http://www.econlib.org/library/Enc/FinancialRegulation.html

6 http://www.sec.gov/news/press/2010/2010-59.htm

7 E.g. Companies with especially high energy consumption have been exempted from the European Union Emission Trading Scheme - http://de.wikipedia.org/wiki/EU-Emissionshandel

8 http://jagouldworld.blogspot.com/2010/03/allan-meltzer-market-failure-or_18.html

9 Goldman Sachs plans already how to circumvent new regulation before its implementation, http://ftalphaville.ft.com/blog/2010/08/02/303751/overcoming-the-volcker-rule-with-etfs/

10 "(,..)to support the housing industry!...)on of its solutions was to encourage the use of new types of mortgage instruments. They (US government) have revised their charter and operate to increase the availability and affordability of homeownership for low- moderate- and middle-income homebuyers (Fabozzi 2001, p.6)

11 "The lower interest rates (...) permit them to out-compete any private-sector rival and dominate any market. (...) their dominance of the mortgage market grows ever greater (Wallison and Ely 2000, p.2-3)

12Support for example "Our results are quite intuitive and demonstrate the benefits of geographic diversification" (Calem and La Cour-Little 2004, p.671), "We conclude that geographic diversification is an important mortgage portfolio objective (Corgel and Gay 1987, p.256), also (Mueller and Ziering 1992), (Ogden, Rangan, and Stanley 1989)

13 1984 the government passed the Secondary Mortgage Market Enhancement Act (SMMEA) to improve marketability of MBS, The Financial Institutions Reform, Recovery and Enforcement Act 1989 (FIRREA) encouraged loan origination, TheTax Reform Act 1986 allowed the creation tax-free special purpose vehicles.

14 " If you are tired of of trying to outguess the stock market, consider MBS with their high yields and above average safety" Your Finances, 75 A.B.A. J. 108 (1989) Mortgage-Backed Securities; Dunnan, Nancy

15 On a meeting with investment bankers from Lehmann Brothers that I attended, they remarked that they would participate in the MPTS trading as long as everyone else does so, because there seems to still be money to earn.

16 http://www.finreg21.com/lombard-street/spelling-regulatory-reform-restructuring-our-alphabet-soup-financial- regulators 7 http://www.finreg21.com/lombard-street/what-does-international-experience-tell-us-about-regulatory-consolidation

18 http://www.treasury.qld.gov.au/office/knowledge/docs/financial-accountability-handbook/1-3-principles-based- legislation.pdf http://europa.eu/scadplus/glossary/subsidiarity_en.htm

20 It should be remembered that the commission are not only 27 commissioners, but also the associated bureaucracy consisting of about 20.000 EU public agents. http://ec.europa.eu/economy_finance/publications/publication14527_en.pdf http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=C0M:2009:0252:FIN:EN:HTML

23 http://ec.europa.eu/internal_market/finances/committees/index_en.htm

24 http://ec.europa.eu/internal_market/consultations/docs/2009/fin_supervision/summary_en.pdf; http://ec.europa.eu/internal_market/consultations/docs/2009/fin_supervision_may/replies_su mmary_en.pdf

25 http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//TEXT+REP0RT+A7-2010-0205+0+D0C+XML+V0//EN

26 An important amendment is that a "delegation of power (...) may be revoked at any time by the European Parliament or by the Council".

27 http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/115787.pdf

28 http://register.consilium.europa.eu/pdf/en/09/st14/st14239.en09.pdf http://www.staff.city.ac.uk/p.booth/regulationstudents1.pdf


ISBN (eBook)
ISBN (Book)
File size
2.6 MB
Catalog Number
Institution / College
University of Mannheim
Centralization Regulation European Union Political Economy; Behavioral Finance Central Bank Reform Proposal Financial Markets Financial Crisis Fiscal Federalism



Title: Centralization of financial regulation