Can Instant Replay Help Europe’s Troubled Banks?

By James R. Barth, Gerard Caprio Jr., and Ross Levine, guest columnists

What underlies the eurozone crisis? Some people view it as a sovereign debt problem due to unrestrained spending by some member countries. Others look at it as competitiveness problem -- the periphery countries being less competitive at exporting their products than some of the northern members, most notably Germany. And still others see it as a banking problem, with banks having provided excessive amounts of credit, most recently culminating in the need to recapitalize troubled Spanish banks, and how to fund such efforts.

Banks Just Part of the Problem

The answer is that the crisis is a combination of all three, with the banking problem closely intertwined with the other two and encompassing the entire region. Just ask the Irish: their banking crisis led to a guarantee of bank debt by the government, thereby threatening Ireland's ability to repay its own debt and pushing the economy into a steep recession. Now Ireland needs a devaluation to stimulate the economy. But as a member of the eurozone, its only option is an internal devaluation -- forcing down prices and wages, steps its citizens and policy makers are reluctant to take.

Over in Greece, a profligate spending spree funded by issuing government debt led to its inability to repay that debt. So Greek banks (like those in Spain and Italy) are saddled with sovereign debt and became the big losers. The result is the same as in Ireland: a sharp recession -- a depression, really. Now Greece, too, needs some form of devaluation, especially since the poor competitiveness of the Greek economy was part of the reason the government was spending so much -- to keep people happy by maintaining or increasing living standards.

Toward a Long-Term Solution

So what should be done to prevent or limit the severity of another crisis? To keep matters simple, consider only the banking problem. In Europe it is not just Greek, Spanish, Italian, and Irish banks that are in trouble. French and German banks, among others, lent substantial sums to these countries (these by the way are the same banks still hurting from having bought some of the worst debt obligations issued in the United States in the run up to its financial crisis), and much of it will not be repaid.

Some pundits and policy makers are now proposing a banking union as way to head off these types of problems in the future. But a new pan-European regulator might not do the job. As a recent New York Times article points out, for years Spanish regulators were insisting that their banks would not require bailouts. Yet the boom in Spanish real estate prices was more than double that of the United States, and not a single massive real estate bubble in history has occurred without the banks being behind it. Regulators in Spain had to have known of the growing risks, yet they took no corrective action. Too sadly, this is a story that has repeated itself in one country after another over time, as we document in our new book, Guardians of Finance: Making Regulators Work for Us, (MIT Press, March 2012).

Regulation Doesn't Work

In our book, we suggest that the all too standard response to banking crises -- involving more regulations and more regulators -- has failed us. Instead, we believe it is well past the time to pursue a new approach. Our proposal for change can perhaps be best captured by a sports analogy. Research has found that in many sports, referees are biased in favor of the home team. The introduction of instant replay has reduced this bias, resulting in more objective outcomes. Since referees' responding to cheers of the home crowd is simply part of human nature, their bias is not a result of malicious intent.

We believe that the same bias exists among regulators. In their case, the home team is the regulated financial institutions, who occupy the plush and close-in box seats, and the away team is the public, who are way up in the 'nosebleed seats', too far removed to see or understand what is happening. This may help explain why regulators in so many different countries and over so many years have failed to take sufficiently corrective action to address emerging banking problems. We believe a way to reduce, if not eliminate, the regulatory bias is to establish a sentinel, an instant replay agency. It would have no regulatory powers but consist of individuals with sufficient expertise to evaluate the riskiness of all types of banking activities. The sole purpose of such an agency would be to regularly report to the public any matters that it believes merit corrective action. This would generate a public discussion that could lead to better outcomes. The cost of such an agency should be relatively modest compared to the potential benefit.

We have tried to regulate finance in a variety of ways without any means of holding regulators accountable. Isn't it about time for a change?

James R. Barth is a Milken Institute senior fellow and the Lowder Eminent Scholar in Finance at Auburn. Gerard Caprio Jr. is the William Brough professor of Economics and chair of the Center for Development Economics at Williams College. As of July 1, Ross Levine, also an Institute senior fellow, is joining the University of California, Berkeley as the Willis H. Booth chair in Banking and Finance.