Phedon Nicolaides, 4 January 2016
One of the benefits of the Christmas break is that you can catch up with the episodes of your favourite series that you have missed. In our case, we watched three seasons [about 45 episodes] of “Breaking Bad” – the hit tv series of the chemistry teacher who became a drug dealer. Yes, we too got addicted, thankfully in a different way.
But as we were watching back-to-back episodes of Breaking Bad I realised that they had managed to solve the principal-agent problem that has bedevilled the new economic governance of the European Union. As of 1 January 2016, the Single Resolution Mechanism became operational. A week earlier, on 24 December 2015, the Official Journal of the EU published the text of an “Agreement between the European Parliament and the Single Resolution Board on the Practical Modalities of the Exercise of Democratic Accountability and Oversight”. Will the European Parliament succeed to exercise effective oversight over the SRB? Before I answer this question, I want to explain how the principal-agent problem was solved in Breaking Bad.
The principal-agent problem occurs whenever a principal cannot monitor the behaviour and the effort exerted by an agent who is supposed to act on behalf of the principal. The principal can observe only the outcome of the agent’s action. In some formulations of the problem, the principal is not even able to determine beforehand what to expect. That is the case in situations where the result that the agent should achieve cannot be defined meaningfully. For example, when you ask a lawyer for advice, you do not really know how much time the lawyer spends in researching the issue and you probably have even less idea of what the correct advice ought to be. The agent cannot be effectively controlled and needs, instead, to be incentivised to work hard to come up with innovative answers.
Most economic literature on the principal-agent problem examines the nature of incentives which can induce an agent not just to exert itself but also to find solutions that the principal had not even thought of as being possible.
In Breaking Bad they did not care much about measuring the effort of agents who were drug makers and drug dealers. This is because the criminal bosses – the principals – could define the desirable outcome very precisely. For drug makers it was the purity of the drug. For drug dealers it was the amount of money they would bring back. In both cases, the incentive for achieving the desired outcome was draconian. If they did not reach their target, something terribly horrible happened to them.
In the case of the SRM, the desired outcome that has been set by the EP and Council – the joint principals – is the orderly recovery [restructuring] and/or resolution [winding down] of financial institutions. But recovery and resolution can be achieved in many different ways. Obviously, the SRB has to find the most effective and efficient way that achieves multiple goals: least disruption to financial markets, most viable restructuring, minimal use of taxpayers’ money. But whenever a public policy has multiple objectives, trade-offs become inevitable, and the assessment of the outcome turns into an impossible task.
No penalties are defined in Regulation 806/2014 which set up the SRM. So, the members of the SRB will not lose their heads, or their jobs. But they will have to account for their decisions. Their penalty is public censure.
Article 45 of Regulation 806/2014 stipulates that the SRB is accountable to the EP, the Council and the Commission. The SRB has to submit an annual report to the EP, national parliaments, the Council, the Commission and the European Court of Auditors. The Chair of the SRB has to present the annual report to the EP and the Council and has to participate in EP meetings and hearings. Lastly, the SRB has to respond to questions by the EP or the Council.
The agreement between the EP and the SRB fleshes out the modalities of participation in parliamentary meetings, hearings and inquiries, requires the SRB to consult the EP when it hires staff and to inform the EP of how it manages its funds and defines more precisely the contents of the annual report.
The provisions of Article 45 and of the agreement do not appear to be too onerous. Reporting what you do is not the same thing as explaining what you do. However, the definition of the contents of the annual report seems to impose a heavier burden on the SRB. The agreement provides that the annual report “shall include detailed explanation” of following:
- The execution of tasks conferred on the Board by the SRM Regulation.
- The sharing of tasks with national resolution authorities.
- The cooperation with other national or Union authorities.
- The cooperation with third countries.
- The evolution of the Board’s structure and staffing.
- The implementation of a Code of Conduct by the Board.
- The amounts of administrative contributions to the single resolution fund.
- The implementation of the budget for resolution tasks.
- The application of the SRM Regulation provisions regarding the Fund [e.g. investment strategy].
Of the above nine items, the first is certainly the most important. It is of course impossible to know precisely how the SRB will act and how it will execute its tasks for the simple reason that it has not yet resolved any bank.
But while explanation is a good instrument of accountability, another equally good instrument is peer comparison. On Monday, 4 January 2016, the Financial Times reported that the SRB is expected to deal with about 10 bank failures over the next four years. An institution that has had comparable experience is the European Commission. Over the past eight years the Commission has examined and approved more than 450 cases of public subsidies to banks and has certainly dealt with more than ten cases of resolution.
Just less than four weeks ago, the Commission opened a formal investigation in the resolution of the Portuguese Banif bank and closed another formal investigation with a negative decision in the Italian Banca Tercas. In both cases, the Commission had serious doubts about the viability of their restructuring plans and whether there was sufficient burden sharing between the public investors and private shareholders. It may sound simple to express doubts about restructuring plans and burden sharing, but, on the contrary, both require rigorous economic analysis.
The Commission cannot do whatever it wants. It too is accountable and subject to judicial review. But EU courts have recognised that in these situations, which require “complex economic assessment”, the review of the courts is “necessarily limited in scope”.
The 8-year practice of the Commission in dealing with bank recapitalisation, restructuring and resolution indicates that it is not easy at all to define what would constitute successful resolution. Each case has to be evaluated on its own merits. It will be difficult for the EP to determine whether the SRB will have executed its tasks properly. And it will be even more difficult for the EP to assess the performance of the SRB because it will not have the requisite specialist skills to figure out whether the SRB did its sums correctly. The same Financial Times article that referred to ten expected bank failures also mentioned that the SRB was seeking advice from large accountancy and legal firms with experience in bank restructuring. If the experts are asking for “economic and valuation services”, then how effective will be the oversight of the EP?