Competition policy: ten lessons learnt from the financial crisis

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  • ORI GIN AL PA PER

    Competition policy: ten lessons learnt from the financialcrisis

    Michael H. Boheim

    Published online: 8 January 2011

    Springer Science+Business Media, LLC. 2011

    Abstract The financial crisis brought great challenges also for competition policy.The aim of this paper is to summarize the most important insights for competition

    policy that could be derived from the turbulent period 20082010. The financial

    crisis is seen as project that demanded sound management from competition policy

    and enforcement. The insights will be presented in the instructive form of lessons

    learnt which represents a common approved project management technique. We

    come to the result that the financial crisis is not the result of too much competition,

    but of regulatory failure and that the main answers to the financial crisis have to

    come from smart regulation. The relaxation of competition policy would be the

    wrong policy response in troubled times since competition policy can play an

    important role in bringing the crisis economy back on track. In contrast to banking

    we see no economic rationale for rescue packages for other economic sectors by

    referring to systemic risk. The renaissance of industrial policy is viewed with great

    skepticism since empirical evidence shows that the effort of picking winners all

    too often results in saving losers.

    Keywords Competition policy Industrial policy Financial crisis Bailouts Regulation State aid

    JEL classification L33 L40 L55

    1 Lesson one: the financial crisis is not the result of too much competition

    The current financial crisis originated in the US real estate market and spread to the

    rest of the world in the wake of the collapse of the market for mortgage-backed

    M. H. Boheim (&)Austrian Institute of Economic Research (WIFO), Arsenal Object 20, 1030 Vienna, Austria

    e-mail: michael.boeheim@wifo.ac.at

    123

    Empirica (2011) 38:315330

    DOI 10.1007/s10663-010-9163-y

  • securities. It is important, however, that the fundamental causes of the financial

    crises are properly diagnosed so that the policy responses are targeted micro-

    surgery to address these causes rather than crude amputation as a reaction to the

    symptoms (Fingleton 2009). The financial crisis cannot, however, be attributed to a

    single cause, but originated from the coincidence of several factors which can be

    classified into three main categories: macroeconomic, microeconomic and regula-

    tory (Url 2010).

    The large international external imbalances combined with fixed US dollar

    exchange rates, carry trades between high and low interest rate currencies, and the

    strongly accommodating monetary policy of the Federal Reserve (Taylor 2009) are

    regarded as the most important macroeconomic causes, while insufficient gover-

    nance principles, weak internal controls with financial institutions and badly

    designed compensation systems are deemed essential microeconomic causes (for

    the global spread) of the financial crisis.

    Regulatory (and supervisory) failures are, however, deemed to be the most

    important contributors to the (hidden) emergence of the financial crisis (Hahn 2010;

    Url 2010). Financial innovations allowed the removing of risks from banks

    balance sheets and made their spreading across international capital markets

    possible (Hahn 2003). On the one hand this higher dispersion of risks strengthens

    the financial system, while on the other hand it weakens the information available to

    supervisors, because financing is shifted outside the banking sector. With the

    (uncontrolled) shift of loans from banks balance sheets to special purpose vehicles

    (SPV), the requirement of capital adequacy for investments by banks, a central

    element according to the Basel II Capital Accord became meaningless. The result

    was a dangerous misallocation of risk where financial assets were transferred to

    those players who least understood their riskiness and not (according to the theory)

    to those who had been best able to bear it.

    In addition to this wide-spread securitisation, risky financial activities were

    shifted from (strictly regulated) banks to less regulated or even unregulated

    subsidiaries. Financial innovation created new products outside the regulatory

    framework which served as substitutes for regulated products, e.g. while mortgage-

    backed securities (MBS) transfer conventional loans from a regulated balance sheet

    of a bank to an unregulated special purpose vehicle (SPV), credit default swaps

    (CDS) replace classical regulated credit insurance. Furthermore the globalisation of

    financial markets also weakened national supervisory authorities control (Url

    2010). Effective supra-national regulatory and supervisory regimes do not exist yet

    leaving plenty of room for regulatory arbitrage.

    The main regulatory regime for financial institutions, the Basel II capital Accord,

    proofed to be both incomplete and pro-cyclical by requiring that the capital base for

    banks assets depends on a risk assessment of these assets. Depending on the

    creditworthiness of the debtor, different risk-weights have to be applied. Higher

    risks require a higher capital base (Borio et al. 2001; Lowe 2002; Hahn 2003). This

    leads to a reinforcement of the credit cycle by underestimation of risks in upswing

    periods and overestimation in downturn phases respectively.

    As counterweight to financial institutions internal risk assessments regulatory

    authorities heavily relied on external assessments of the creditworthiness by credit

    316 Empirica (2011) 38:315330

    123

  • rating agencies (CRA),1 which in turn lead to a substantial upgrading of their role.

    The ratings of CRAs showed, however, substantially increased volatility during

    financial market crises (Hahn 2003) and thus proofed to be (equally) biased and

    misleading.

    The inaccuracy of credit ratings could distort incentives, cost structures and

    competition. If banks are able to use credit ratings in order to calculate capital

    requirements (as under the Basel II rules), they have an incentive to select highly

    rated borrowers since doing so mechanically lowers their capital requirements. If

    credit ratings do not adequately reflect credit risk, the banks capital structure might

    give the illusory impression that it constitutes a sufficient cushion against risk,

    which could threaten the safety and soundness of the banking system (Jenny 2009).

    The excessive confidence of banks in their internal risk management as well as

    the overestimation of the performance of CRAs by regulatory institutions led to an

    underestimation of the possibility of simultaneous shocks and low probability (tail)

    risks. The risk assessment of regulatory authorities focused too much on the

    situation of the individual financial institutions whereas general developments in the

    banking sector were given too little attention.

    Beyond guaranteeing the stability of individual financial institutions the capital

    requirements of the Basel II regime were not sufficient to ensure the stability of the

    financial system as a whole. The underlying micro-prudential financial market

    regulation of Basel II even had destabilising effects on system stability, because the

    capital requirements under Basel II had a strongly pro-cyclical impact on banks

    lending making it easier for banks to obscure credit risks. Basel II suffers from the

    fundamental structural shortcoming that it regulates only risky investments and

    neglects those, which are (supposedly) risk-free but of systemic relevance.2 The

    stability of complex financial systems is, however, challenged much more by the

    sudden occurrence of systemic external effects and spillovers than by market failure

    due to asymmetric information or imperfect competition. Only a macro-prudential

    regulatory approach that focuses on systemic risk can this problems take into

    account (Hahn 2010, cf. Lesson 6 below).

    The above sketched regulatory failures should, however, not be mistaken as

    market failure. If we mistake regulatory failure for market failure, we risk

    undermining the source of much of the wealth creation that came from the opening

    of such markets to competition. Extensive research provides for convincing

    empirical evidence that poorly designed product market regulations are a serious

    impediment to competition, innovation, employment, productivity and growth in

    many economies (Wolfl et al. 2009). Since market failure has in the course of the

    economic crisis become a mantra recited whenever economic outcomes do not

    accord with what well-organised interest groups want, competition authorities have

    1 A revision of the original Basel II agreement in 2004 granted banks the option of relying on ratings

    provided by CRAs to assess counterparty credit risk for the purpose of calculating their capital

    requirements. The US SEC also relies on CRAs assessments of the riskiness of assets of financial

    institutions it regulates.2 Almost all spectacular collapses of banks since 2008 have been triggered exclusively by a high and

    supposedly risk-free exposure to systemically relevant investments. According to regulatory criteria

    these banks had (almost without exception) backed their risks with sufficient capital.

    Empirica (2011) 38:315330 317

    123

  • to emphasize their efforts in competition advocacy (Fingleton 2009; cf. Lesson 5

    below).

    2 Lesson two: competition (policy) is not part of the problem, but should bepart of the solution

    It is clear that tougher competition policy and enforcement would have not been

    able to avert the financial crisis. Since mainly regulatory failure have lead to the

    crisis (cf. Lesson 1 above), the main solutions must be expected from smarter

    regulation (cf. Lesson 6 below), not from competition policy. Competition policy

    should, however, be able to accompany the process of replenishing the financial

    crisis by supporting regulatory reform (Gerard 2008; Lindberg 2009).

    The crisis has not undermined the basic economic principle that competition

    breeds competitiveness: it enables an efficient allocation of resources and stimulates

    technological development and innovation which in turn leads to a wider choice of

    products and services, lower prices, better quality, and higher productivity. Because

    of the well established link between effective competition and economic growth

    (Cf. Boheim 2004; Aiginger 2008) the benefits of competition are particularly

    relevant at times of economic crisis, a fortiori since there is absolutely no evidence

    that more competition leads to net employment losses on the aggregate level (Lowe

    2009).

    The crisis enhances the need for diligent and vigilant competition policy.

    Alongside fiscal and monetary policy, competition policy should be an integral part

    of the toolbox on which governments rely for responses to the economic crisis. The

    benefits of pursuing a competition policy based on economic principles are clear.

    Rather than fall into the fallacy of sacrificing competition (Cf. Lesson 3 below)

    supposedly to avoid the short-term consequences of recession, there is a need to

    enforce it robustly to avoid negative long-term consequences. The anticompetitive

    features of government interventions are not always noticed in the heat of a crisis.

    Such features may or may not be intentional, but they are often long-lived. It is

    unwise to bend competition rules for short-run expediency, though some new issues

    may be raised in relation to appropriate remedies. In none of the traditional areas of

    competition policy enforcement (cartels, market power abuse and mergers) a

    relaxation of strict pre-crisis standards is indicated (Lions 2009).

    3 Lesson three: the relaxation of competition policy is the wrong policyresponse to any economic crisis

    Recessions and economic crises are potentially hostile towards competition policy:

    the less visible and less immediate costs of restricting competition can look more

    attractive to policy-makers faced with a range of unpalatable options. Policies to

    relax competition in the US in the 1930s and in Japan in the 1990s added to the

    duration of recession and the delay in economic recovery in both countries (Cf. Cole

    and Ohanian 2004; Porter and Sakakibara 2004; Crane 2008).

    318 Empirica (2011) 38:315330

    123

  • A recession has the dangerous potential to be inimical to competition, and policy

    to support it, for several reasons. First, competition delivers its best market

    outcomes when it drives improved efficiency. This diffusion process takes time and

    does not come quickly. Second, it does this in part by enabling new entry of efficient

    firms and driving the exit of inefficient incumbent firms. Third, competitive, and

    especially innovative, markets often produce better value for consumers alongside

    more uncertainty around price, quality, range or service. The immediate costs of

    competition to existing business, employees and consumers may be up-front and

    visible, with the benefits delayed and less visible. In a recession, the short-run may

    be prioritised; the exit of failing firms may be perceived to be more costly for

    society, especially if concentrated in a specific sector and/or local area. Tolerance

    for this will be lower in a recession (Fingleton 2009).

    Overall the number of anticompetitive interventions worldwide appears relatively

    limited (Lions 2009). Competition policy, in terms of the overriding policies which

    influence and shape competition in the market, became, however, less strict during

    the financial crisis because state aid was permitted and granted generously to

    particular sectors (not only but mainly in banking and finance) and businesses which

    were classified as too big to fail. As a result of this political decision the crisis

    brought with it a certain amount of distortion to free competition.

    During the crisis, on both an EU and country level, the role of competition

    authorities to pursue cartels and to impose sanctions against companies abusing a

    dominant market position remained unchanged. To compromise on the rules merely

    as a result of the crisis would, in the long term, be both generally and in specific

    cases, nothing more than counterproductive. However, during the crisis, at least in

    the financial sector, a more tolerant stance towards mergers can be observed as far

    as National Champions were concerned (Cf. Lesson 8 below). Furthermore state

    aid is now distributed much more liberally than before the crisis. As far as this is

    concerned the regulatory bodies need to return to tighter controls especially where

    state aid is being provided to large businesses. Returning to tighter controls on state

    aid is important on the one hand to avoid the distortions to competition and the

    ensuing inefficiencies, and on the other hand to prevent competition to receive

    subsidies at the cost of the tax payer (Boheim 2010).

    4 Lesson four: the framework conditions for competition policy have changedsubstantially

    The financial and economic crisis brought significant new demands and challenges

    for competition policy. In the face of troubles on the international financial markets

    and the severe effec...

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