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ORIGINAL PAPER Competition policy: ten lessons learnt from the financial crisis Michael H. Bo ¨heim Published online: 8 January 2011 Ó 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 2008–2010. 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 Á Industrial policy Á Financial crisis Á Bailouts Á Regulation Á State aid JEL classification L33 Á L40 Á 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. Bo ¨heim (&) Austrian Institute of Economic Research (WIFO), Arsenal Object 20, 1030 Vienna, Austria e-mail: [email protected] 123 Empirica (2011) 38:315–330 DOI 10.1007/s10663-010-9163-y

Competition policy: ten lessons learnt from the financial crisis

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Page 1: Competition policy: ten lessons learnt from the financial crisis

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 2008–2010. 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: [email protected]

123

Empirica (2011) 38:315–330

DOI 10.1007/s10663-010-9163-y

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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

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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 bank’s 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.

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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).

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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 effects on the real economy, state intervention significantly

in-creased as a way to ‘stabilise the market’. Indeed this intervention did not only

concern stricter regulation of the financial markets but affected practically every

sector of the economy. As a result, a large amount of state funding flowed into

providing financial support during the crisis, the result of which was large budget

deficits. At the time little regard was held for how these deficits would later be

reduced. This was because, at least for the state and the businesses which had been

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rescued, it was never in question whether the state should intervene in economic

activities but rather to what extent it should do so. Any distortions to competition

were accepted as unavoidable collateral damage.

The economic environment, in which the competition authorities were working,

had changed considerably. Mergers (especially in the financial sector, and more

specifically in the Anglo-American part of the world), which before the crisis would

have been closely inspected and indeed even prohibited, were rushed through and

permitted without imposing any conditions, due to a fear of insolvency if the merger

did not go ahead. All this was happening often without sufficient regard to its long

term consequences on competition.

Acute insolvency problems affecting banks were solved internationally using

mergers or partial nationalisation. Nationalisation as an expeditious rescue measure

(possibly even exempted from any merger control) can be defended as an absolute

emergency measure in a singular crisis, if in the short term there is no other suitable

alternative available. However, the risk of inefficiency and market distortions are

inherent in any long term involvement of the state in a business (Heitzer 2009).

The case for a government stake in a system relevant financial institution can be

economically justified if, at the outset, the government’s involvement is clearly de-

fined as temporary and the conditions are also clearly laid out in advance. How-ever,

as soon as financial finding is available on the capital markets again, the state should

immediately withdraw from any stakes it acquired during the crisis.3

Concerning competition enforcement one has to distinguish between flexibility in

process and flexibility in substance. While the former is clearly indicated in times of

crisis, there should be no room for the latter. Support schemes such as guarantees or

re-capitalization schemes as well as mergers should have been cleared by

competition authorities very quickly only as long as conditions, which guarantee

that they are well-targeted and proportionate and contain safeguards against

unnecessary negative effects on competition, are properly fulfilled (Lowe 2009).

While competition authorities were (more or less) able to differentiate between

(necessary) speed and substance, policy makers proofed to be much less resistant to

competition imitating interferences4 (Vickers 2008).

5 Lesson five: competition authorities need to adapt to the new environment

The challenges for competition authorities in the wake of the financial crisis can be

classified under the following headings: flexibility, prioritisation, vigilance,

3 The approach taken in Switzerland can be used by way of example: here the government recapitalised

one of the two largest Swiss credit institutions by injecting capital (by way of an ordinary shares bought

by way of a mandatory convertible bond; Keil 2009). As soon as finance was available again on the

capital markets it withdrew as a stakeholder (within only 9 months) by selling its shares to private

investors for a considerable profit.4 The clearance of the Lloyds TBS/HBOS merger by the British Secretary of State despite negative

assessment of this case by the Office of Fair Trading is a prominent example of this kind of political

interference. The diecision was deemed a mistake in economic terms since it has potentially high costs in

terms of a serious risk of an irreversibly less-competitive banking service market for SMEs in Scotland

for the long term (Lions 2009; Vickers 2008).

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coherence, transparency and advocacy (Lasserre 2008; Fingleton 2009). Each of

them will be elaborated below in some detail.

First, in troubled times competition agencies need to be able to respond quickly

to changing priorities and display a substantial degree of pragmatism and flexibilityconcerning processes, albeit no change in core principles of competition policy and

enforcement seem necessary. While recognising that in crisis and recession the

types and areas of intervention that best achieve workable competition may change,

there should, however, be no trade-off between flexibility and substance (Cf. Lesson

4 above).

Second, prioritisation in the allocation of competition authorities’ resources is

deemed necessary. Impact, strategic significance, risk and resources should form an

integral decision framework for focusing on those cases that poses the greatest

threat to consumer welfare.5 This also includes recognition of the need to avoid

imposing unnecessary burdens on business. It is also of particular importance that

other policies (e.g. industrial policy, financial services policy, environmental policy

etc.) harness strong competition to deliver their objectives. It may be the case that

competition in the market may not be the answer in all situations. It is, however,

essential that costs of foregoing competitive solutions—especially the longer-term

and less visible ones—are fully included in the decision-making process. In case a

restriction on competition is considered necessary, its scope and duration should be

narrowed as much as possible.

Third, vigilance concerning newly evolving challenges is a conditio sine qua non

for competition authorities. In the wake of economic crisis the potential rise of

‘crisis cartels’ and of mergers involving failing firms deserve special attention. In

order to be able to develop pro-active competition enforcement practice competition

authorities need to think about how they work, and understanding and anticipating

what is happening across the economy. A sound knowledge management system

within an agency is essential to best deal with complex cases under the restrictions

of (always) scares resources. Human resources development is vital for attracting

both qualified and ambitious people for public service in competition enforcement

which is even the more difficult since comparable qualifications almost always find

better remuneration in the private sector (e.g. in law firms and economic

consulting). Strict human resource management has to allow for achieving early

resolution of cases which may be a useful way to increase efficiency, and free up

resources to address other issues.

Fourth, coherence and predictability of competition enforcement is essential for

providing legal security of both processes and decisions for all stakeholders

(enterprises, consumers and government). For this purpose stable framework

conditions and an efficient division of labour between competition policy and

enforcement is necessary. Politics should concentrate on developing strategic

guidelines and legislating practicable competition law so that competition authorities

can focus on competition enforcement (Boheim 2010).

5 Cf. OFT Prioritisation Principles, OFT 953, October 2008 available at

www.oft.gov.uk/advice_and_resources/publications/corporate/general/oft953.

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Fifth, since (almost) all competition authorities enjoy far reaching independence

as a necessary prerequisite for unbiased antitrust enforcement—sometimes even

granted by constitutional exceptions—transparency of processes and decisions have

to be demanded from them by politics. This implies at least that all formal decisions

have to be available made to the public—if necessary in an anonymous form

without revealing business secrets. Optimally also the processes and considerations

that lead to the decisions should be published. Maximum transparency also has

substantial impact on the coherence of competition enforcement since erratic

changes in antitrust practice could easily be discovered and are thus vulnerable to

public criticism. Accountability demands from competition authorities to constantly

improve their efficiency and effectiveness and to demonstrate to society that their

work deliver real measurable benefits.

Sixth, agencies will need to engage more actively in competition advocacy.

Market studies and market investigation instruments, could be used to build public

confidence in markets, not just by solving problems but also by ensuring and

demonstrating that markets are publicly accountable. This also includes that potential

side effects of competition are openly discussed since often markets work well, but

have e.g. adverse distributional consequences. Advocacy efforts must, however, be

extend beyond individual competition issues to so-called ‘framework advocacy’, that

is, for the competition framework. In many countries, competition authorities have a

statutory role in advising government on the effects of restrictions on competition: a

feature generally designed to help counter-balance the power of strong producer

vested interests that lobby for less competition. The importance of open markets and

workable competition for long-term business investment and decision-making of a

consistent and clear framework of competition and consumer enforcement have to be

emphasised. Restrictions on competition would represent a long-term drag on

economic development in the future. Advocacy efforts should not stop at national

borders, since there is also a common responsibility of national competition policy to

use its influence on the development of a policy of open markets, challenging

protectionism, and leading best practice in the European Union and beyond.

All six tasks require good communication and co-ordination within government,

across business and consumer stakeholders, and across international partners.

Working with international partners is key not just to ensuring that our responses to

the crisis and recession build on best practice and are co-ordinated, but more so that

long-term business investment can be based on a consistent international approach

(Fingleton 2009).

In order to be able to master these tasks and cope with the challenges arising from

the crisis well-established competition regimes should not require a lot of

adjustment and a compromise on the core principles of competition policy.

The following types of possible adjustments have been identified and can be used

as basis for a roadmap for reform (Lowe 2009):

• Streamlining of processes to accelerate the reaction rate in a dynamic economic

environment;

• Focusing of enforcement efforts towards competition infringements that have the

greatest impact on consumers and are industrial and service sectors that are the

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most important for productivity growth of the economy (e.g. energy and

telecommunications);

• Strengthen competition advocacy to restore public confidence in competitive

markets.

6 Lesson six: regulatory answers must address the causes of the financial crisis

Regulatory failure—not market failure—has been identified as one key trigger of

the financial crisis (Url 2010; cf. Lesson 1 above). Therefore the prevention

of further crisis is inter alia conditional on the adaption of the regulatory framework

of financial markets.

The international financial regulatory framework, the Basel II Capital Accord,

has been assigned the tasks to channelling competition into appropriate behavior by

setting minimum standards for financial institutions. Basel II rests on three ‘pillars’:

minimum capital requirements; regulatory supervision; and risk disclosure to

facilitate market discipline. The application of this framework has, however, proved

inadequate in the face of complex financial innovations and distorted incentives.

The dominating regulatory paradigm relied on the (false) assumption that the

financial system will be automatically stable and efficient, if every single financial

institution is. This micro-prudential financial market regulation does not take into

account that the financial market is more than the sum of its parts, i.e. the financial

institutions.

Future financial market regulation must therefore be oriented towards the

objective of systemic safeguarding of the financial sector to a much greater extent

than before. This requires a comprehensive reorientation of financial market

supervision toward macro-prudential regulation. The borderline between regulated

and unregulated financial institutions should exclusively follow the principle of

systemic relevance. Scope and depth of the regulatory measures should be geared to

the potential systemic effects of the respective financial institutions.

Financial institutions, whose activities and expenditures entail substantial

systemic risks, should be induced by appropriate supervisory measures to internalise

the negative systemic effects (e.g., via a very high capital requirement or tight limits

for borrowing). The potential systemic failure due to external effects and spillovers

should be counteracted in a ‘forward-looking’ manner by primarily macro-oriented

financial market supervision and financial market interventions. This requires a

close co-operation and co-ordination of financial market supervision and monetary

policy both at the national and at the international level (Hahn 2010).6

In addition to the above mentioned standard components of Basel II the

following ‘soft’ elements of regulation are deemed necessary (Cf. Lions 2009).

6 Recent proposals for a reform of financial market supervision and financial market monitoring

presented by the EU (Larosiere Report), the British financial market supervision FSA (Turner Review),

the G-20 (G-20 Report) and the US administration (US regulatory reform proposals) take the necessity of

a stronger macro-orientation into account, but differ in their assessments of its relevance.

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First, incentives given to individuals within banks must follow a transparent two-

sides bonus-malus system which avoids paying bonuses for short-term profit with no

downside risks for long term losses.

Second, credit default swaps and other elements of diversification and insurance

must be allowed as prudent trading activities, but forbidden as ‘bets’.

Third, idiosyncratic assets (CDS, CDO and other complex or opaque financial

innovations) have to undergo regulatory scrutiny and need to receive positive

approval from an independent regulatory body, and not from credit rating agencys

with system immanent conflicts of interest due to their double role as credit raters

and consultants.7

Fourth, over-the-counter-trade (OTC) of idiosyncratic assets should be forbidden

in order to avoid market manipulation. Trading of these kinds of financial assets

should be restricted exclusively to public stock exchanges which are controlled by

financial regulation authorities.

Fifth, banks should be charged ex ante for the explicit (and implicit) guarantees

they receive from government. The size of this ‘insurance premium’ should reflect

the size and risk profile chosen by each particular bank, including the amount of

debt financing relative to its equity base (‘leverage-ratio’).

Sixth, a credible bankruptcy regime must be established for banks so that

contagion is limited. This is likely to require pre-emptive action by a monitoring

central bank (and not the daily regulator which may be reluctant to admit that it has

failed to keep the bank on track).

7 Lesson seven: banks are banks, but (car) manufacturers are not

In the wake of the financial crisis ever more distressed businesses—not only banks—

turn to government for assistance. The biggest ‘real economy’ corporations, most

notably car manufactures, claim mutatis mutandis their ‘systemic relevance’ by

perverting this terminus technicus which was originally coined as an advancement of

the popular expression ‘to-big-to-fail (TBTF) to describe the special relevance of

large and interconnected financial institutions for the whole economy.

The banking system is distinct from any other economic sector in combining two

characteristics that are not shared in this dorm by any other economic sector (Lions

2009).

The first distinctive characteristic of banking from the competition perspective is

that banks are so interconnected that the collapse of a large bank is contagious and

contaminates the whole banking system. A large bank with substantial trading

activities has a negative externality on its rivals: if it collapses, the stability of its

rivals is undermined. This is in sharp contrast to other sectors of the economy where

competitors in the industry can usually benefit from the collapse of a rival by

snapping up its market share. The second distinctive characteristic is that bank

finance provides the essential ‘lubricant’ in the economic system, allowing other

7 Credit rating might also be privatised (again) at a later date once an appropriate regulatory regime is

established.

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firms to absorb the bumps of fluctuating revenues and payments. The product of no

other industry is similarly quintessential to every other market in the system.

Given these characteristics of banking, the major banks could ex ante expect to

be bailed out. The anticipation of bailout created a moral hazard that biased

decisions towards risk taking. But while bailouts have saved many banks from

collapse, they only further reinforce moral hazard. This problem has to be overcome

by implementing regulatory reform (Cf. Lesson 6 above).

Intervention to rescue the financial system from systemic collapse in exceptional

circumstances can be crucial, but should not be seen as a reason to suspend the

importance of competition in other sectors, either via State aid, anti-competitive

mergers or cartels (Fingleton 2009).

No other sector of the economy shares the described pair of characteristics that

set banks apart for state intervention in the current crisis (Lions 2009). Thus public

intervention in the real economy cannot be justified by referring to systemic risk.

The rationale for rescue packages in the real economy is very limited and there is

principally no need to deviate from the core competition rules for state aid for and

mergers of failing firms respectively.

Subsidizing failing non-financial enterprises impedes creative destruction, derails

necessary structural change, distorts competition by privileging inefficient and

unproductive businesses, limits long-term economic growth by delaying economic

recovery.

Undifferentiated subsidies undermine market outcomes and allocation processes.

A justification of subsidies can only be justified in the case of market failure. In the

short-term restructuring of failing firms might be painful, but the long-term

consequences of artificially keeping inefficient structure alive will cause even more

harm to the economy and the society by allowing efficient rivals suffering from

reduced market share; customers to be offered costly and unattractive products;

taxpayers with falling real income and socially disadvantaged people suffering from

diverted public spending.

Public support policy should thus stick to the approved framework of State Aid in

the EU, which specifically requires that aid be specific and constrained, transparent

in application, time-bound, and with a clear rationale. The EU framework pays close

attention to the distortionary effect on the market (i.e., prevents beggar-thy-

neighbour approaches) and thereby supports open markets and a level playing field

(Fingleton 2009).

8 Lesson eight: national champions distort competition

The new EU Internal Market Strategy (Monti 2010) speaks openly of the

‘possibilities of an active industrial policy’. The fact that industrial policy at EU

level is (again) under discussion as an economic policy option represents a paradigm

shift. This brings the primacy of competition policy to an end; competition policy is

now to be placed at the service of industrial policy. The Monti report explicitly

advocates a ‘forward-looking industrial policy’ that uses all the synergies between

competition and industrial policy and should flexibly control all regulatory and

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political instruments. Furthermore, it demands ‘vertical elements’ for strategic

support to ‘promising sectors’ where, for example, in general terms, ‘energy,

innovative industries and environmentally-friendly vehicles’ are named.

As a recent empirical study (Lin and Monga 2010) shows, industrial policy can

only be successful under very narrowly defined conditions. In this regard, the

prospects for a national industrial policy are greater the more it is built on existing

national competitive advantages, the more a market trend is followed and the

nearer the area funded lies to core state competencies and interests. Industrial

policy successes are, in contrast to failures, extremely rare; collateral damage to

non-assisted areas and the economy as a whole are largely discounted. Instead of

selecting supposed ‘winners’, all too often ‘losers’ are saved (The Economist

2010).

The open commitment to actively promote certain economic sectors at European

level is all the more surprising as it comes from a former Competition

Commissioner of the European Union: it is largely at odds with the previous

doctrine of horizontal measures. Behind this new approach is the (incorrect)

political conviction that through targeted interventions by the state in certain sectors

‘key industries’ or ‘national champions’ respectively can be created that would be in

a position to act as ‘global players’ at the top of the world market. In reality, these

politically promoted national champions typically prove, on the one hand, to be too

small to be able to actually play a significant role in the world market; on the other

hand, they are too big for the domestic market and hinder competition. (Cf. Tichy

2002).

That government attempts to direct the production structure of the economy

should be avoided is an idea that enjoys broad consensus among economists, unless

there are special reasons responsible for a ‘market failure’. This principle also

applies to the correlation between production and trade in the international

exchange of goods and services. As little as policy-makers and bureaucrats are in a

position to assess what goods and services should be produced, so little are they able

to assess which goods and services should better be purchased abroad or made at

home. These decisions are also usually best left to the markets, which coordinate the

activities of millions of companies (suppliers) and consumers (buyers). A state-

promoted policy of ‘national champions’, which intervenes in these structures by

favouring one company or sector while burdening another, runs counter to this

principle and is harmful to the economy in the long run (Monopolkommission

2004).

An active industrial policy cannot be securely founded on a strategic foreign

trade policy. The underlying theoretical model abstracts too much from the problem

of the identification of appropriate technologies, companies and sectors as well as

from the incentive effects of privileges bestowed by the state. Competition as an

incentive to innovation and competition as a discovery process for new technologies

are unavailable under this construct. Instead of pursuing a strategic trade policy, it

seems more appropriate that the European Union works for further liberalisation of

world trade and the dismantling of trade and investment barriers. In the long term, a

pro-active competition policy remains the best form of industrial and business and

commercial centre policy. The most pressing task for policy-makers (and their

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advisers) would be to bring home to the population these complex interactions in an

intelligible form.

9 Lesson nine: free markets require a strong state

The financial crisis demonstrated perfectly that public ownership does not in itself

guarantee more stable markets (e.g., state-owned banks as speculators). If the state

successfully creates the necessary regulatory framework and manages to guarantee

that it is both complied with and kept constant, its withdrawal from business

activities need not per se bring with it a destabilisation of the markets. It is not a

question of whether the state should be more or less involved in business activities.

Rather what is needed is a strong state where strict regulation (of the financial

markets) is indispensable. The key to any future economic strategy to achieve

growth and employment is to ensure that fundamentally, the private sector is as

large as possible. It is not a contradiction in terms to have a strong state which

focuses on key areas and a strong private sector. Rather it is this very combination

which is the prerequisite to an efficient and effective economy. However, to achieve

this goal the state must be prepared to renounce public ownership, thereby foregoing

a certain amount of influence and allowing the private sector to grow.

A prerequisite of a free market is, at least in particular areas, a strong state. To

this end, on a political level, the state would be assigned three main functions

(Huther and Straubhaar 2009):

• In order to ensure competition the state must create the appropriate framework

conditions for contestable markets.

• In order to enable competition the state must guarantee equal opportunities for

market participants to access the market.

• In order to regulate competition the state needs to combat market failures where

a market solution to the problem is not available.

These three main tasks create a so called ‘regulatory sequence’: Only when the

state acts to ensure free competition and only when there are equal opportunities for

all market participants to participate in a competitive market, is it actually possible

to selectively neutralise/mitigate any negative side effects of a free market. In the

past politics focused far too much on trying to correct the effects of competition and

did not optimise its positive effects for growth and employment. In the future it

would be much more efficient to prevent any market failure before it occurs rather

than trying, at great cost, to combat it after the event.

The financial crisis has also shown that state ownership, most notable in the

financial and banking sector, does not necessarily guarantee an institution’s

stability. Public authorities’ withdrawal from economic activity as an active player

does not inevitably lead to market destabilisation, as long as the state succeeds in

establishing the relevant framework, guaranteeing adherence to it and ensuring its

long-term viability. This requires smart regulation and efficient competition

oversight.

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The above sketched concept of division of labour between state and private

entities has the ultimate consequence that the state has to withdraw from direct

economic activities wherever market solutions work (better).8 Since the size and

scope of public enterprise is still substantial in many countries the potential for

privatization is comparably large (Boheim et al. 2010; Wolfl et al. 2009).

10 Lesson ten: do not forget about crisis independent pending competitionproblems

During the wake of the financial crisis competition policy makers and competition

enforcers were very busy in trying to master the direct consequences of the crisis.

This meant a concentration and re-allocation of scarce resources to ‘crisis

completion’ and thus a negligence of crisis independent competition problems.

Even if the crisis cleanup is far from accomplished by now, it is important to remind

competition policy and enforcement to engage again on neglected tasks. This means

especially fighting against persistent ‘oasis of reduced competition’, e.g. in the

energy sector and the liberal professions (most notably pharmacies and notaries).

11 Conclusions

The financial crisis is due to regulatory failure, but not market failure or ‘too much

competition’ respectively. Consequently the main answers to the financial crisis

have to come from ‘smart regulation’. The relaxation of competition policy would,

however, 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

there is no economic rationale for rescue packages for other economic sectors by

referring to systemic risk. The renaissance of industrial policy has to be viewed with

great skepticism since empirical evidence shows that the effort of picking ‘winners’

all too often results in saving ‘losers’. Instead of pursuing ‘industrial policy

fantasias’ the state should concentrate creating the necessary framework conditions

for a functioning market. This goal can best be achieved by using a clear and

consistent set of regulatory policies and a strict competition policy which is co-

ordinated on an international level, as well as by using ‘Smart Regulation’. In the

future for some sectors (e.g., the banking and financial sector) this might mean a

stricter and more comprehensive regulatory framework. In other sectors (e.g.,

energy, telecommunications, liberal professions etc.) there might still be ample

room for further substantial deregulation.

Competition authorities are unable to meet expectations regarding fundamental

questions of competition policy. Competition enforcement can only complement

8 Here once again banks are different from other corporations. Our concept does not rule out the

possibility of temporary nationalization of systemically relevant financial institutions which became

distressed. It implies, however, that these institutions are sold again by the state as soon as the capital

market allows for privatization. Optimally the privatized entities are much smaller and less exposed to

systemic risk (Lions 2009).

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competition policy at the operational level, but not replace it at the strategic level.

Thus a coherent competition policy strategy is of utmost importance.

Finally, the following strategic recommendations for fostering an innovation- and

growth-orientated competition policy can be derived:

• The establishment of a competition-friendly climate as well as the development

of an overarching strategy for competition policy should be given top priority.

• The effectiveness of competition law and its enforcement should be enhanced.

• The regulatory obstacles hampering the development of entrepreneurial activity

should be further reduced.

• The stimulation of competition in the remaining ‘oasis of reduced competition’,

most notable in the energy sector and in some fields of liberal professions should

be energetically pursued.

• Competition-distorting subsidies should be, to the greatest possible extent,

abandoned.

• Privatizations of state-owned enterprises should be used to foster competition

and strengthen competitiveness.

Acknowledgments The author is grateful to Karl Aiginger, Gunther Tichy and Michael P. Truppe for

valuable comments. The responsibility for the views expressed in this paper remains with the author

alone.

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