sou · GOB311d5 · 2001-01-01 00:00:00 — In particular, the choice of auction technique illustrates a role for private interests in the details of the institutional changes. Governments consistently adopted sealed-bid, multiple-price auctions (also called discriminatory or first-price auctions) rather than uniform-price auctions (also called non-discriminatory or second- price auctions). 11 The popularity of the multiple-price auction technique 10See (1997) for a detailed political-economy explanation of why governments may wish to sell their debt to foreigners. 11In multiple-price auctions, winning bidders pay the price that they bid, so different winners may pay different prices. Winners are determined by ordering bids by price and filling bids from highest to lowest price until the total quantity of securities auctioned has been sold. Volym D:148 Supplement 25 in the recent reforms contrasts sharply with the sustained academic criticism that this format has received relative to the uniform-price technique as a way to issue securities (e.g., 1960 and 1966, and more recently Rheinhart 1992, U.S. Treasury et al. 1992, Umlauf 1993, Tenorio 1993, and and Sundaresan ). Unlike the uniform-price auction, the multiple-price auction is subject to the winner's curse. The probability of winning is positively related to the price that one bids in both types of auctions. In the multiple-price auction, unlike in the uniform-price auction, the expected profit from winning is negatively related to the bid price, given that there is some uncertainty as to the exact value of the securities in the secondary market. As a result, bidders will tend to bid a bit less at the auction than what they estimate the secondary market value will be. In addition, potential bidders without access to detailed information on which to base the estimates of the secondary market value would be less willing to participate directly in a multiple-price than a uniform- price auction. Consequently, the demand curve at auction using a multiple-price format will be below that in the uniform-price auction. The demand curve also is likely to be flatter, since the uncertainties generated by the pay what you bid format tend to make the bidders at the auction more price sensitive. In principle, the revenue loss from the downward shift in demand at a multiple-price auction relative to a uniform-price auction could be offset by the ability to price-discriminate in the multiple-price auction. Actual and experimental evidence, however, generally indicates that the added revenue from price-discrimination is not sufficient to compensate for the lower and flatter demand curve (see, e.g., 1966). In , for example, Umlauf (1993) showed that the governments auction revenue increased in their Treasury bill market when temporarily switched from multiple-price to uniform-price format. Tenorio (1993) found similar results for . The sealed-bid, multiple-price technique also suffers from the potential for manipulation and may cartel-like behavior among dealers. The potential for precisely such manipulations was widely understood, having been described by (1960) decades earlier. When briefly switched from a multiple-price to a uniform-price auction, for example, bidders overall profits fell sharply and auction auction, all of the successful bidders pay the same price. Who wins is determined the same way as in the multiple-price auction, but the price that the winners pay is highest unsuccessful bidder's price, not the price each winner bid (see U.S. Treasury et al. revenue rose, suggesting that the multiple-price format permitted greater scope for manipulation (Umlauf 1993). Given that the potential problems of the multiple-price auction were well-known, why have the reforms almost universally adopted this format? One explanation is that other countries were simply copying the U.S. which had used this format for many years. This solution, however, is unsatisfactory. Although the reforms followed the general pattern of moving in the direction of a US-style market, there are enough country- specific variation that adopting a different auction technique certainly would have been feasible. An alternative explanation is that the multiple-price technique enhances the value of the information to which the primary dealers have privileged access. The reforms initially gave primary dealers or syndicate members exclusive access to the inter-dealer brokers, consultations with the , regular dealings with the central bank through open market operations. Most trading in the government securities also is concentrated in their hands. In a uniform- price auction, information gathered from such sources and activities is less valuable since both the informed and the uninformed bidders will pay the same consensus price. The primary dealers, ceteris paribus, thus would prefer to have the government use the multiple-price technique, and governments appear to have obliged. Also, it is extremely difficult to measure the extent of this benefit for there is no line item in the government's budget to represent it. Obscure transfers are much more likely to avoid public scrutiny (as described in more detail at the end of the next section) and, hence, are a preferred means of compensation by the government. The reforms provided some benefits to the government, reducing their fiscal burden, and preserved some rents for the large financial institutions.12 Part of the trend toward globalization and financial liberalization, thus, can be accounted for by public finance motives. 12 Rapid technological innovation, however, has begun to erode the information advantages associated with being a primary dealer. Proliferation of inter-dealer broker screens and the growth of organized derivatives markets, for example, are narrowing the information gap between the primary dealers and others. As this trend continues, the value to the primary dealers of the multiple-price format may fall sufficiently that they would be indifferent between the two techniques. Eventually, governments then may switch over to uniform-price auctions and relax some of the distinctions between dealers and non-dealers that no longer provide important benefits to the primary dealers (see Kroszner 1997b). Volym D:150 Supplement 25 5What is the Role of Crises in the Political-Economy of Regulatory Reform? Reforms are often associated with banking and economic crises, and the crisis hypothesis provides an alternative to the political-economy approach. Developing as well as developed countries experiencing major bank insolvencies have subsequently undertaken some reform and restructuring of their banking regulatory and supervisory systems (Caprio and Klingebiel 1996), and is no exception. First on the list of sixteen hypotheses about reform drawn up by (1994), distilled from the experiences of top policy-makers presented at a conference on The Political Economy of Policy Reform, is that policy reforms emerge in response to crisis Are crises an independent factor which can be said to cause reform to occur? (1996) has been critical of the crisis hypothesis because it is almost nonfalsifiable – if reform does not occur, proponents of this view will say that the crisis was not sufficiently severe – and because reforms responding to similar crises take very different forms (e.g., Caprio and Klingebiel 1996). The U.S., for example, responded to the banking and economic crisis of the early 1930s by fragmenting the financial system (Kroszner 1996). The Glass-Steagall Act of 1933 narrowed the range of activities permissible for commercial banks, and a series of Acts starting with the Act of 1932 created modern institutions which narrowly focused on the financing of residential mortgages. In , however, a number of countries responded in the oppose way by increasing the diversification of their financial institutions, by introducing or broadening powers. From a political-economy perspective, crises are associated with reform because crises are likely to upset the old political-economy equilibrium. There are four reasons for this. First, crises rarely affect all parties similarly and tend to have important distributional consequences. Since the relative position of competing interests is one of the key elements to a political-economy equilibrium, it is thus not surprising that reforms often occur following crises. Powerful groups or coalitions may fragment as their interests diverge during economic trouble, and new constituencies may be created. Although smaller, less diversified banks tended to support federal deposit insurance, for example, they became politically powerful enough to enact it only in 1933 (et al. 1996, but also see Calomiris and ). Second, economic upheaval can change the relative costs and benefits of particular regulations. An interest rate ceiling, which may act like a price-fixing arrangement among banks to enhance their profits during normal times, for example, could lead to large outflows of funds and liquidity problems during high-interest crisis periods (see 1991 and Kroszner and Strahan ). Hyperinflation crises turn many of the regulations that had protected banks from competition into obstacles in the new circumstances. Innovations in financial technology may create new markets and institutions, and new constituencies with them. Third, crisis can also affect bureaucratic incentives for regulatory change. Deposit insurance, for example, commits the government to bail- out banks that have liquidity and solvency problems. During times of crisis, deposit insurance funds typically are bankrupt so an explicit taxpayer-financed bail-out would be necessary. To postpone such actions, politicians and regulators may have incentives to reduce various regulatory barriers as a quid pro quo for a financial institution using its private funds to bail out a troubled institution. Special dispensations to cross geographic or product lines have occurred in the U.S., particularly during the Savings & crisis (Kroszner and Strahan ), , where Citicorp recently took a large stake in a troubled local Mexican bank, dramatically easing the expansion of its operations in , and in , where arranged mergers have helped some banks expand into new activities. Finally, the enormous costs of a financial crisis may serve an important educational role for the public (see 1996). During normal times, individual voters may not know the full value of the implicit or explicit guarantees that the government, that is, the taxpayer, is making. After a crisis, however, the government is likely to have to raise taxes and sell bonds in order to pay for the bail-out. This more explicit accounting will reveal the costs of policies that the public may not have known were so costly. Bank failures thus may heighten the publics awareness of the costs of regulation and may make it more difficult, that is, more costly in terms of votes, to maintain the old regulatory regime. The banks now would have to provide more support to politicians, for example, through greater campaign contributions, in order to offset the greater popular opposition. Since the banks are experiencing financial distress, they may not be in a strong position to provide the additional funds, so the likelihood of reform increases. The reform and repeal of the deposit insurance system follows this pattern. During the 1980s, experienced two major Volym D:152 Supplement 25 The first in 1980-1982 has been estimated to have required more than 50 percent of GDP to resolve and the second crisis in 1989-90 roughly 13 percent of GDP to resolve (Rojas-Suarez and Weisbrod 1996 and , , and Saal 1996). With such large costs to the bail-outs, the public was now acutely aware of the costs of government guarantees of deposits. to the hyperinflation, there were relatively few deposits left in the bank system to be insured by 1990, so there were fewer depositors demanding insurance. Also, the banks were in a rather weak position. In other words, the crisis involved a dramatic shift in the relative strength of the groups supporting and opposing deposit insurance. In these circumstances, it became politically feasible to eliminate deposit insurance and did so. This reform, however, was not completely sustained. Five years later, during the Tequila crisis, the interests in favor of deposit insurance grew and a private deposit insurance scheme was instituted (Guidotti 1996). The deposit insurance premia are relatively high but the insurance agency is owned by the banks that contribute to it. Thus, if the system stays healthy, they earn the profits from the insurance agency but will bear the burdens when the banks require bail-outs. The changes in geographic restrictions within the U.S. also can be understood within this framework. (1996) argues that an important shock to the old equilibrium favoring branching restrictions was an increase in the publics understanding of the costliness of having government-insured but (geographically) undiversified financial institutions. During the 1980s, an increasing number of depository institution failures and the Savings and crisis culminating in the taxpayer bail-out heightened the awareness by the public of the costs of restrictions that make depository institutions more fragile and more likely to require infusions of taxpayer funds. The result is the 1994 Efficiency Act which phases out geographic restrictions on bank expansion within the U.S. (see Kroszner and Strahan ). 6Conclusions for Facilitating the Policy Reform Process The thrust of the arguments above focus on interest group competition and how the battle among the interests will be a key determinant of the regulatory outcomes. Are careful scholarly analyses of regulations and their reforms then of relevance for policy so academics should retreat to the ? An organized interest group, money, and/or votes may be necessary for a view to prevail in the political marketplace but it is not sufficient, due to the rivalry among interest groups. Theory and facts, not only money and power, are relevant to the debates. Without an interest group to champion a position, however, an argument may have effect. (Television, radio, and the internet, however, have been reducing the costs for both information to be disseminated and for groups to organize.) A logical and empirically supported argument affects the productivity of the lobbying efforts by an interest group, much like a technological shock that can increase the productivity of investments. Although rival interests will always have an incentive to provide disinformation and generate hack alternative studies, a well executed can be a great help to a particular group. In terms of pressure group model, careful studies can inform the rival groups about the size of the dead weight losses involved with policy alternatives. Reducing uncertainty about the outcome can energize the losing side to increase lobbying effort. Thus, one implication of the political-economy analysis is that the education of the public and of policy-makers of the actual and potential costs of regulation can play a useful and important role in the policy reform process.13 13 (1996) argues that bank regulators and beneficiaries of restrictions on geographic expansion of banks purposefully misinformed the public and legislators about the costs of the regulations. Only a combination of large failures and costly bail-outs with academic studies explaining why the bail- outs are so costly were able to change the perception of the social welfare effects of the regulation. (1991) argues that much popular support for corporate governance regulation protecting incumbent management arises primarily from ignorance rather than purposeful misinformation, so that more policy-relevant research is important to effect reform. Volym D:154 Supplement 25 A second implication is that competition among rival interest groups can increase the likelihood of beneficial reform. Rival groups have an incentive to battle each other in addition to battling the consumer. If they dissipate their efforts against each other, they are less likely to be able to support narrow special interest regulation. In many emerging markets today, e.g., , a major question concerns whether creating banks would allow one particular interest to have too much political power and thwart reform. In addition, the rival groups have an incentive to try to unmask any misinformation that the competing side is generating. This can help to inform both the policy-makers and the public. Third, the structure of regulatory and government institutions also plays a role. A clear structure of legislative oversight of the regulatory process through, for example, specific committees in the Parliament with responsibility for banking and financial matters may provide a forum which the information generation process (Gilligan and Krehbiel 1989, McCubbins, Noll, and Weingast 1989, Krehbiel 1991, Austin- and 1992 and 1994, Kroszner and Stratmann 1998). Similarly, the incentives for groups to overcome free-rider problems and organize is related to the expected benefit of them doing so. In other words, the organization of interests is endogenously related to the structure of the regulatory process (see and Kroszner 1999). Opening the regulatory process to include clear channels for new groups that would tend to oppose narrow special interest capture regulation increases the likelihood of regulatory reform by increasing the costs of maintain the regulation to the special interest. Fourth, greater transparency in government involvement in the financial system is significant. Politicians often use the financial system, either through implicit guidance or explicit through state owned banks, to provide low-cost financing to targeted industries or groups. Directed lending leads to implicit or explicit quid pro quos in order to have the banking sector follow this direction. Problems in Korean banks, for example, stem from encouragement by the government to continue lending to troubled enterprises in return for implicit of a bail- out. Privatization of state owned enterprises, for example, can reduce the benefit to politicians of directing credit and can generate new constituencies for an efficient banking and financial sector – as long as the firm has been fully privatized and does not have special influence with the government (Kroszner 1996b). Requiring that any such transfers or subsidies be explicitly included in the governments fiscal accounts would clarify such transactions and help to break nexus of implicit agreements and quid pro quos through regulation that support them. Less secrecy and increased disclosure in government supervision of financial institutions also would permit increased monitoring of the governments role in the financial system. Finally, foreign entry can generate a virtuous circle because foreign institutions tend to be less politically connected domestically and less likely to be able to capture the regulatory authorities. Foreign institutions also are less likely to succumb to pressure for directed lending by the government. With capture less likely and fewer direct benefits to the politicians of regulation (e.g., through quid pro quos for directed lending), regulatory reform becomes more likely. 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