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Queasy riders

11 October 2011 By Peter Thal Larsen

The drive to recapitalise Europe’s banks is running into a familiar problem. While boosting the capital buffers of the region’s lenders is a key step to restoring confidence in the euro zone, individual institutions would prefer to avoid the cost. It’s a problem that could be overcome by governments – if only they weren’t faced with the same dilemma.

When asked about restoring faith in Europe’s banking system, many bankers admit that overall capital ratios should be raised, but insist that their institution is fine as it is.

It’s a pattern of behaviour that would not have surprised Mancur Olson, the U.S. economist who explored the dynamics of group behaviour in his 1965 book “The Logic of Collective Action”. Olson showed why individuals are reluctant to act together even when it is in their collective interest to do so. A stable financial system that benefits everyone is what economists call a public good. But each bank would prefer others to bear the cost of providing it. In the economic jargon, they are free riders.

In economics textbooks, this kind of problem is usually solved by government intervention. In the euro zone, however, governments suffer from a similar affliction. Each country would like to end the euro zone crisis, but with a minimal burden on its own taxpayers. Hence David Cameron, Britain’s prime minister, urges European leaders to get out a “big bazooka”, but also maintains that the UK government won’t have to put any more cash into Royal Bank of Scotland.

Regulators have tried to level the playing field, but when it comes to boosting capital ratios they remain agents of national governments, which hold the purse strings. This limits their ability to work together – just look at Europe’s pathetic attempts to co-ordinate credible bank stress tests. Countries are more likely than banks to set their narrow self-interest aside – there are fewer of them, which should make co-operation easier. Even so, it may take a severe crisis for governments to overcome the powerful impulse to enjoy a free ride.


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