Crisis of confidence

As market instability raises the spectre of a pan-European systemic crisis, debate is heating up over how EU banks should be regulated. David Benyon assesses the various proposals for changes to the regulation framework and whether they will be capable of preventing another crisis

The current financial market instability is raising calls for greater co-ordination among regulators - even consolidation of regulators - around the globe. In Europe, work to provide greater co-ordination of regulatory efforts is already well under way, thanks to the implementation of the Capital Requirements Directive. Now, however, politicians and regulators are taking another look at whether a European-wide financial services regulator is the answer to prevent future systemic crises.

Two recent case studies of crisis will be on the minds of financial services regulators - Northern Rock and Bear Stearns. The 'run on the Rock' caused public infighting between HM Treasury, the Financial Services Authority and the Bank of England. Delay and confusion resulted in Northern Rock being nationalised after a protracted crisis.

By contrast, the Bear Stearns bailout happened over a weekend. But the Federal Reserve had to step in to bail out an entity that was supposed to be regulated by the Securities and Exchange Commission. Now, US regulators are also concerned about their fragmented structure - which includes five national bank regulators and 50 state-level regulators.

What the European Commission is concerned about is the potential for serious difficulty if a bank with significant EU-wide operations gets into trouble. Although the EU emphasises its regulatory drive towards a single market, there is no effective regulatory framework in place either to prevent or to manage a pan-European banking crisis. What if Northern Rock had been a bank with capital spread between several EU states under several national regulators? What if it had been Barclays, Deutsche Bank or Santander?

Charlie McCreevy, the EU internal market commissioner, said in a speech last December: "So far we have not had to cope with a crisis in a major EU financial institution. And I hope we never have to. But in the light of recent events we do need to assess how well our response mechanism would work if, say, one of the 45 banks with cross-border activities was in trouble"

The awkward truth is, nobody knows. But whatever the impact, it would be much larger today than a decade ago. In 1997 Barclays held 71% of its assets in the UK and only 8% in the rest of Europe. These figures had shifted by 2006 to 41% and 20%. For Deutsche Bank the 1997 figures were 32% and 35%, shifting to 18% in Germany and 47% elsewhere in the EU by 2006. Santander held 55% of its assets in Spain back in 1997, with 8% elsewhere in the EU - shifting to 26% and 58% by 2006.

"A cross-border crisis was something fairly theoretical a couple of years ago. Now banks have integrated and the market has become more volatile, so it becomes a much more distinct possibility. So the question for the politicians then becomes, 'What about their responsibilities?'" says Nicolas Veron, research fellow at EU think-tank Bruegel. The issue has dominated Ecofin - the Committee on Economic and Financial Affairs, composed of national finance ministers - meetings over the past six months.

The starting point of these Ecofin discussions is the review of the Lamfalussy process and the Capital Requirements Directive (CRD). Both initiatives predate the current market conditions.

The Lamfalussy process - an amended legislative structure created to make financial services laws more flexible - was under review in 2007, and a report was produced in November 2007. Proposed amendments to the CRD have been issued in a consultation paper published in April 2008 as part of a review provess.

Noemie Francheterre, adviser for banking supervision at the European Banking Federation (EBF), says: "These two work streams were planned in any event. The financial crisis has to some extent influenced the debate and the way in which the CRD in particular will be reviewed, depending on the area of the CRD that is concerned. For instance, on the review of the large exposures rules, the turmoil has definitely shaped supervisors' thinking, whereas on the supervision part it has been more limited."

One suggestion that has been raised is to turn the committees created by the Lamfalussy process - such as the Committee of European Banking Supervisors (CEBS) - into a fully fledged supervisory entity that would parallel the European Central Bank. However, looking to the near or medium-term future, the Lamfalussy committees would be a problematic starting point in constructing a regulator. "The Level 3 committees have not been set up as decision-making entities," says Bruegel's Veron. "I don't think they could be given decision-making powers without very significant changes because they don't have either the resources or the governance to entail that. So you would need to transform them into something different from what the Level 3 committees are now."

Politically, among the Ecofin members, a single European financial services regulator isn't an acceptable option. "If (a single regulator) ever comes it will be a very long-term prospect," says the EBF's Francheterre. "At the council, member states level, this is a hugely politically sensitive issue and really not on the table. Member states are very much divided on this. Some would favour a more centralised regulator and others are very much against it."

Other initiatives to centralise banking regulation in the EU have also come and gone. In late November 2007, Italian finance minister Tommaso Padoa-Schioppa proposed the creation of a single set of rules for cross-border EU banks, acting "in the spirit of Lamfalussy", but the proposal was quickly scuttled by the UK and Germany.

Ecofin has instead concluded in favour of further evolving the 'colleges of supervisors' concept, first created under the CRD to co-ordinate the directive's implementation. These colleges - composed of a lead supervisor and host supervisors - will monitor Europe's biggest banks to share information and co-ordinate supervision across borders. Because of its role in implementing the CRD for banks, CEBS has been at the forefront of creating colleges of supervisors. Arnoud Vossen, deputy secretary-general of CEBS, says: "I think you should see the college as a setting of individual supervisors who exchange views and provide each other with information in a timely fashion to be informed of what is going on in a bank. The college does not report to anyone externally such as CEBS, but college members directly address issues relevant to the bank itself."

There are already a number of colleges in place for many of the large, international banks, but the concept remains largely untested in a crisis. Cecile Meys, a member of the CEBS secretariat, says: "Some colleges of supervisors are long-standing colleges, while others have been established more recently. There is no single blueprint for the organisation of a college, as colleges of supervisors reflect the structure of the bank. Within a college, there are various layers of supervisory co-operation. We refer to this as the variable geometry of a college. Having a college already in place for a crisis situation can only help, because there is an infrastructure for co-operating closely in order to facilitate the actions and the timely decision-making process of the authorities responsible for the management and resolution of the crisis."

Commissioner McCreevy signalled his favour for colleges in December. "A college of supervisors would be much easier to achieve than an EU supervisory body. Such colleges of supervisors would meet regularly and have a full exchange of information about the company. In the event of difficulties the supervisors would be able to take effective and co-ordinated measures on the basis of a general approach worked out beforehand."

But while a legislative EU solution might have been impolitic, colleges are not without detractors. "The debate is whether colleges of supervisors can provide a creditable solution to the problem of supervising cross-border banks, and there are many people around, including myself, who are deeply sceptical that colleges of supervisors can do that," says Veron at Bruegel. "In a major crisis you have to react very quickly, with all the information or very quick access to the information. Think of Bear Stearns, it had a week to fix this and the question is, 'Can you do that by committee?' There is no evidence that committee work can provide that in times of crisis."

Karel Lannoo, chief executive officer of the Centre for European Policy Studies, is another critic. In a short paper entitled Financial supervision is not well served by half-baked solutions published in early January, he wrote: "The measures proposed and the mandates given to the Commission and the supervisory committees constitute little more than short-term plumbing, lacking any long-term vision or coherent institutional framework. The clearest example of this short-sightedness is the move to allow supervisory committees to take decisions by majority vote. Although this move is to be welcomed, it lacks any legal basis, as it concerns committees that are empowered to act merely in an advisory capacity, and whose advice can thus be ignored by member states, as some have already implied is their intention."

Ecofin has requested further proposals to "clarify the role of the Level 3 committees and consider all the different options to strengthen the working of these committees without unbalancing the current institutional structure or reducing the accountability of supervisors", which were expected as this edition of the magazine was going to press in late April.

But for many, the jury is still out on just how the EU's financial services regulatory framework will be modified, and whether these modifications will work in the event of a crisis.

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