The European Commission recently published a consultation on the operation of the European Supervisory Authorities (ESAs), the three EU financial regulatory agencies established in 2011. This debate is timely. In the short term, Brexit will force a relocation of the European Banking Authority (EBA), which is currently based in London. Separately, but also as a consequence of Brexit, the European Union needs to rethink its capital markets oversight framework. Following the recent pooling of euro-area banking supervision at the European Central Bank (ECB), it should further separate prudential oversight from the protection of savers, investors and market integrity, thus implementing an institutional concept known in financial regulatory debates as “twin peaks.” In this blog post, we tentatively explore how to bring these strands together in the European Union’s next legislative steps.
The three ESAs are the EBA, the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA). This sectoral approach of having separate bodies for banking, insurance and securities is a historical legacy. The European Union had set up sectoral committees in the 1990s and 2000s: first came the Forum of European Securities Commissions (FESCO) in 1997, followed by the so-called Lamfalussy Level-3 Committees of the 2000s. After the financial shock of 2007-08, the Larosière Report of February 2009 crystallised a consensus to move one step further towards EU-level policy integration and a “single rulebook.” However, given widespread lingering differences among member states, the Larosière Report opted for the path of least resistance for institutional design, namely to keep the sectoral scope and intergovernmental governance of the three Lamfalussy Committees while transforming them into fully-formed EU agencies with their own legal personality.
In fact, the apparent institutional parallelism between the three agencies was slightly misleading from the start. Not only do they cover different sectors, they also have different roles. Notably, ESMA was quickly granted directly binding powers over several market segments: it is the sole supervisor of credit market agencies and trade repositories, and it also has authority to recognise third-country Central Counterparties (CCPs) for their operation in the European Union. In 2015, ESMA created a dedicated Supervision Department to handle these tasks. The EBA and EIOPA have no comparable competencies.
Almost a decade later, after major developments like banking union and Brexit, it is time to re-examine the ESA architecture. It should be reframed in a long-term vision for EU financial oversight, and this vision should bebased on the ‘twin peaks’ concept. Twin peaks is shorthand for the separation of conduct-of-business supervision from prudential supervision, originally proposed by Michael Taylor in a 1995 pamphlet and since adopted by jurisdictions including Australia, the Netherlands and the UK.
There are three main reasons to support a twin peaks model.
First, Europe’s banks and insurers are often linked in financial conglomerates, which warrants integrated supervision of banking and insurance. Based on end-2015 disclosures, we calculate that bank-insurance conglomerates account for 49% of the aggregate assets of the EU’s 30 largest banks, and for 40% of the assets of its 30 largest insurers. In a crisis, problems may emerge in any part of a financial conglomerate, even though the nature and maturity of liabilities are structurally different between banking and insurance. Since the European Union does not appear to envisage a tighter regulatory separation between banking and insurance, it should move towards more integrated prudential supervision of both sectors. In the same spirit, the European Union should amend its capital requirements legislation to reverse the so-called Copenhagen compromise, which allows for double-counting of the same capital for banking and insurance regulation purposes and does not fully comply with the global standards set by the Basel Committee on Banking Supervision.
Second, the EU27 urgently needs to upgrade the supervision of its capital markets after Brexit. An empowered EU-level markets supervisor – in practice, a reformed ESMA with additional direct authority – is needed to adapt quickly to this new reality, as we argued in an earlier blog post. This would help to revive the EU’s capital markets union, whose rationale is sound but which so far has delivered only limited results. A twin peaks design enhances the importance of the markets supervisor by granting it authority over most aspects of the protection of investors’ and savers’ interests.
Third, prudential supervision and conduct-of-business supervision (including markets supervision) require different mindsets, skills and approaches. Prudential supervision requires staff trained in economics, finance and/or accountancy, while conduct-of-business supervision is more behavioural and legalistic. Conduct-of-business supervision involves policing the conduct of financial institutions in the markets (insider trading, market abuse, disclosure, etc) and towards clients (adequate information provision, duty of care, know your customer, etc). But on these issues, long and sometimes painful experience demonstrates that prudential supervisors often prioritise the interests of supervised entities over those of their customers.
Overlapping tasks between the prudential and markets authorities typically result in the failure to protect savers. This is one of the lessons of the debacle of securities misselling in Italy, with major negative consequences for individual households, for the reputation of banks, for that of public authorities, and for financial stability.
The recommendation for twin peaks is a long-term aspirational goal. Indeed, the treaty basis for ECB banking supervision expressly prevents its extension to insurance. Current national arrangements vary widely. For example, Cyprus, Greece, Italy, Luxembourg, Portugal, Slovenia and Spain have separate insurance supervisors. Moreover, in many member states, conduct-of-business supervision of banks and insurers is at least partly located in the prudential authorities. Nevertheless, defining a long-term goal is important for making the right decisions on short-term issues.
The most urgent priority is the relocation of EBA. Uncertainty about this will have damaging consequences for EBA staff morale and makes recruitment of qualified experts near-impossible. To remedy this, we recommend that the European Union announce a decision on the new location as soon as the late spring or summer of 2017.
We simultaneously caution against recently broached suggestions to merge EBA with either EIOPA or ESMA, which we view as counterproductive. An EBA-EIOPA merger would not achieve twin peaks, since neither agency is actually a supervisor. Instead, it would generate unwieldy governance complexities given the absence of a counterpart to banking union in the insurance space. An EBA-ESMA merger would be even worse, going squarely against the twin-peaks vision and creating damaging conflicts of interest between the conduct-of-business and prudential mandates of the resulting entity. It is also worth recalling that EBA is needed for technical rule-making and supervisory convergence, as long as the banking union framework does not cover all EU member states. EBA is the right venue to balance the interests between the “ins” and “outs” of banking union: as long as there are “outs,” its competencies cannot be directly assumed by the ECB.
Given all these considerations and the operational imperative to come to a decision quickly, we suggest that the 2017 decision on EBA should be only about relocation, and not about any further reform at this stage. Even though the choice of a new location can be expected to be a political one, rather than policy-driven, it is worth noting that having EBA in Frankfurt, even without a merger with EIOPA, would facilitate joint work with both EIOPA and ECB banking supervisors. It would also ease an eventual merger in a hypothetical long-term scenario in which all EU countries would have joined the banking union. Alternatively, EU leaders may opt for locating EBA in a non-euro-area member state, as a signal that the post-Brexit dominance of euro-area banks (which represent about nine-tenth of the EU27’s total banking assets) will not result in the “outs” being ignored in the preparation of banking regulations.
While EBA reform can wait, the reform and further empowerment of ESMA should be an immediate priority for EU leaders. This would give an important sense of direction for EU financial markets policy at a time when many financial firms need to determine their operational response to Brexit by end-2017 or early 2018. In essence, ESMA’s governance and funding should be reformed to make it more independent and accountable. Its direct authority should be extended to include registration of all EU-critical market infrastructure (in liaison with prudential authorities for CCPs which are systemically important for financial stability, including presumably a legislative empowerment of the ECB and Single Resolution Board in that area); accounting enforcement; audit firm supervision; wholesale market activities of investment banks (under the EU Markets in Financial Instruments legislation); and most conduct-of-business regulatory relations with market authorities outside the European Union.
In accordance with the subsidiarity principle, most other tasks currently lodged in national authorities, such as authorisations for initial public offerings, fund management registrations, and the conduct-of-business supervision of smaller investment and insurance intermediaries to protect retail investors and savers, should remain there for the foreseeable future. However, national authorities should operate under ESMA’s umbrella to ensure EU-wide consistency.
The pooling of conduct-of-business supervision under ESMA’s oversight also implies that an increasing number of financial firms (including banks, insurers and CCPs) will be subject to “double supervision” by both conduct-of-business and prudential authorities. Special interests will surely denounce this duality as unacceptable complexity. But given the different objectives of the two types of supervision, it should be viewed as not only unavoidable, but actually desirable.
The European Commission’s review of Capital Markets Union, scheduled for June 2017, provides an appropriate opportunity to trigger a decision-making process that could result in EU decisions of principle on ESMA reform and further empowerment later this year. Of course, the finalisation and implementation of the corresponding legislation would inevitably take longer.
As for insurance, the EU Solvency II legislation, in force since last year, allows insurers to use their internal models for capital purposes. Given the strong cross-border nature of the large European insurers, EIOPA should become responsible for the approval and monitoring of these internal models. EIOPA might thus get direct supervisory tasks vis-à-vis the large insurers in the European Union.
These decisions would support the long-term vision of a Twin Peaks regulatory framework for the European Union. The completion of that framework would require treaty change, to merge ECB banking supervision with a still-to-be-created EU level of insurance supervision; and an extension of banking union to all EU member states, to allow the duplication between ECB Banking Supervision to be eliminated. None of these two conditions can be expected to be fulfilled any time soon. In the meantime, the swift relocation of EBA, elevation of ESMA into a vigorous conduct-of-business supervisor at the EU level, and gradual build-up of EIOPA direct authority, would together represent a consistent and effective European approach.
Given London’s current central role in the European financial system, Brexit will generate significant risks and opportunities for the financial system of the remaining members of the European Union (EU-27). With Britain’s departure from the EU single market nearly certain to occur before mid-2019, the EU-27 should not wait to adapt its financial regulatory structure to successfully manage the resulting shifts. The main risks relate to the supervision of wholesale activities of financial firms and capital markets. To address these risks, European leaders should reinforce the European Securities and Markets Authority (ESMA) with significant additional resources and an expanded responsibilities.
Market disruption is not the main risk for the EU-27’s single market: Most market participants have enough time to prepare for the worst-case scenario of a lack of agreement on “B-day” in early 2019. Rather, the main risk is the market fragmentation along national lines that would occur with the loss of the London hub . Fragmentation could result in less effective market supervision than is currently achieved by the UK authorities, a higher likelihood of misconduct and systemic disturbances, and a more onerous cost of funding for EU-27 corporates and households.
Fortunately, and thanks to wide-ranging reforms introduced during the past years of crisis, the EU-27 is much better equipped to face these challenges than it would have been a decade ago. All euro area banks are now supervised on the prudential side by the European Central Bank (ECB), directly for the larger ones and indirectly for the smaller ones, which minimizes the possibilities of regulatory arbitrage and of a concentration of systemic risk in a given country. However, on market activity and regulation—including securities firms (also known as broker-dealers), asset managers and financial infrastructure, e.g., central counterparties (CCPs, also known as clearing houses)—and the conduct-of-business oversight of banks themselves, the ECB has no jurisdiction. Many wholesale market activities will need to be relocated from the United Kingdom to the EU-27 so that financial firms can keep serving local customers within the single market.
ESMA was created in 2011 to help foster “supervisory convergence” and mitigate the vast existing differences of approaches, experience, and effectiveness between individual member states’ national authorities, such as BaFin in Germany, AMF in France, and Consob in Italy. ESMA also has some direct supervisory authority, but only over comparatively tiny market segments, namely credit rating agencies and trade repositories. ESMA has accumulated a decent track record, but its current mandate is not sufficient to integrate EU-27 capital markets and ensure high standards of compliance with EU regulations.
The obvious solution is to enhance ESMA's responsibilities, especially over those wholesale market segments that are currently concentrated in London and that require uniform, high quality supervision. Recommended expanded responsibilities include the authorization of significant investment intermediaries (e.g., banks and securities firms) under the EU Markets in Financial Instruments Directive and Regulation (MiFID/MiFIR); the registration, supervision, and resolution of CCPs, at least those that serve international clients and have a potentially systemic importance from an EU perspective; and also the supervision of audit firms and the enforcement of International Financial Reporting Standards.
In parallel, the governance and funding of ESMA should be overhauled to better suit an enhanced scope of authority. Its current supervisory board, in which only representatives from national authorities have a vote, should be reformed to include an executive board of, say, five or six full-time members vetted by the European Parliament, as is the case with the ECB and the recently created Brussels-based Single Resolution Board. And in line with international best practices, ESMA’s funding should rely on a small levy on capital markets activity under scrutiny from the European Parliament, instead of the current political bargaining through the general EU budget.
Moreover, ESMA should be the single EU-27 point of contact for all interaction with third-country (non-EU) authorities. It should represent the EU-27 securities regulatory community in international supervisory colleges wherever relevant, and in international standard-setting bodies such as the International Organization of Securities Commissions and the Financial Stability Board. It should also, importantly, be given oversight authority over non-EU financial infrastructure that is systemically important for the European Union, similar to what already exists in the United States. This would allow flexibility in handling the financial stability challenges linked to the location of derivatives transactions, especially those denominated in euros, without having to force a costly relocation of their clearing in the euro area in the short term.
These reforms are significant but can all be achieved within the current treaty framework and without having to wait for the actual UK exit, since they would all take the form of Internal Market legislation approved by a qualified majority vote. In fact, the United Kingdom can be expected to favor them all, for the same reasons it supported the inception of banking union in 2012–14: It is in the interest of the United Kingdom to have a well-regulated, well-supervised EU-27 financial system as its neighbor, for economic growth and financial stability reasons.
There is no compelling counterargument against financial market policy integration, especially now that the early achievements of banking union, including a broadly strong and effective European banking supervision led by the ECB, have provided a “proof of concept.” Significantly, the influential German Council of Economic Advisors (Sachverständigenrat) indicated in its latest annual report that “organizing the supervision of banks, insurance companies and financial markets at [the] European level is the right approach.” The European Commission will review its signature policy of capital markets union in June: This should mark the opportunity to announce the reinforcement of ESMA along the lines suggested above.
Other initiatives are also needed to make the best of Brexit for the EU-27 financial system. In particular, banking union is still an unfinished project that will need strengthening in order to better share the risks and benefits of the forthcoming relocation of financial activity from London. The distracting project of a European Financial Transaction Tax should be either reframed as a stamp duty on securities transactions or abandoned altogether. Most importantly, leaders should make it clear that the inevitable competition among European financial centers to attract business from London should not be based on financial regulatory competition, but on other, nonregulatory factors such as infrastructure, skills, quality of life, as well as labor and tax legislation within the boundaries set by EU law. A swift move towards a stronger, more authoritative ESMA would be the best way to cement this vision.
In this brief video interview with Eitan Urkowitz at the Peterson Institute, I answer questions on the likely impact of Brexit on the City of London and on the EU27 (EU minus UK), and what policy initiatives may be envisaged to prevent the worst outcomes.
I gave this lecture on January 24 at ESMT, the business school in central Berlin. While not a verbatim transcript of the presentation, the text below is based on oral delivery and on unpresented but prepared notes. It was also published online by ESMT (with a video of the lecture) and by PIIE.
At a time when there is much uncertainty in the world, this open lecture will focus on the challenges that are facing the European Union this year and, among them, on those that have a specific economic and financial dimension and may be addressed by European policy initiatives in the near future. I am very grateful to Jörg Rocholl, President of ESMT, for his generous invitation to speak today in this intimidating historic room, and to Michał Grajek who has kindly accepted to moderate the questions-and-answers session after my initial remarks.
The title of this lecture is an invitation to look forward, but it is also important to remember where we come from. The European Union is only slowly emerging from nearly a decade of continuous economic and financial emergency, which started with the first indications of major dysfunction in the financial system in the middle of 2007—including here in Germany, with the rescue of IKB in late July of that year. Financial and economic turmoil later morphed into disruptive political developments, which in turn generated economic and financial challenges of their own.
Of these political developments, at least one will certainly have lasting structural consequences—the choice made last year by the United Kingdom to leave the EU, or Brexit. Apart from the UK, there are many current challenges in European politics, but it remains to be seen whether they are of more than a temporary nature. The initial political impact of Brexit itself has been weathered by the rest of the EU, better than many observers (including myself) would have anticipated. There has been shock and disbelief, but no obvious contagion to other member states in terms of collapse of public support for European integration; if anything, the opposite has been observed in several opinion polls since June 2016. It is early in the year, of course, and a string of elections later this year will give us a number of new data points. As for financial system aspects, there is no question that Brexit represents a significant shift in the European landscape, given the central role of London as a capital markets hub for the entire European Union in the recent past and the present.
2017 is likely to mark the end of the EU’s decade-long sequence of economic and financial emergency. Such a statement may appear overly optimistic given all the catastrophist media headlines about the EU and the euro, which are routinely depicted as on the verge of collapse. But while that alarming picture was definitely appropriate during the transatlantic financial meltdown of the early autumn of 2008, or during the climax of the euro-area crisis in late 2011 and early 2012, or even during the high drama of the Greek crisis in mid-2015, it rings less true now.
The last major pockets of country-specific banking sector fragility—in Portugal and Italy—are belatedly on the way towards being properly addressed, at least if a number of important ongoing transactions are confirmed. These include the privatization of Novo Banco, the capital increases of BCP and Caixa Geral de Depositos in Portugal, and in Italy, the public recapitalization of Monte dei Paschi di Siena and that of the entity resulting from the announced merger of Banca Popolare di Vicenza and Veneto Banca. If and when all these are completed, which I hope and expect will be the case in a few weeks, a picture will emerge of a euro-area banking sector still in need of considerable restructuring but no longer in a situation of systemic fragility (even though smaller banks in Italy and elsewhere will remain a concern).
Similarly, while negotiations on continued financial assistance to Greece remain difficult, they are unlikely to degenerate into the kind of unreasonable brinkmanship that occurred in mid-2015. And while Brexit creates significant challenges for the financial system of the EU-27 (the 27 other EU countries, excluding the UK), it is unlikely to generate financial instability given the long lead times that will allow financial firms to adapt their structures and anticipate even the most non-cooperative outcomes. Altogether, in a broadly probable baseline scenario, there will be situations to manage in 2017 but they won’t be as existential as in every year of the last decade. Of course there are tail risks that could trigger severe financial instability—such as a far-right government in France, for example—but their likelihood should not be exaggerated. In a turbulent global environment, and somewhat ironically given the recent experience, the European Union (minus the UK) could even quickly become an area of comparative stability.
Even if one accepts this comparatively benign assessment, there is evidently no room for complacency. The European Union is far from having reverted back to a normal economic and financial condition. The clearest sign of this is the continuation of extraordinary monetary support by the European Central Bank, including in the form of the current program of quantitative easing. Greece is very far away from regaining market access for its sovereign financing. And as previously mentioned, the European banking system cannot retain its current structure; major changes in the financial landscape will have to happen before it becomes healthy again.
Thus, the desirable transition back to normal will only happen if further efforts are made, including in the area of new policy development. This lecture focuses on outlining a realistic agenda for such efforts, which should also draw appropriate lessons from the last almost-ten years of crisis. One hopes that 2017 will be a busy year for the EU policy debate, so that the new governments that will emerge from the sequence of elections scheduled this year in several key countries, including this one in September, will be able to initiate useful actions once they are in place.
Such new policy initiatives at the European level should not be thought of as overly radical. Experience suggests that paradigm shifts in EU governance only occur under massive short-term pressure and, as highlighted above, such pressure is not expected to be repeated in the year ahead, at least in a baseline scenario. In particular, there should be no expectation of treaty change in the immediate future. Indeed, treaty change would be very hazardous as long as the negotiation with the UK on Brexit is not completed.
In the same vein, there should be no expectation of fiscal union, understood as a fully-fledged system of debt issuance and revenue collection at the European level. The euro area has limited elements of a fiscal framework, such as size-bound financial firepower (including the ability to issue debt) at the European Stability Mechanism, and a limited-purpose levy on European banks to feed into the Single Resolution Fund, which is expected to become fully transnational by 2024. More longstanding arrangements include the European Investment Bank’s financial capacity and the EU’s own resources, such as customs duties and sugar levies. But these arrangements stop well short of a full fiscal framework. There is no expectation here that the political and legal parameters which so far have prevented the emergence of genuine fiscal union in the euro area will change any time soon.
Even within these constraints, a lot can be done. Four areas in particular can be singled out for bold reform. They may be labelled, respectively: a stronger banking union; a reframed capital markets union; a common information backbone for fiscal policy; and renewed thinking on how to achieve a true single market in regulated services sectors, which may also be thought of as economic union. The rest of this lecture is devoted to examining these four possible projects in a bit more depth.
Banking union refers to the pooling of banking-sector policy instruments at the European (in this case, euro-area) level to achieve the objective “to break the vicious circle between banks and sovereign” as memorably stated by the euro area political leaders in their landmark declaration of 29 June 2012, which started this project, and in subsequent pronouncements. This unusually clear statement of intent came from the painful lessons of the months preceding that mid-2012 policy breakthrough. During that period (late 2011 and early 2012), it became increasingly evident to all that the financial linkages between national banking systems and the respective sovereign issuers, through mechanisms that may variously be labeled implicit government guarantees of the banking sector, financial repression, and banking nationalism, were generating a destabilizing dynamic of contagion and escalation that came close to forcing an irreversible break-up of euro-area monetary integration. As long as genuine fiscal union was not on the cards, banking union was eventually, and correctly, identified as the only way to break that vicious circle.
Several policy initiatives came from this recognition: mainly the creation of a brand-new system of European banking supervision (also known as the Single Supervisory Mechanism) in which the central role was entrusted to the ECB, operational since late 2014; the acceleration and strengthening of the hitherto tentative shift from a default assumption of public rescue (or bail-out) of creditors of failed banks towards that of burden-sharing by private stakeholders (or bail-in), materialized in the Bank Recovery and Resolution Directive (BRRD) of 2014; and the partial centralization of bank resolution decisions in the euro-area through the establishment of the Single Resolution Board and Single Resolution Fund, both in place for more than a year now. But despite these path-breaking achievements, Europe’s banking union remains, to borrow the words (if not the full analysis) of Germany’s finance minister in a 2013 article, “timber-framed,” an unfinished construct that mitigates the bank-sovereign vicious circle but is not strong enough to break it. To achieve that aim, again borrowing Mr. Schäuble’s expression, a “steel-framed” banking union should replace the timber structure, and this requires further legislative reform.
The specific content of such reform requires public debate, which itself can only be fruitful once the European public, including observers in this country, has been sufficiently persuaded that the existing system works as intended, and in particular that European banking supervision is “tough and fair,” as its officials often put it. This requires clear indications of progress in countries such as Portugal and Italy, but also a sense of direction on high-visibility German cases such as Deutsche Bank or, in a completely different category, HSH Nordbank. The lack of that perception in the past goes a long way towards explaining, in particular, the lack of progress in the discussion on “strengthening banking union” during the Dutch Presidency of the Council of the EU in the first half of 2016. But if, as previously suggested, the picture of ECB supervisory effectiveness improves significantly in the near future, then a much broader space will be opened for further constructive steps.
There is not enough time today to describe in much detail what these steps should look like. But they should include at least three dimensions. First, the framework for bail-in should be made more consistent across member states, an aim that inevitably entails harmonization of bank insolvency law. Second, regulation should ensure that banks cannot be used by governments as instruments to get easy funding, which suggests a binding framework of well-calibrated exposure limits on banks’ sovereign debt portfolios, with proper transition arrangements. This is a complex and important matter that requires much more public debate than has happened so far, but the euro area will not escape that debate—nor can it be successfully delegated to international bodies such as the Basel Committee, because the problem is the unduly high home bias in euro-area banks’ sovereign debt exposures and this problem is essentially unique to the euro area. Third, there is a need for explicit risk-sharing to rule out the possibility that local banking problems, especially in smaller countries, may trigger sovereign default. This should take several forms, including the creation of a European Deposit Insurance System broadly along the lines suggested in November 2015 by the European Commission, a financial backstop from the ESM for the Single Resolution Fund and the future European deposit insurance fund, and also the ability for the ESM to intervene financially in precautionary bank recapitalizations under the conditions set by BRRD.
These three dimensions are mutually interdependent, not only politically but also on substance, and should be envisaged as a single policy decision package even though their implementation will inevitably occur in several stages. In addition, more work is needed on subsidiarity and proportionality in the banking union architecture, to ensure that smaller banks are subject to consistently high prudential and supervisory standards without burdening them with unnecessary administrative requirements. This latter objective may take more time to achieve but also deserves open discussion as soon as this year.
The EU project of Capital Markets Union (CMU) was initially announced in July 2014 as part of the broader policy program of the new European Commission led by Jean-Claude Juncker. At the time, the aim was to reduce an excessive dependence on bank intermediation in Europe’s financial system but also, plainly, to signal a financial-market-friendly attitude in the run-up to the UK referendum. But far from rendering CMU obsolete, Brexit actually adds to the project’s urgency and should force a reframing on how to achieve its aims.
The underlying reason is that London’s role as a central hub has meant that the EU’s wholesale financial markets were overseen in a consistent way—by the UK authorities—because they were overwhelmingly located in a single member state. In a EU-27 context post-Brexit, there is a major risk of oversight fragmentation, with different national authorities taking different approaches leading to regulatory loopholes, lack of enforceability of EU policies, and a higher cost of funding for the EU economy.
Even though banks represent a major share of financial intermediation, banking union per se doesn’t address this challenge, if only because many of its aspects are unrelated to prudential supervision. For example, the enforcement of the Markets in Financial Instruments directives and regulation (known as MiFID/MiFIR) is largely in the hands of securities authorities, not prudential supervisors, and in most member states (though not Germany) these are entirely separate organizations. Thus, the new incarnation of CMU in the changed context created by Brexit should put the emphasis on the reform of the oversight architecture (possibly complemented by regulatory harmonization projects), in order to reach a status in which, to borrow a recommendation from the last annual report of the German Council of Economic Advisers, “the oversight of financial markets [should be] located at the European level.”
In practice, this would require a reform and reinforcement of ESMA, the European Securities and Markets Authority created in 2011, to make it the hub of policy-setting in that area. Many individual decisions would remain in the scope of national authorities, but under ESMA’s binding oversight, in a hub-and-spokes framework akin to those for competition policy or for banking supervision. For example, ESMA should have authority over the enforcement of International Financial Reporting Standards throughout the EU, and similarly for the oversight of audit firms and of critical market infrastructure (such as clearing houses), as it already has over credit rating agencies and trade repositories (disclosure: I am an independent director in a trade repository supervised by ESMA).
This vision for “CMU 2.0” would also allow for the creation of third-country regimes that would allow European authorities, including ESMA and the ECB, to oversee market infrastructures located outside of the EU-27—for example, in London—if they play a critical role for the EU-27 financial system. Such a vision is not at all utopian, since a framework along these lines already exists for US authorities, which have arrangements in place to directly supervise and inspect some critical financial infrastructure in London and elsewhere. It is high time for the EU to revise its approach in this area and learn the right lessons, both from the American experience and from the shortcomings of its own frustrating past attempts to address this challenge through the means of equivalence recognition.
As mentioned earlier in this lecture, it is arguably not realistic at this stage to advocate decisive steps towards fiscal union—eurobonds, eurotaxes and euro-spending even if they’re not called that way. There is a sound intellectual case to be made for such things, but it is abundantly clear that Europe is not yet ready for them politically and can most likely overcome its current challenges without them. But that doesn’t imply that nothing can or should be done to improve the euro area’s current highly imperfect fiscal framework.
Sadly, the Maastricht treaty’s stability pact (later, stability and growth pact) has not worked as intended by its framers—and my country and yours, France and Germany, were the ones who first and foremost breached it almost fifteen years ago. Since then, increasingly complex patches have been applied, but their credibility has not been better. If the rules are simple, they tend to be too rigid and in many cases even “stupid,” as was memorably put by a former president of the European Commission; in order to better meet economic objectives, the framework requires more nuance and judgment, but then it quickly becomes overly complex and open to political tweaking, which is more or less the present situation.
Meanwhile, the EU does not appear to have fully drawn the lessons from its most obvious fiscal policy failure: the repeated misrepresentation by Greece of its true fiscal condition (under different political coalitions) that led to the well-known drama of 2010 and ever since. Some changes have been introduced to make national numbers more reliable, but they have not gone nearly far enough.
One case summarizes the problem: that of Mr. Andreas Georgiou, head of the Greek national statistical office for five years from 2010 to 2015 and, in that capacity, the one who established the definitive figures for Greece’s deficit and GDP developments in 2009 in particular. These figures have been validated by Eurostat and have not been questioned outside of Greece. Within Greece, however, they have become a matter of highly emotional controversy. The government has repeatedly declined—again under successive political coalitions, including but not limited to the current one— to vouch for them. Worse, Mr. Georgiou was accused of harming the national interest by publishing them and has been the target of a number of high-profile lawsuits that are still ongoing. It is evidently not acceptable that a statistician should be persecuted for doing his job with integrity and left to his own devices by both national and European authorities for his defense. As long as such a thing can happen, the potential for undue political interference in the production of national accounts and statistics is achingly obvious, and not only in Greece. This situation cries for reform.
What is needed is—with reference to the arrangements existing in the private sector and in particular those covering publicly listed companies—a proper accounting and auditing framework for European governments, with a robust enough central function to ensure relevance, comparability, reliability, and understandability. The accounting standards should be based on the age-old principle of accruals accounting, which has only recently been introduced into government accounting in some countries, including some EU member states but far from all of them, for example Austria but not Germany. Equally important, the current oversight by Eurostat should be transformed into a genuine euro-level auditing authority. These more centralized arrangements should also apply, with due adaptations in accordance with the subsidiarity principle, to the accounts of subnational governments, to the extent that they contribute to national aggregates. Such ideas are bound to be controversial, but the lessons from the Greek tragedy in general, and from the more specific but significant Georgiou tragedy in particular, must not be allowed to be lost.
The Four Presidents’ report of June 2012, whose lead author was then-President of the European Council Herman Van Rompuy, has popularized a framework of “fourfold union” to think about the missing pieces of euro-area policy: financial union (i.e., banking union and capital markets union), fiscal union, economic union, and political union. This lecture has already included suggestions for financial union and for a sounder information basis for fiscal policy even as fiscal union is left for a more distant future. Political union is not discussed here, beyond the observation of the EU-27’s initial resilience following the shock of the Brexit vote.
Economic union, however, deserves more debate and attention than it has habitually received since Mr. Van Rompuy’s report. Different analysts have used the expression in many different ways. It is proposed here that it may best refer to those structural economic policies that are conducted at the European level, not the national level. Viewed that way, economic union may be taken as just another name for the completion of the European single market, particularly in services sectors where EU-wide market integration is partial at best.
Single market policy has been very successful in markets for goods and unregulated services but much less so in regulated services sectors. This distinction is especially significant since regulated services tend to represent an increasing share of the EU’s economies, and this increase implies that national economies become less not more integrated if the EU is not able to complete the single market in such sectors. The underlying reason for the gap is that, in regulated sectors, market structures are shaped not only by the content of rules and regulations but also by the way they are implemented and enforced, which typically involves a degree of administrative discretion and judgment. If such administrative oversight and enforcement is in the hands of national authorities, as is habitually the case, then markets tend to be segmented across national lines. One aspect of this is the tendency of national authorities to give preferential treatment to “national champion” companies, as is being illustrated by the burgeoning cases about the control of car emissions—even though one would expect this type of technical standards not to be susceptible to national twisting.
“Capital markets union 2.0” as previously discussed, and indeed also banking union, can thus be viewed as early examples of a new and promising approach to promoting EU single market integration in regulated services sectors, by complementing the structure of national enforcement authorities with a European overlay, thus achieving a hub-and-spokes architecture comparable to the one that has long existed for the implementation of competition policy. This approach can and should be extended to an increasing range of regulated sectors, be it energy (e.g., electricity and gas networks), digital services (e.g., the enforcement of privacy protections), as well as various regulated professions, commercial health and education services, and more.
Overhauls of EU supervisory architecture through the creation of sector-specific EU-level authorities with a mandate for binding decision-making, not just loose coordination, has long been considered unachievable politically. But the initial successes of European banking supervision have led to a shift in perceptions. With the UK veto removed by Brexit, it may now be time for the EU-27 to envisage new initiatives to create appropriate institutional settings that would allow for the vision of a seamless single market to be achieved, in a broader range of economic sectors than has been the case so far.
The theme of this lecture has been that the EU-27 is just exiting a decade-long period of short-term emergencies, and now needs to consider fresh initiatives to reach a more consistent framework for banking, capital markets, fiscal (if only as regards the information base), and structural economic policies, building on the early achievements of recent shifts such as European banking supervision. This might strike some observers as an exceedingly optimistic way of looking at the EU’s current situation and challenges.
Only time will tell if there is too much optimism in this vision, but in any case it should not be mistaken for complacency. As previously emphasized, even assuming no new dramatic development in the EU-27 in 2017, the area is far from having returned to a normal economic and financial condition. This is precisely why a strategic, forward-looking policy debate is so important this year. As the old American saying has it, Europeans will hang together or hang separately.
A week ago, Bruegel published this Policy Brief which I co-authored together with André Sapir and Dirk Schoenmaker. We start from the observation that Brexit will generate major structural change not only for the UK but also for the financial system of the EU27, a side that has received comparatively little media attention so far. We present a ballpark estimate of the aggregate impact in terms of relocation of business and jobs, make the analytical case for a policy response that fosters financial market integration inside the EU27, and outline three main policy recommendations: a stronger ESMA, a strengthening of banking union, and a new policy regime for financial infrastructure.
Update (February 21): a lightly revised version of the same text was published today by the Peterson Institute.
Global cooperation on financial regulation has become increasingly important and valuable over the last decade, but its effectiveness cannot be taken for granted. Following November’s U.S. presidential election, Asia, and particularly China, needs to take a more central role to ensure the viability of the global system.
Compared with other modes of international economic cooperation, the global financial regulatory system is in a nascent stage of development. It is made up of a network of diverse organizations and groupings, many of them without legally binding authority, with the Financial Stability Board acting as a coordinating hub.
This system has grown in importance, particularly since the global financial crisis, and its impact has been overwhelmingly positive. The Basel Committee on Banking Supervision, for example, has helped to limit cross-border competitive distortions resulting from incompatible prudential rules and has been increasingly forceful in monitoring national compliance with its agreed standards. The widespread adoption of the International Financial Reporting Standards Foundation’s accounting principles has greatly enhanced the international comparability of listed companies’ profit statements, even if not yet on a universal basis. The Global Legal Entity Identifier Foundation has opened the way toward universal interoperable financial data formats by issuing codes to transaction participants that function in a way comparable to the internet protocol addresses that underlie the World Wide Web.
Such arrangements are even more valuable as the global financial system becomes increasingly multipolar and interconnected, enhancing the need for joint work by public financial authorities on a commonly agreed basis.
Aside from the above organizations, key participants in the regulatory system include treaty-based organizations such as the Bank for International Settlements, which hosts the Financial Stability Board, the International Monetary Fund, the World Bank, and the Organization for Economic Co-operation and Development and its Financial Action Task Force. These are complemented by independent groups such as the International Organization of Securities Commissions, the International Association of Insurance Supervisors and the International Forum of Independent Audit Regulators. The roots of the treaty-based institutions can be traced to the second quarter of the 20th century, but none of the other entities in this global network are more than 45 years old.
The global financial regulatory system has long been lopsided and in need of change as the emergence of new financial powerhouses, particularly in Asia, has challenged the dominance of North American and European states.
Significant improvement has flowed from the 2008 shift to tackling financial and economic issues at Group of 20 leaders’ summits from Group of Seven nation summits. The membership ranks of the Basel Committee and the Financial Stability Board, for example, have been expanded to include major emerging economies and financial centers.
But blatant imbalances remain. On a recent count, all but one of the 27 most senior leadership positions in this system were held by nationals from North Atlantic countries. Almost all entities in the network are similarly headquartered in the North Atlantic region, the only exception being the soon-to-be-established permanent secretariat of the International Forum of Independent Audit Regulators in Tokyo.
The system’s institutional fragility is about to be tested by the incoming administration of U.S. President-elect Donald Trump. His “America first” stance will surely create multiple challenges for all international cooperation frameworks, and financial regulation will be no exception.
The response to this test should include an accelerated rebalancing and reform of the global regulatory system to ensure its viability in the new environment. Asia, and specifically China, should claim a much more central position in the system than is currently the case and other nations should facilitate this evolution.
Specifically, China should propose highly qualified officials, of which it has an increasing number, for positions of leadership in global financial regulatory bodies and engage more proactively in their various workstreams. As with action against climate change, and given Europe’s current internal difficulties, China is fast becoming the indispensable anchor for sustainable joint efforts at the global level and should invest accordingly in its representation in global discussions.
In this context, Europe should streamline its presence in the system, as a logical consequence of its own ongoing reform and thus leave room for greater Asian and Chinese leadership. Specifically, Europe’s banking union implies that the representation of individual euro-area countries in bodies in charge of financial stability has become anachronistic and should be replaced by euro-area or EU-level participation. The Basel Committee is a case in point. Now that banking supervisory policy has been comprehensively pooled within the euro area, the separate membership of Belgium, France, Germany, Italy, Luxembourg, the Netherlands and Spain should be phased out.
The relevant bodies should then demonstrate their continued relevance by further improving the system’s effectiveness, even if the new U.S. administration does not initially join some of the resulting initiatives. For example, the Bank for International Settlements, IMF and others should further harmonize formats for financial statistics and data collection. Global regulatory standards should be forcefully developed in new areas in which their need is increasingly evident, such as derivatives. And steps should be considered toward establishing a global level of supervision for limited but critical segments of the financial system, starting with those with no likely fiscal or quasi-fiscal impact in a crisis, such as credit rating agencies or audit firms.
The events of the past decade have amply demonstrated the need for strong global regulatory and supervisory arrangements to keep the inherent risks of cross-border financial integration in check. The prospect of a more unilateralist America should force a rapid realignment in China, other Asian countries and Europe, so that the existing, beneficial financial regulatory system is not left to unravel.
This is a belated update on a paper I recently co-authored with Zsolt Darvas and Dirk Schoenmaker. "Reforms to the European Union Financial Supervisory and Regulatory Architecture and their Implications for Asia" was published by the Asia Development Bank Institute in November, and republished by Bruegel shortly thereafter.
We give an overview of the last few years' EU reforms, with a focus on banking union, and suggest a few lessons for Asia even while keeping in mind the vast differences between the two regions.
This op-ed was published yesterday by The Hill.
Italy’s banking problem has been left unaddressed for too long. Similar to Japan in the 1990s, it is best understood as a combination of structural and cyclical factors.
Most of Italy’s banks, many of which are small and local, have politicized governance features that blur commercial incentives. As a consequence, they were unable to rein in their lending during the downturn of the late 2000s.
Many of these loans turned sour in subsequent years and local connections prevented the banks from working them out, so they kept supporting borrowers in a pattern of “pretend and extend.”
The system’s non-performing exposures now total hundreds of billions of euros. Many of these loans are collateralized, but repossession is not really an option given the country’s antiquated judicial system.
It gets worse — many banks sold their own shares and debt to their retail clients, often without proper disclosure of the risks and at inflated prices. Such self-dealing is prohibited in many jurisdictions, but wasn’t prevented in Italy and even received favourable tax treatment until 2011.
Bank equity and debt became even riskier once the EU introduced legislation on the resolution (or orderly liquidation) of failing banks, a shift that was signalled as early as 2009-10 and became official in mid-2012.
By then, Italian authorities should have forced the banks to buy back their risky securities from non-professional clients. That they failed to do so was a massive failure of public policy.
This context largely explains the country’s subpar growth rate — banking system fragility results in credit misallocation and a severe drag on economic activity.
Particularly in the last half-decade, weak Italian banks have been culprits, not just victims, of economic sluggishness. In a telling contrast, Spain started cleaning up its banks in 2012 and has enjoyed comparatively dynamic growth since.
The problem was diagnosed more than two years ago by the European Central Bank (ECB) during its comprehensive assessment of the euro area’s 130 largest banking groups (of which 15 are Italian), which paved the way for its assumption of supervisory authority as part of a broader reform known as banking union.
Nine Italian banks were among the 25 that failed the exam, and four of them were still undercapitalized when the results were announced in October 2014.
Remarkably, they were the same that are widely believed to be in need of fresh capital now — Monte dei Paschi di Siena (MPS), Banca Popolare di Vicenza, Veneto Banca, and Carige.
The ECB did not immediately assert itself and, earlier this year, the constitutional referendum campaign deterred any forceful action. But the ECB appears to be moving into action now.
It is forcing MPS to find fresh capital before year-end. If this fails, the “world’s oldest bank” will face nationalization and drastic restructuring (with a specific protection scheme for victims of past misselling).
Similar initiatives are expected with the other three significant problem banks, and probably follow-up moves in the first half of 2017 to identify and handle weaknesses among the country’s hundreds of smaller banks which remain supervised by the Bank of Italy.
Mercifully, favourable market reactions to recent announcements by UniCredit, another large Italian institution, show that those banks that are not critically weak can still mobilize private capital.
Assuming reasonably competent handling, the entire system might reach broadly adequate capitalization to start seriously working out its bad loans by the summer of 2017.
This would have beneficial impact on three separate levels. First, putting an end to Italy’s banking fragility will revive the country’s growth, and also mark the near-completion of a protracted process of bringing the euro area’s banking sector back to soundness, in which Italy has lagged behind most other countries.
Second, it would herald the successful inception of banking union, with the ECB being a demonstrably more forceful supervisor than the national authorities it replaced in 2014.
Third, it could unlock a new phase of reform grounded on that success, including the long-debated creation of a European deposit insurance scheme and related policy measures to deepen Europe’s still unfinished banking union.
As usual in Europe, the path of progress is belated and tortuous. But it may well be that an important corner is just being turned.
Correction (January 2, 2017): the sentence in the column that reads "they were the same that are widely believed to be in need of fresh capital now — Monte dei Paschi di Siena (MPS), Banca Popolare di Vicenza, Veneto Banca, and Carige" is not fully accurate. The four banks that were assessed as undercapitalized in October 2014 were MPS, BP Vicenza, Carige and Banca Popolare di Milano. Veneto Banca was found undercapitalized as of December 31, 2013, but was viewed as having addressed its capital gap in the meantime. The author apologizes for this regrettable error.