Written evidence submitted by Dr Kern
Alexander[3]
PROPOSALS FOR EUROPEAN MACRO AND MICRO PRUDENTIAL
FINANCIAL REGULATION
INTRODUCTION
The Europe Commission has proposed a major institutional
restructuring of EU financial regulation that involves the creation
of a European Systemic Risk Board to monitor macro-prudential
risks and three EU supervisory agencies to adopt a regulatory
code and to oversee member states micro-prudential supervision.
The Commission proposals, if approved by Council, will lead to
significant institutional consolidation at the EU level. This
will bring important changes to the existing EU framework of financial
supervision that is based on home country control and mutual recognition
based on minimum standards. It also has important implications
for international supervisory and regulatory arrangements because
the proposed EU financial supervisory agencies and ESRB are likely
to play a significant role in setting the international regulatory
agenda. This memorandum examines how the Commission's proposals
will change the institutional structure of financial supervision
and regulation in Europe and discusses some of the institutional
and legal issues regarding the operations of the proposed framework.
1. EUROPEAN FINANCIAL
REGULATION AND
SUPERVISION
The challenge arising from the increasing integration
of European and global financial markets and the recurrence of
financial crises, such as the 2007-08 financial crisis, is how
to strike the right institutional balance between EU institutions
and member states in the regulation and supervision of financial
markets. In the EU, most financial regulation is based in the
member state where the financial firm is incorporated or has a
headquarters. Supervision is based on the principle of home country
control in which the supervisor of the jurisdiction where the
bank is chartered or incorporated exercises extraterritorial regulatory
responsibility over the bank's EU branch operations. However,
when an EU-based banking group has subsidiaries operating in other
EU states, the supervision of those subsidiaries is exercised
by the host state supervisor of the jurisdictions where the subsidiaries
are incorporated.
The regulatory policy incentives of home country
regulators are to protect the depositors and creditors of banks
based in their home jurisdictions. This works as long as banking
activities are largely confined to one country—normally
the country where the bank is incorporated and has its home license.
It has also worked well for banking groups which have fragmented
management structures in which the management of foreign subsidiaries
is largely autonomous from the day-to-day management of the parent
group, hence allowing the foreign subsidiaries' management to
deal independently with host state supervisors can result in satisfactory
regulatory objectives.
However, as global financial markets have become
increasingly integrated, the structure of banking markets and
their management have changed significantly. Large banking groups
have been created from a growing number of cross-border bank mergers.
As a result, many banking groups today have major operations in
multiple jurisdictions where they can pose systemic risk to a
host state banking system. In addition, large banks are increasingly
dependent on international capital markets for much of their funding.
Banking groups are also progressively centralising a number of
key functions at the group level. For instance, risk management,
liquidity management, funding operations and credit control, are
typically exercised at the group level or in specialised affiliates
in order to gain economies of scale and synergies in specialist
operations. This also has led to the distinction between branches
and subsidiaries becoming blurred. For instance, it is no longer
the case that a large subsidiary bank operating in one jurisdiction
will be allowed to stay in business if its parent company bank
defaults or fails in another jurisdiction (at least not for the
short-run).
These market changes pose a number of challenges
for the existing EU regulatory framework. The recent financial
crisis in Europe had substantial cross-border effects because
of counterparty exposures through the money markets and the disruptions
to trade and finance caused by the cross-border operations of
many large banking groups and financial conglomerates.
The EU legislative and regulatory framework
of home country control based on mutual recognition and minimum
standards has accomplished a great deal in promoting the objectives
of the EU internal market but has recently come under strain because
of growing integration in key areas of European banking and capital
markets and increased risk exposures of counterparties located
in multiple member states. The financial crisis demonstrated that
the EU's home country control supervisory framework was inadequate
to deal with the cross-border dimension of risk-taking in European
financial markets. An important reason for this is that the legal
competence of EU state supervisors has primarily focused on home
markets, with little attention given to the impact of their actions
on the broader European market or other EU host states.
2. THE LAMFALUSSY
PROCESS AND
INSTITUTIONAL CONSOLIDATION
The evolution of EU markets to more integrated
structures based on liberalisation of capital restrictions and
trade in financial services has been facilitated by the growing
importance of the euro as a reserve currency and advances in technology
that enable market participants to operate more easily in a cross-border
environment. The role of EU member state institutions in regulating
financial markets has undergone significant changes as well. The
EU Financial Services Action Plan (FSAP) has recognised the Lamfalussy
four-level framework as essential in achieving the EU Treaty objectives
of an open internal market for capital movement and trade in financial
services. The Lamfalussy four-level legislative decision-making
process now applies to all major financial sectors, including
banking, securities, insurance and pension fund management.[4]
The three so-called Lamfalussy Level 3 networks
presently consist of the Committee of European Securities Regulators
(CESR), the Committee of European Banking Supervisors (CEBS),
and the Committee of European Insurance and Occupational Pensions
Supervisors (CEIOPS). These three committees have been acting
in a regulatory capacity and prior to the crisis were successful
in expediting the regulatory standard-setting process by making
it more flexible and efficient. The successful operation of the
regulatory networks depends on cooperation and frequent contacts
between member state supervisors. To this end, the Committees
have begun a number of initiatives to increase cooperation and
convergence; but the changing structures of financial markets
necessitates further institutional coordination in the Level 3
committees to address the growing cross-border effects of financial
crises and the cross-border activities of large financial groups.
The Lamfalussy programme does not create a legislative
competence to supervise financial markets at the European level.
Indeed, the original Report of the Committee of Wise Men in 2000
envisioned only two principal functions for the Level 3 committees:
(1) technical advice regarding the development of implementing
measures, and (2) promotion of consistent implementation of Community
legislation and enhancement of convergence in EU supervisory practices.
It is essentially a regulatory process that relies on existing
comitology procedures as set forth in Article 202 of the Treaty
of Rome to develop EU financial legislation based on proposals
from national finance ministers and regulators, in consultation
with industry. Although the early stages of implementation of
the Lamfalussy programme ignited some controversy concerning the
scope of legislative authority for EU institutions, it has resulted
in streamlined decision-making, promoted a wide ranging dialogue
with industry and consumer groups and has disseminated its work
and proposals to all relevant stakeholders. The Council and Parliament
have recognised the early success of the Lamfalussy programmes
and the ongoing work of the networks of the three regulatory committees.
The Lamfalussy framework has, however, been
criticised as being too slow and lacking the institutional capacity
to respond effectively to a cross-border financial crisis within
the European Union. Prior to the crisis, EU authorities had recognised
that the changing structure of European financial markets and
the cross-border operations of large banking groups necessitated
further institutional consolidation at the EU level and in particular
raised important issues regarding how much authority the Level
3 committees should be given in overseeing national supervisors
and cross-border firms and wholesale capital markets.[5]
Moreover, the International Monetary Fund's 2004 surveillance
report identified the weak link in EU supervisory arrangements
to be the absence of a clear framework of coordination between
EU national supervisors with respect to the oversight of the cross-border
operations of financial groups in EU states.[6]
The recognised weaknesses in the EU institutional framework of
financial supervision became even more apparent in 2007 and 2008
when the credit crisis incapacitated wholesale financial markets
and EU supervisory authorities were unable to respond in a coherent
or effective manner.
3. EUROPEAN UNION'S
REGULATORY RESPONSE
TO THE
CRISIS
The Commission's proposals are premised on the
notion that current supervisory arrangements proved incapable
of preventing, managing and resolving the recent financial crisis.
Although the EU regulatory response lacked coherence in the early
stages of the crisis in 2007 and early 2008, the European Commission
has now proposed specific and meaningful proposals for EU regulatory
reform. The catalyst for EU reforms was the publication of the
Report of the Committee chaired by Jacques De Larosie"re
in February 2009. The De Larosie"re Report was commissioned
by the European Commission and it contains substantial proposals
for the reform of European financial regulation.
The De Larosie"re Report proposed the creation
of a European Systemic Risk Board (ESRB) that would have responsibility
for macro-prudential oversight throughout the European Union.[7]
The ESRB would consist of EU central bank governors, including
the ECB President, the chairpersons of the three EU Supervisory
Authorities[8]
(the former Chairmen of the Lamfalussy Committee level 3 committees),
and representatives from the EU national supervisory authorities,
as well as the Chair of the European Financial Committee and the
President of the European Commission.[9]
The De Larosie"re Report also proposed the creation of a
European System of Financial Supervision that would consist of
a more institutionally consolidated version of the existing 3
Level 3 Lamfalussy Committees working in tandem with the EEA member
state supervisory authorities.
On 23 September 2009, the Commission adopted
several Regulations that incorporated most of the De Larosie"re
recommendations including establishing the ESRB and ESFS along
with the three new EU financial supervisory agencies.[10]
Under the Regulation, the ESRB would consist of the representatives
and officials of over 60 EU agencies and member state regulatory
authorities. Under the proposal, the ESRB would monitor and assess
systemic risks—individual banks and the whole European financial
system. The ESRB would also issue recommendations and warnings
to countries or financial groups or other concerned entities and
would report all recommendations and warnings to the European
Council of Ministers. The ESRB would devise specific follow-up
procedures and "moral incentives" to follow recommendations
or explain why not. The ESRB can inform the Council if unsatisfied
with a member state or entity's explanation and can conduct "name
and shame" publicity if necessary.
Regarding micro-prudential regulation, the Commission
adopted three regulations[11]
that would create a European System of Financial Supervisors (ESFS)
consisting of a network of national supervisors along with three
new European Supervisory Authorities (ESAs), created from the
existing Lamfalussy Level 3 Committees of supervisors, with responsibility
for banking, insurance and pensions and securities markets regulation
respectively.[12]
The ESFS would oversee the exercise of shared and mutually reinforcing
responsibilities between member state supervisors and the ESAs
with the ESAs performing specifically delegated tasks.
The Commission's Regulations would restructure
and consolidate the EU regulatory and supervisory framework in
order to enhance its effectiveness, coherence and accountability
to Parliament and Council. The institutional framework would look
like the following:
The above institutional framework recognises
the interdependence between micro- and macro-prudential risks
across EU financial markets and the need to be accountable to
the views of market participants and all EU stakeholders, including
financial institutions, investors and consumers. It provides a
more consolidated and rational institutional design for linking
micro-prudential supervision of individual firms with the supervision
of the linkages between institutions and between institutions
and the broader financial system. The ESRB is expected to provide
a broader perspective of the financial system and to interact
with supervisors in monitoring and assessing system-wide risks.
In this capacity, the ESRB would serve as the basis for developing
a more integrated EU supervisory structure that would improve
consistency in regulatory and supervisory practices and approaches
across EU/EEA states, thus creating a level playing field and
a more efficient regulatory framework for controlling systemic
risk and preventing market failure.
The ESRB was created as a body without legal
personality pursuant to article 95 of the EC Treaty. The absence
of legal personality provides it with more institutional flexibility
and scope to fulfil its core functions and broader mandate to
monitor the whole European financial system. It also allows the
ESRB to interact flexibly with the ESFS and member state supervisors
to form a common framework of regulation that allows for regulatory
innovation to address evolving market risks.
The Regulation confers a specific role for the
European Central Bank in the ESRB's operation: the ECB's President
and Vice President serve on the ESRB Board. The ECB would provide
the ESRB secretariat that provides administrative, logistical
and analytical support. The ECB's integral role in overseeing
and effectively discharging the operations of the ESRB means that
under Article 105 (6) of the Treaty the Council is required by
unanimous to adopt this Regulation in order for the ECB to have
the authority to carry out certain tasks indirectly through the
ESRB that would constitute prudential supervision.
4. THE ESFS AND
COLLEGES OF
SUPERVISORS
The ESFS would place greater emphasis on using
colleges of supervisors from EEA states to supervise the operations
of Europe's largest cross-border banks and financial institutions.
The proposed European Banking Authority (formerly the Lamfalussy
Level 3 Committee of European Bank Supervisors (CEBS)) would have
responsibility for overseeing the implementation of guidelines
and decision-making procedures for the colleges. Membership of
the colleges would include: All EEA supervisors of subsidiaries;
EEA supervisors of branches recognized as significant; third country
supervisors with equivalent confidentiality provisions; and central
banks as appropriate.[13]
The main function of colleges will be to exchange
information between supervisors, coordinate communication between
supervisors of the financial group, voluntary sharing and/or delegation
of tasks, joint decision on model validation (eg Basel II). The
colleges will also be involved in joint risk assessment and joint
decision on the adequacy of risk-based capital requirements. The
planning and coordination of supervisory activities for the financial
group and in preparation of and during emergency situations (ie
crisis management).
The overarching philosophical rationale for
designing the college system and the ESRB/ESA institutional structure
is that systemic risk and financial instability create negative
externalities in European financial markets and it is a necessary
policy objective of the European Union institutions to control
financial risks that can threaten the efficient operations of
the internal EU market.
5. EU PROPOSALS
AND INTERNATIONAL
REGULATORY DEVELOPMENTS
Most policymakers and regulators in Europe,
the United States and in other major jurisdictions are now in
agreement that the micro-prudential regulation of individual banks,
firms and investors should be expanded to include a macro-prudential
dimension that links the regulation of individual firms (at the
micro-prudential level) to developments in the broader financial
system and macro-economy. An important regulatory challenge will
be how regulators and central banks can strike the right balance
between micro-prudential regulation and macro-prudential regulatory
and supervisory controls that are determined by factors in the
broader financial system and economy. Recent international initiatives
(eg the G20 and Financial Stability Board and Basel Committee)
have recognised the importance of macro-prudential supervision
and regulation and are examining some of the main issues regarding
how to link micro-prudential supervision with broader macro-prudential
systemic concerns. Indeed, many national policymakers and regulators
(eg US and UK) are debating which regulatory measures would be
most effective in enhancing financial regulation by incorporating
macro-prudential objectives.
The Commission's proposals for an ESRB and ESFS
could potentially change the role that the UK plays in international
standard setting bodies. Under the Commission regulations, the
ESRB would interact with global macro-prudential risk bodies,
such as the Committee on Payment and Settlement Systems and the
Committee on the Global Financial System. It would also contribute
to the surveillance operations of the International Monetary Fund.
Similarly, although not formally recognised yet, the ESFS's three
financial authorities would participate in the international standard
setting bodies, such as the Basel Committee, IOSCO and the IAIS.
The involvement of European institutions in these international
bodies would enhance the effectiveness of Europe's role and influence
in the global financial architecture.
6. UK REGULATION
AND LONDON'S
INTERNATIONAL POSITION
This Committee has published several reports
analysing the causes of the credit crisis and its impact on the
UK economy. The causes of the crisis have been attributed to macroeconomic
factors, major weaknesses in corporate governance in financial
institutions, and serious regulatory failings. The costs of the
crisis for the UK economy have been enormous, with recent estimates
of more than 19% of UK GDP. It is evident that poorly regulated
financial markets can lead to huge social costs for the broader
economy and that these social costs in regional and globalised
markets can be exported to other economies. The UK is a member
of the European Union's internal market with free capital flows
and cross-border trade in financial services. The crisis demonstrates
that London's important position as an international financial
centre brings both economic benefits and social costs to the European
economy.[14]
It is essential therefore that Europe have a more comprehensive
framework for regulating and controlling the social costs of financial
risk-taking, especially those social costs that arise from poorly
supervised and managed risks in the City of London.
Macro-prudential risks are evident in the European
financial system. Banks have exposure to each other throughout
Europe in the money markets through a variety of risk exposures,
and European policy-making needs to have better surveillance of
the systemic risks posed by certain banking groups and financial
institutions that operate in Europe and the inter-connected nature
of wholesale capital markets. It does not mean that EU regulation
and oversight should displace national regulators; it simply means
that member state regulators, at the national level, must have
more accountability to committees of supervisors at the EU level
in order to carry out more efficiently cross-border supervision
of the largest forty or so of Europe's banks and to monitor systemic
and liquidity risks that arise in the capital markets.
UK financial regulation is already undergoing
major changes that will lead to increased costs for the financial
sector. More intrusive regulation, if applied effectively, can
result in more effective control of the social costs of financial
risk-taking. The Commission's adoption of the Regulations creating
the ESRB abd ESFS have this objective in mind: the monitoring
and control of systemic risks in the European financial system.
It is for this reason that UK policymakers should support these
important regulatory initiatives.
3 November 2009
3 Professor of Law and Finance, Queen Mary, University
of London, and Senior Research Fellow, the Centre for Financial
Analysis and Policy, University of Cambridge. Back
4
Commission Decision 2001/527/EC (6 Jan 2001) (establishing Committee
of European Securities Regulators); Commission Decision 2004/5/EC
(5 Nov 2003)(establishing Committee of European Banking Supervisors);
and Commission Decision 2004/6EC (establishing Committee of European
Insurance and Operational Pensions Supervisors (CEIOPs). The four
levels consist of (1) legislative proposals of high level principles
through the traditional EU co-decision process; (2) based on the
legislative proposals, EU finance ministers agree to implementing
measures for member states; (3) member state regulators make proposals
to Level 2 finance ministers regarding the implementing measures
and then consult with each other regarding implementation; and
(4) national compliance and enforcement. See Lamfalussy Committee,
"The Final Report of the Committee of Wise Men on the Regulation
of European Securities Markets" (15 February 2001)(Brussels). Back
5
See CEBS and the European System of Central Bank's Banking Supervisory
Committee (BSC) Joint Guidance (2006) (extending the guidance
role of the Level 3 Committees from "going-concern"
activities to crisis management cooperation). Moreover, CEBS and
the Banking Supervisory Committee (BSC) created a Joint Task Force
on Crisis Management in order to enhance cooperative arrangements
in a financial crisis and which has issued guidance for supervisors
to follow in the event of a systemic financial crisis.(IIMG, 2007,
p 19). Back
6
IMF Article IV Surveillance Report, (2007) p 27; see also IMF
Article IV Surveillance Report (2006) para 12. Back
7
The European Commission welcomed the proposal in its Communication
entitled "Driving European Recovery" (4 Mar. 2009) COM(2009)
114. Later, the Commission in its Communication entitled "European
Financial Supervision 2" (27 May 2009) proposed a series
of reforms to the current Lamfalussy institutional arrangements
for safeguarding EU financial stability which included the creation
of a European Systemic Risk Board responsible for macro-prudential
oversight, and a European System of Financial Supervision (ESFS)
responsible for overseeing micro-prudential supervision of firms
operating in Europe. Back
8
The three authorities would be a European Banking Authority, European
Securities and Markets Authority, and the European Insurance and
Occupational Pension Authority. Back
9
The Presidents of the EFC and Commission would be observers and
not have voting rights. Back
10
The ESRB secretariat would be entrusted to the European Central
Bank. The legal basis of the Regulation is Article 95 of the Treaty
on European Union (as amended), which requires co-decision by
the Council of Ministers and the European Parliament. Back
11
Regulation of the European Parliament and of the Council COM(2009)
503 (establishing a European Securities and Markets Authority),
COM(2009) 502 (establishing a European Insurance and Occupational
Pensions Authority), and COM(2009) 501 (establishing a European
Banking Authority). Back
12
The three ESAs would be known respectively as the European Banking
Authority (EBA), European Securities and Markets Authority, and
a European Insurance and Occupational Pension Authority (EIOPA). Back
13
Moreover, the Capital Requirements Directive (CRD) (Art 131a)
provides the legal basis for a single college for global EEA-based
banks. Back
14
For example, the collapse of the Royal Bank of Scotland demonstrated
how the risk-taking of UK banks can generate cross-border externalities
to other countries and financial systems. Back
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