The Committee's Opinion on proposals for European financial supervision - Treasury Contents

Written evidence submitted by Dr Kern Alexander[3]



  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.


  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.


  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.


  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.


  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.


  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.


  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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Prepared 16 November 2009