Reconfiguring Financial Regulation in the European Union

ESRC World Economy and Finance programme

28 January 2010, London

Professor Kern Alexander University of Zurich Law Faculty &

Specialist Adviser to the European Parliament Committee on Economic and Monetary Affairs

Main points

• International regulatory redesign • European financial markets and systemic risk• EU financial legislation and regulation • The new EU institutional structure

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International Developments

The G20 Washington Action Plan and the London & Pittsburg Summit Statements on strengthening the financial system

FSF’s April 2008 and 2009 Reports A roadmap on financial supervision and regulation A more robust supervisory and regulatory framework based

on new rules not only for financial institutions but also other actors, markets and supervisors

Macro prudential to complement micro prudential regulation

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FSB Initiatives

Off-balance sheet activities Trading book Valuation Credit Default Swaps Credit rating agencies Short selling Supervisory co-ordination for LCFI (large complex financial

firms) Standards for Sound Compensation Practices

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Further international initiatives

By January 2010

the IMF, BIS and FSB will have issued a paper setting out for use by national authorities guidelines to assess whether a financial institution, a market, or an instrument is systemically important;

regulators working through IOSCO and the FSB will have agreed a consistent regulatory framework for hedge funds oversight;

consistent frameworks for registration, regulation and oversight of credit rating agencies for consideration by legislatures

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European Central Bank WGMA

Banking Stability CommitteeWGBD

Level 3 Committees :

CEBS (Committee of European Banking Supervisors)

CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors)

CESR (Committee of european Securities Regulators

27 EU National Central Banks

and/or EU National Supervisorsand/or banks, insurance, securities

Bank of International Settlement Basel Committee - BCBS (Basel Committee of Banking Supervision)

CGFS (Committee of Global Financial System)

CPSS (Committee on Payment and Settlement Systems)

In Europe

IMF

On vulnerabilities assessment On supervision and regulatory corporation On standards implementation

Joint Forum

WorldwideFSB

Federal Deposit Insurance Corporation

Federal Reserve Office of the Comptroller of the Currency

Thrift Office of Thrift Supervision

Insurance States

Securities SEC

In the US

Banks

EU & US Institutional regulatory settings

European financial markets European financial markets

• Increasing financial integration Cross-border capital flows and payments Cross-border establishment of banks & financial firms –

thru group structures

Financial regulation and crisis management have not kept pace with increasing integration of wholesale capital markets and growing cross-border operations of EU financial institutions. How to regulate most efficiently the cross-dimension of systemic risk?

Defining systemic riskG10 Report (2001) defined systemic risk as:

the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy. Systemic risk events can be sudden and unexpected, or the likelihood of their occurrence can build up through time in the absence of appropriate policy responses. The adverse real economic effects from systemic problems are generally seen as arising from disruptions to the payment system, to credit flows, and from the destruction of asset values.’

Note the negative externalities extend into the real economy with relatively high probability. However, no generally accepted methods for identifying and measuring before a crisis event occurs. Financial innovation over time changes the nature of the sources of systemic risk and how it can be measured.

Financial Innovation

• Technical developments in data analysis, statistical theory and in finance theory have transformed risk management, pricing, and the range of financial products.

• Disintermediation: credit risk transfer & securitization led to originate, rate, relocate model (ORR)

• Financial regulation and crisis management have not kept pace with these changes.

Financial innovation and the risks of inter-connectedness in financial markets – 1990s

• Bank of England Board of Banking Supervision ‘. . .the Bank should explore ways of increasing its

understanding of the non-banking business (particularly financial services businesses) undertaken by those banking groups for which it is responsible for consolidated supervision... It should also seek to obtain a more comprehensive understanding of how the risks in those businesses interrelate to one another and to such groups’ (Bank of England, 1995, para. 14.35).

EU financial legislation & policy

Pre-1986 – unsuccessful efforts to approximate and make equivalent financial law and regulation across EU states

1985 White paper and 1986 Single European ActHome country control, mutual recognition based on minimum standards – the EC passport

EU legislation is a tool for liberalisation with little oversight of member state regulatory practices

Lisbon Council Decision (post 2001)– FSAP & Lamfalussy: Harmonisation of laws and coordinated regulatory practices based on market-based models (Bolkestein & McCreevy eras)

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The EU Lamfalussy structure

•

EBC¹

Commission Parliament

EIOPC¹ ESC¹ FCC¹

Enforcement Commission

Council

CEIOPS³ CESR³

L1

L2

L3

L4

CEBS²

EBC = European Banking CommitteeEIOPC = European Insurance and Occupational Pensions Committee ESC = European Securities CommitteeFCC = Financial Conglomerates CommitteeCEIOPS = Committee of European Insurance and Occupational Pensions SupervisorsCESR = Committee of European Securities Regulators

¹ Finance ministries ² Supervisors and Central Banks³ Supervisors

Legislation

Implementing details

Convergence

Incremental change in EU Legislation

• Art. 122a – originators/arrangers retain 5% of risk on balance sheet (but not affect originator’s 1st loss exposure)

• Arts. 49/50 enhance flow of information from supervisors to central banks/finance ministries

• Art 42a host supervisors more say in model approval. Art 42b – CEBS obligatory

• Art 129, 131a – colleges of supervisors (soft law)

Commission’s response – more of the same and not recognising risk of interconnected firms and markets

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The future of EU financial supervision

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From De Larosière Report (Feb 2009) to the EU Commission’s proposed

Regulations (Sept 2009)

On the microprudential: the European System of Financial Supervisors (ESFS).

It will consist in the current Level 3 Committees of supervisors, which will

be transformed into new European Supervisory Authorities (ESAs)

responsible for banking, insurance and securities respectively.

On the macroprudential side, a European Systemic Risk Board (ESRB) will be

established.

It will be composed of EU central bank governors, including the ECB

President, the chairpersons of the ESAs, a representative the European

Commission, as well as representatives of national supervisory authorities

and the Chair of the EFC (the latter two without voting rights).

The future of EU financial supervision

European Systemic Risk Board (ESRB)[Chair elected by ESRB Board]

Members of ECB/ESCB

General Council (with

alternatives where necessary

+Chairs of

EBA, EIOPA & ESA

+European

Commission

Information on micro-prudential development

Early risk warning

European System of Financial Supervision (ESFS)

European Banking

Authority (EBA)

EuropeanInsurance

OccupationalPension

Authority(EIOPA)

EuropeanSecuritiesAuthority

(ESA)

National Banking

Supervisors

National Insurance

Supervisors

National Securities

Supervisors

Macro-prudential supervision

Micro-prudential supervision

European Supervisory Authorities

• Ensuring that a single set of harmonised rules and consistent supervisory practices is applied by national supervisors;

• Ensuring a common supervisory culture and consistent supervisory practices;

• Collecting micro-prudential information;

• Ensuring consistent application of EU rules, and resolving disputes in cases such as the manifest breach of EU law or ESA standards and disagreement between national supervisors or within a college of supervisors.

Legal basis

• Article 114 (TFEU) as the legal basis for the establishment of bodies that are vested with responsibilities for contributing to the harmonisation process and facilitating uniform implementation by MSs (Case C-66/04, C-217/04, Enis case)– Actually and objectively apparent from the legal act creating the

body in question that its purpose is to improve the conditions for the establishment and functioning of the internal market

– Tasks conferred on such a body must be closely linked to the subject-matter of the relevant harmonizing legislation

The European Systemic Risk Board: organizational structure

• General Board, Steering Committee and Secretariat; supported by an Advisory Technical Committee

•  General Board: decision making body of the ESRB; 61 voting & non-voting members

•  Voting members (29)– governors of national central banks– president and the vice-president of ECB– European Commission representative– Chairpersons of the three ESAs

•  One-member, one-vote; simple majority (2/3 for public warning /recommendation)• Chair/vice-chair•  Non-voting members

– MS competent authorities– president of the Economic and Financial Committee

• Duty of impartiality • Too big? Too dominated by central bankers? Steering committee and non-

eurozone representation?

ESRB: building credibility – challenges•  Central bankers not legitimate politically for making decisions that involve

important trade-offs between political and economic objectives and that such decisions should be left with finance ministries and other elected officials (Buiter)

• Lack of diversity/unwieldy size (Sibert) • Technical competence re systemic risk (Treasury Committee/Buiter)• And also re interpretation of data at both the micro and macro-levels

(Treasury Committee/Danielsson)• Price stability and financial stability objectives pull in opposite directions

(Buiter) • Liberalised and integrated financial markets → increase financial fragility

(Dungey & Tambakis)

 

Legal basis and ESRB mission• “The ESRB shall be responsible for the macro-prudential oversight of the

financial system within the Community in order to prevent or mitigate systemic risks within the financial system, so as to avoid episodes of widespread financial distress, contribute to a smooth functioning of the Internal Market and ensure a sustainable contribution of the financial sector to economic growth”

• Tasks conferred on the ESRB must be undertaken for the purpose of discharging overarching responsibilities with respect to macro-prudential oversight and containment of systemic risk

• “Macro-prudential”/”systemic risk” and existing EU law – can the link between subject-matter of the harmonizing laws and the tasks delegated to the ESRB be established?

• Stability and soundness as pre-requisites for the smooth operation of any financial market

•  ESRB within the room for innovation in harmonization techniques that article 114 provides

 

Summing up - analysis of financial law & regulation

• An excessive reliance on markets to deliver systemic stability!

• Far reaching re-appraisal of the role of EU financial law/regulation and the institutional design of EU regulation for controlling ‘externalities’.

ConclusionConclusion

• Evolving financial risks and increasing integration in EU financial markets along with globalisation of financial risk (ie., US subprime)

• EU legislation has evolved from liberalisation, to harmonisation of law, to uniform rulebooks and supervisory practices and EU bodies

• Recent Commission proposed regulations on ‘micro and macro prudential supervision’ address the need for more institutional coordination in monitoring and controlling systemic risks in EU financial markets but gaps.

• EU legislation still remains excessively focused on micro-prudential, while role for ESRB/ECB presently lacks clarity.

• ESAs rulebooks, standards and guidelines enhance member state’s ability to achieve regulatory objectives, but legal risks remain.

Further readings – EP Parliament Reports

• Financial Supervision and Crisis Management in the EU’ (Dec. 2007), K. Alexander, J. Eatwell, A. Persaud & R. Reoch http://www.europarl.europa.eu/activities/committees/studies/download.do?language=en&file=26588

• ‘Clearing and Settlement in the EU’ K. Alexander, J. Eatwell, A. Persaud and R. Reoch (Sept. 2009) IPA ECON 2009/001. http://www.europarl.europa.eu/activities/committees/studies/searchPerform.do?page=2&language=EN