21 November 2019

Bruegel: Bank regulation in the European Union neighbourhood: limits of the ‘Brussels effect’

The EU model of financial market regulation is increasingly copied by third countries. In this context, the EU’s efforts to promote its model beyond its borders should take into account the underdevelopment of financial markets in many partner countries, and the often insufficient capacity of regulators and supervisors.

The EU’s policy in its neighbourhood in eastern Europe has for some time been to encourage countries to bring their regulatory standards into line with those of the single market, in exchange for increased access to EU markets.

In financial services, this policy is motivated by the need to prevent financial instability being imported from third countries into the single market. For this reason, advanced countries can seek formal recognition that their regimes are ‘equivalent’ to the EU’s. But in emerging markets and developing countries, wholesale adoption of EU legislation runs up against the weaknesses of local supervisors, and might also result in the introduction of legislation that is irrelevant in underdeveloped financial markets.

Exporting EU regulation to third countries irrespective of the broader development of institutions and laws will not automatically yield equivalent benefits in terms of financial stability as in the EU itself. Inadequate accounting standards and creditor rights might undermine this. In capital markets regulation a high standard law may, in fact, be counterproductive without good enforcement.

Some instruments that are central to recent EU legislation might be missing entirely in local markets, such as the requirements for subordinated bank debt that could be subject to a bail-in based on well-defined creditor hierarchies, if a bank has to be resolved. Other EU targets may be out of line with local market development (such as the level of deposit insurance coverage). Capital markets in EU neighbourhood countries are even less developed than banking sectors, and adopting some recent EU legislation (such as the Directive 2014/65/EU on markets in financial instruments, MiFID II) would be well out of proportion.

More practically, local supervisors might lack the resources to enforce complex regulation. Some evidence of this emerged in the November 2019 update of the World Bank database on practices in bank regulation and supervision. Across the 160 countries surveyed, there have been significant increases in the number and complexity of regulations since the global financial crisis. This has not been matched by an increase in supervisory powers and capacity. Rules on disclosures and stress testing of bank assets place particularly severe strains on supervisors.

Brussels might, therefore, be risking the unilateral imposition of EU rules on third countries and thereby discriminating against market participants originating in jurisdictions with incompatible standards.

However, this seems less of a concern in banking regulation than in product standards. EU banking regulation, on the whole, reflects international standards, most importantly the Basel III framework and the resolution regime promoted by the Financial Stability Board. These are in essence sensible targets, though the timeframe for adoption should be proportionate to the development of markets and institutions.

But the effort to promote in emerging markets financial regulation that resembles that adopted in the EU since the financial crisis should be focused on those countries where euro-area banks already have extensive stakes, primarily emerging Europe and Latin America. There is also a justified interest in aligning supervisory practices, which will facilitate the coordination of cross-border supervision and crisis management.

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