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European Financial Supervision:
Commission Communication of 27 May - COM(2009)252
Analysis and Commentary by Graham Bishop
2 June 2009
Background
The De Larosiere Group (DLG) published its report in February 2009 after intensive discussions and set out an agenda for reform that was both demanding, yet stopped short of requiring changes to the founding Treaties of the European Union. That absence generated some criticism from those who wanted a giant step but seems pragmatic in that the chances of a new Treaty being ratified seem minimal while the EU is struggling to ratify the Treat of Lisbon. There is unlikely to be political appetite for a new Treaty for very many years to come. In any case, it may not even be desirable at this stage of the progressive unfolding regulation of the financial markets. There are many twists and turns to come and fixing the process into the concrete of a Treaty text could easily turn out to be a major error if (or should it be “when”?) unforeseen circumstances require an adjustment to the approach.
In the absence of a Treaty change, the proposed arrangements will have to be agreed by all Member States. However, it is conceivable that some might not wish to participate in the system. Would that leave the EU with system of financial regulation that was dangerously defective? The DLG considered this possibility and commented in Para. 190 that “The goal set out above is an ambitious one. It will require important institutional, legislative and operational changes. It will also require the emergence of the broadest possible political consensus on the necessity to move in this direction and the steps that must be taken to do so. The Group hopes that all Member States will aspire to these changes. If not, a variable geometry approach based on the mechanisms of Enhanced Cooperation or an inter-governmental agreement provided for in the Treaty may be required”.
Without doubt, this is a decisive period in the development of the EU. October 2008 may well be seen by historians as the precise pivotal moment because that was the month when the initial response to the financial crisis looked ragged and more like a disparate collection of nation states. By the end of the month, the EU had achieved a cohesive reaction that crossed several important hurdles to developing a common economic policy. That is not to deny that many difficulties will remain in the years ahead!
The political conclusions that month included the following:
For the first time, the euro area made policy decisions as an entity defined by participation in the single currency.
The EU showed the ability to take executive and legislative action promptly in a crisis – perhaps the hallmark of a genuine political entity.
The euro area set the agenda for the EU’s decision to call for global action, including a Summit of the G20 – thus changing the map of the countries at the world’s economic top table.
The De Laroisière Group will report in the spring initially, and begin the process of re-shaping the EU’s financial framework that will be followed through by the next Parliament and Commission in 2009/14.
The Heads of Government also decided to take EU-level action on issues directly affecting a class of individual citizens – the remuneration policy of bankers!
It will be difficult for individual Member States to drop out of the process at this stage as all Governments agreed to the EU’s approach to the G20 in December and a Summit in March agreed the approach for the April G20 meeting. That approach was built on the assumption that the EU would proceed with a plan that would demonstrate to the world that it was serious about putting its own house in order.
The UK did propose an alternative approach to that of the DLG in early March. It had some intellectual merit but the political approach of an inter-governmental agreement - rather that the ”Community method” of the DLG - had eerie parallels with the UK Treasury’s inept misreading of the political mood that characterised Mrs. Thatcher’s “hard ECU” plan ahead of the agreement on the Treaty of Maastricht two decades earlier. Two weeks after proposing this idea, UK Prime Minister Brown then agreed to the statement from all EU heads of Government that the DLG report would be “the basis” for moving forward.
At this stage, it would be very surprising if any Member State opposed the principles underpinning the Commission’s Communication. Doubtless, there will be much debate about the fine print of the forthcoming legislative proposals on the grounds of whether they will achieve the agreed goals efficiently. But the question that must now be answered is “do we genuinely want a single market in money and financial services?” If the answer is Yes, then the Commission’s Communication seems a good basis for moving forward. If the answer is really No, then any member State that gives that answer will have to ponder long and hard what the full implications might be.
If that State decided to change its mind and deviate from existing agreement by its Head of Government to participate in this process, then it is difficult to see how its arrangements could be judged as “equivalent” to EU arrangements for the purposes of 4.2 (7). At a time when all Member States are in heavy deficit on their public finances (in some cases, massively so) they should have a strong interest in seeing their financial system being regarded as robust in order to attract external capital.
The plain fact is that the single market in finance has developed strongly over the past decade and the Commission now estimates that 70% of the bank deposits in the EU are held by just 40 banks. A couple of years ago, the estimates were that 45 banks held two-thirds of the deposits. So the crisis has actually enhanced the cross-border concentration. Unwinding that would be a massive task so the entire purpose of the exercise is ensure proper supervision of cross-border firms. Allowing financial institutions based in a non-participating State to undertake cross-border activities into participating States would, by definition, create an obvious weakness in their own regulatory arrangements. Undoubtedly they would – and should - resist that risk.
Principles of the system
NOTE: A more detailed summary and description of the most important elements of the proposal is provided in the Appendix.
The approach closely follows the DLG Report but the crucial details are now being filled in – but there is immense practical detail yet to be provided. Wisely, the Commission is proceeding step by step so that there is full agreement on principles first.
European Systemic Rick Council (ESRC)
• Will provide early warnings of system-wide risks and issue recommendations but would not have any legally –binding powers. Given the thoroughness of its work, it would be an “act or explain” mechanism of influence.
• Participation of Finance Ministries would “blur” its functioning so the Chair of the EFC will be an observer. Central bank governors would be accompanied by a senior supervisor (non-voting). The Vice Chair should be elected form the non-euro area States. There would be a small (11 person) steering committee to ensure “efficient meetings”. Votes would be un-weighted and on a simple majority.
• Legal basis will be Treaty Article 95 – the single market article – so that all financial sectors can be included.
European System of Financial Supervisors (ESFS)
• The rationale for its structure is “the EU cannot remain in the situation where there is no mechanism to ensure...best possible supervisory decisions for cross-border institutions...”
• The ESFS would have shared and mutually re-inforcing responsibilities, defined legal powers and develop a single set of harmonised rules including binding technical standards and interpretive guidelines on licensing and supervision.
• If mediation and conciliation between national regulators fails, the Authority “should, through a decision, settle the matter”. In case of “manifest breach of Community law... Authorities could be empowered to adopt decisions directly applicable to financial institutions...”
• The Authorities would have full supervisory powers for certain entities with a pan-European reach e.g. credit rating agencies and CCPs
• Crisis management would be co-ordinated by the Authorities and could have the power to adopt emergency decisions e.g. on short-selling.
• Voting on technical rules would be QMV but decisions on the application of existing laws should be a simple majority of “one person, one vote”
• Legal basis would be Treaty Article 95 as the entire task is for the process of harmonisation.
Commentary
It is welcome that the EU is explicitly developing this process to fulfil its obligations to the G20 process and also to set an example of international leadership.
This process is being put on a very fast track for enactment: The June European Council is asked to approve the principles and detailed sectoral legislation (and amendments) will have to follow thick and fast if the deadline of having it up and running during 2010. However, such a rapid process is not without risks and there has already been significant criticism amongst stakeholders about the problems of the European Parliament enacting legislation in a single Reading. If issues are genuinely non-contentious, then that process is appropriate on grounds of speed.
In this case, it seems very likely that details will be highly contentious – sometimes perhaps being used as wrecking tactics, but also on proper grounds of questioning whether the proposal has been fully thought through. It takes time and discussion for all the ramifications of a legal text to be considered, especially where it will include major amendments to existing texts and the risk that linkages will be missed on the first analysis. All too often, attention of all participants focuses on the big “problems” and the minor details get relatively little scrutiny until it comes to the moment of implementation in practice. It is only at that moment that implementation defects become apparent.
It would be better to take the time for Second Readings especially on all the measures to set up the EFSF. Indeed, perhaps there should be two separate packages which can run on separate timescales. After all, the most likely task for the ESRC in the near future is not going to be private sector credit bubbles but “concerns related to fiscal matters (e.g. excessive deficits or accumulation of debt)” as the DLG report put it so delicately.
The ESRC proposal marks a further development in the process of external scrutiny of a State’s economic affairs – but this process has been developing for decades with IMF surveillance and OECD reports, quite apart from the EU’s Broad Economic Policy Guidelines and Convergence Reports as part of the Stability and Growth Pact commitments. However, the distinctive – and welcome - feature is that the assessment is to be performed by an independent body, and one whose voting members are themselves independent of their domestic governments.
As the intention is to produce a warning that is so well documented that its arguments demand a reaction, it is also welcome that Finance Ministries are excluded as the evidence of their actions on say OECD reports is to emasculate them so that no action is seen to be necessary.
There should be a presumption that all early warnings will be published:
• With such a large number of people involved, it will probably leak at some stage anyway.
• These warnings are likely to be market-moving events – especially if they are based on an analysis of data that is not already public. If the warning would change the perception of market risk, then insider trading could easily develop. Moreover, false rumours about a State’s credit-worthiness could cause runs on its bonds (and currency, if not in the euro area).
• The certainty of publication would enhance market discipline on errant governments, re-inforcing the peer pressure from other governments.
• Governments (or other bodies to whom the warnings are addressed) would find it very difficult to ignore this type of public warning in the way that countries such as the UK have regularly brushed aside any international criticism of its public finances for the last decade.
• In the absence of any legal power to take direct action, putting both the users and suppliers of finance on notice about the risks raises the chances of corrective action as investors will be the more reluctant to put their funds at risk. Moreover, financial intermediaries will feel themselves at risk of subsequent legal action from beneficiaries if they ignore such explicit warnings and the underlying clients lose money.
The ESFS concept is a major integrative step for the EU. The case is simple and powerful – if the single market is to continue and deepen, then proper regulation of cross-border entities is now proven necessary beyond all reasonable doubt. To paraphrase FSA Chairman Lord Turner, “the choice now is more Europe or less Europe”. If a State does not wish to participate in this process, then its commitment to a key element of the single market is also undermined. There could well be powerful consequences for its financial institutions if its regulatory structure were seen as inadequate for cross-border activities (see comments in Background above).
A key requirement for such a system is probably an ex-ante agreement on burden-sharing – presumably for each cross-border entity that is regulated by a college of supervisors. On the one hand, the home state is particularly concerned about the safety of its citizen’s deposits so it might well argue for a distribution of burdens based on deposits. On the other hand, the host states will be most concerned about the functioning of the payments systems in their country and the continued flow of new credit to their citizens and businesses. The proposal underlines that rescues are likely to remain the province of those with money – national taxpayers. But it also re-inforces the need for host states to be properly involved. The details of home/host balance of powers (and thus burden sharing?) will be the most difficult issue to resolve.
The new Authorities will need to be given comparable legal powers and the proposals list of the functions is lengthy and contains enormous details that will have to be agreed at EU level. The Commission infers that these should generally be in the form of Regulations so they take direct effect. But that was the idea behind the Lamfalussy proposals and in the end the Commission shied away from widespread use of Regulations. That was partly form fear of legal uncertainty about the way in which courts would enforce a Regulation if it conflicted with domestic laws. Whatever the choice, this proposal would call forth a swathe of domestic legislation to conform to the new Regulations. Wisely, the Commission has foreseen the possibility of “manifest breach of Community law” and made provision for empowering an Authority to adopt directly applicable decisions. This need is obvious – but is also a major constitutional step by the European Union.
Conclusion
The set of proposals are wide- ranging and creates many constitutional novelties. But the breadth of them is perhaps the most striking element. Directly enforceable Regulations are not new, agreements on public financial obligations are not new (the European Investment Bank, for example), agreements to delegate tasks and responsibilities from one government to another already exist (Schengen border controls).
But the situation that created the need for such measures is profound and the peoples of Europe need to feel secure that this cannot happen again. The actual cash losses to taxpayers are likely to exceed 10% of GDP eventually and cumulative lost output is also likely to exceed 10% of GDP. As a result, about 10m citizens will be without the jobs that they would otherwise have expected. This is not the moment for bureaucratic turf wars to prevent a root and branch reform of financial regulation. The financial system must return to its traditional function of gathering up investments from aging savers and channelling them into productive economic investment – and it must do that in a way that makes all its stakeholders confident in the system’s stability.
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