Jun 01 2009 Susannah Hammond
The European Commission has published a communication (PDF) on European financial supervision together with supporting impact assessment (PDF) and frequently asked questions.
Main issues arising
The commission has set out for consultation a series of wide-ranging structural reforms which aim to increase the strength of financial supervision across the EU. Charlie McCreevy, European commissioner for the internal market and services, has stated that "financial supervision in Europe has not kept track with market integration. The crisis has shown that the current system is not sufficiently responsive and not appropriate for a single financial services market."
In response to the current crisis and in line with the recommendations that both the de Larosière report (PDF) and the commission's previous communication "Driving European Recovery" (PDF) and accompanying annex (PDF) made, the commission has proposed a completely new architecture for financial supervision in the EU, which includes the creation of a European Systematic Risk Council and a European System of Financial Supervisors.
European Systemic Risk Council
The ESRC is to monitor and assess the risks to the stability of the financial system as a whole. It would provide early warning of systemic risks that may be building up and, where necessary, recommendations for action. The creation of an ESRC aims to address one of the fundamental weaknesses that the crisis has highlighted, namely the exposure of the financial system to interconnected, complex, sectoral and cross-sectoral systemic risks. It is proposed that the ESRC should be established as a new independent body which is responsible for safeguarding financial stability by conducting macro-prudential supervision at the European level. To perform this role, the ESRC would need to:
• Collect and analyse all the information that is relevant for monitoring and assessing the potential threats to financial stability that arise from macro-economic developments and developments within the financial system as a whole.
• Identify and prioritise such risks.
• Issue risk warnings where risks appear to be significant.
• Where necessary give recommendations on the measures to be taken in reaction to the risks identified.
• Monitor the required follow-up to warnings and recommendations.
• Liaise effectively with the International Monetary Fund, the Financial Stability Board and third country counterparts.
The chairperson of the ESRC would be the president of the European Central Bank with a vice-chair elected by ESRC members. The members would consist of:
• Governors of the 27 national central banks.
• Vice-president of the ECB.
• Chairpersons of the three European supervisory authorities.
• Member of the European Commission.
It is also proposed that there would be a series of observers at ESRC meetings with a representative of the national supervisory authorities accompanying the central bank governor in a 1+1 formula together with the chair of the EU Economic and Financial Committee.
European System of Financial Supervisors
The proposed ESFS is designed to enhance the supervision of individual financial institutions and will consist of a network of national financial supervisors working in tandem with new European supervisory authorities which the transformation of existing Lamfalussy committees will create. The aim is for the ESFS to be built on shared and mutually-reinforcing responsibilities, combining nationally-based supervision of firms with the centralisation of specific tasks at the European level. It aims to foster harmonised rules and coherent supervisory practice and enforcement. The current committees of European supervisors are perceived as having a number of limitations which the current crisis has highlighted, including:
• The lack of a mechanism to ensure that national supervisors arrive at the best possible supervisory decisions for cross-border institutions.
• Insufficient cooperation and information exchange between national supervisory authorities.
• Joint action by national authorities requires a tour de force to take account of the patchwork of regulatory and supervisory requirements.
• National solutions are most often the only feasible option in responding to European problems, where different interpretations of the same legal text abound.
The new ESFS will be designed to overcome these deficiencies and provide a system that is in line with the objective of a stable and single EU financial market for financial services — linking national supervisors into a strong community network. To achieve the aims of the ESFS, the three new European supervisory authorities, to be known as the European Banking Authority (replacing the Committee of European Banking Supervisors), the European Insurance and Occupational Pensions Authority (replacing the Committee of European Insurance and Occupational Pensions Supervisors) and the European Securities Authority (replacing the Committee of European Securities Regulators) will be specifically charged with, and equipped to fulfil, the following functions:
• Ensure a single set of harmonised rules including those for the licensing and supervision of financial institutions.
• Ensure consistent application of EU rules including:
o Mediation and ultimate settlement of disagreements between national supervisors.
o Ensure that national supervisory authorities comply with community legislation with a right of referral to the commission for persistent breach and where there has been inaction, delay, or in the case of urgent need will be empowered to adopt decisions that are directly applicable to financial institutions.
• Ensure a common supervisory culture and consistent supervisory practices.
• To take up full supervisory powers for certain pan-European entities, such as credit rating agencies and the EU central counterparty clearing houses.
• Ensure a coordinated response in crisis situations with the ability to adopt emergency decisions, e.g., on short selling.
• Collect micro-prudential information.
• Undertake an international role.
To facilitate the operations of the three European supervisory authorities an overarching steering committee will be part of the structure to ensure mutual understanding, cooperation and consistent supervisory approaches between the three authorities in addressing cross-sectoral challenges, including financial conglomerates, and to ensure a level playing field. The proposed new architecture for EU financial supervision will only work if the ESRC and the ESFS cooperate efficiently. The annex to the communication includes a diagram which shows how the bodies will work together and the primary flows of information.
Compliance tips and next steps
The proposals from the commission represent a major change to the current framework of regulations and supervision of financial institutions. At this stage the proposals are very high level with much of the critical detail missing. The EU wants to be seen to be moving the reform issues forward and to be using the political will and momentum to drive through the required changes. Gertrude Tumpel-Gugerell, a member of the executive board of the European Central Bank, picked up this point in a recent speech (PDF) on the new financial architecture and the role of Europe. In the wake of the crisis, the international community has shown remarkable unity and has achieved a common understanding of the responses that are required to the crisis and it is now very important to maintain the momentum of implementation of important changes. Tumpel-Gugerell went on to say that the policy initiatives should be coupled with a further striving for financial market integration in Europe.
There is a huge amount for compliance officers and their firms to consider in the proposals. It is clear that the commission has far-reaching plans and sees the global accord reached at the G20 and the de Larosière report as its opportunity to not only drive through the required reforms, but also to come closer to its goal of a truly single market in the EU. The communication is framed as a consultation on which a series of issues are posed to the European Council for their consideration. The intention is for legislation to follow in the autumn.
Interested parties are invited to submit their reactions on the communication before July 15 and firms may wish to consider the following in their response:
• The urgent need for more detail — the practical reality of how the proposed new supervisory architecture will work only takes shape once there is a great deal more detail on the planned functioning of the new structure. A case in point is precisely how the new ESAs' powers and right to adopt decisions will interact with national supervisors. If the ESAs are de facto supervisors of supervisors, there needs to be clear rules and guidelines as to the limits, scope and rights of appeal on decisions reached. There is likely to be a huge political and regulatory response to the proposals and it may make sense for the commission to be encouraged to produce a far more detailed plan for consideration before legislation is framed.
• The execution of pan-EU crisis management needs to be considered. Both the ESRC and the ESFS are to be bodies with a large, international membership which is not necessarily conducive to prompt action being taken in a crisis. The protocols to be followed, what precisely is deemed to be a crisis or near-crisis, as well as the range of available responses, all need to defined and agreed.
• The ESRC would not have any legally binding powers and would exert its authority through warnings and recommendations issued on an "act or explain" basis. The ESRC would decide in each case whether or not to make the recommendation public. The experience in the UK has shown that too much or mis-placed transparency can be far worse for the public's confidence in banks than a possible lack of information. The criteria on which the ESRC would base its decision to publicise any warnings or recommendations should be drafted in detail and consulted upon before being implemented.
• Possibly the biggest issue which is not addressed in the communication is the question of insolvency. Mervyn King, the governor of the Bank of England, has said that the big banks are international in life but local in death. The national nature of insolvency has not been addressed under the topic of "burden sharing" in the proposals. National authorities and the tax payers who both elect them and end up paying to support failing institutions will expect to maintain sovereignty over how those firms are treated. This would appear to be at odds with the powers that are being granted to the new ESAs and firms may wish to seek clarity on the scope of burden sharing, insolvency and the remit of the new bodies.
• The proposed new structure raises the debate about the right to passport across EU member state borders and the role of home and host supervisors. In the past the FSA has been able to refuse permission for firms to passport into the UK; the most recent case was the Lithuanian domiciled firm Bankas Snoras. The position of passporting and a national regulator's right to refuse entrance to a firm needs to be clarified.
• One potential issue with the proposed high level structure itself is the continuation of the sectoral approach with the three separate authorities, rather than a more combined approach. One of the major aims of the reforms is to improve the oversight of significant international firms, very few of which are truly monoline within a particular sector. Further consideration should be given to having a single supervisory authority which would also have the advantage of taking out a layer of complexity and bureaucracy from the structure.
• The communication does not touch on the skills of the proposed members of the new bodies. The ESRC, for example, is to operate on a simple voting majority basis with many of the members being governors of central banks with a very limited financial services market in their home state. These governors would have an equal vote with the governors of the central banks of the UK, France and Germany where there are much more developed, complex, liquid and international financial services marketplaces. Any pan-EU body should have appropriate representation, but the skills, knowledge and experience of the constituent voting members should be carefully assessed. The whole skills question is further complicated by the mix of euro and non-euro zone countries, which a euro zone ECB president chairs at the ESRC level.
• The potential for the imposition of a single EU rulebook for financial services. All the EU member states have different marketplaces and each country has been developing its own response to the crisis. In the UK there have been a series of publications with the next one expected to be the House of Lords Economic Affairs Committee report on banking supervision and regulation, which is due out in early June. The committee has been investigating bank regulation since December 2008 and has looked in detail at many aspects of regulation, including the tripartite regulatory regime, banks' internal regulation and the role of non-executive directors, bank capital and liquidity requirements and the role of ratings agencies in the financial system. In the creation of a new EU financial supervisory architecture, national voices still need to be heard and reforms which are of particular benefit to the UK should not be lost. It should also be remembered that much of the design of financial products is tax-driven and a truly single market for financial services will only happen when there is tax harmonisation across the EU and the member states are as far away from that as ever.
