3 National financial stability arrangements are ill-adapted to pan-European banks
While pan-European banks are emerging, Europe’s financial stability arrangements remain grounded at the national level. They now run the risk of lagging behind market developments.
Much headway has certainly been made in giving national financial stability arrangements a European orientation. The European Commission’s 1999 Financial Services Action Plan put in place a largely harmonised set of financial regulations. The so-called Lamfalussy framework for financial rule-making complemented this with a structure intended to implement these regulations consistently and adapt them over time, while reinforcing market consultation. In the banking sector, it brings together all European banking supervisors and relevant agencies within the Committee of European Banking Supervisors (CEBS), established in 2004. To improve cross-border cooperation between existing national agencies, an extensive network of bilateral memorandums of understanding (MoUs) has been built since the late 1980s, complemented more recently with multilateral MoUs on information sharing during a crisis and on specific banking groups.
But the interlocking of many national sources of authority has also created complexity and blurred the lines of responsibility for supervision and crisis management. CEBS is an advisory body, with no decision-making powers. The MoUs are non-binding, and their effectiveness has yet to be tested by a crisis. The European Central Bank (ECB), established in 1998, has no supervisory mandate and, apart from its responsibility for open-market operations, its only financial stability task is a monitoring role, supported by the ECB’s Banking Supervision Committee.
The prudential framework for pan-European banks has become a maze of national authorities (51 are members of CEBS alone), EU-level committees (no fewer than nine) and bilateral arrangements (some 80 mentioned in June 2007 by European Commissioner Charlie McCreevy). Prudential fragmentation imposes costs on the financial system. One recent study estimates that the resulting absence of scale economies adds 15 percent to the cost of Europe’s banking supervision (Schüler and Heinemann, 2005). Additional costs are created as banks need to cope with different requirements and reporting systems in each country.
But these supervisory costs are of secondary importance compared to the risks related to an inadequate response to major crises. No national or European authority presently has routine access to supervisory information on all pan-European banks, or in-depth knowledge of their developments. EU countries’ existing tools are no longer adequate to contain the impact of financial crises in ways that minimise collective costs and avoid moral hazard (ie precedents that encourage imprudent behaviour by financial players, including banks).
The effects of financial integration are most advanced in the countries that joined the EU in 2004 and 2007, in which the banking system is dominated by foreign-headquartered institutions (Figure 2). Elsewhere, the influence of nondomestic banks is also increasing as cross-border activity gathers pace. As banks increasingly centralise key business functions such as risk, liquidity and asset-liability management, local branches or subsidiaries become less independent from the rest of the group. As a consequence, national authorities increasingly lose leverage over the main banks in their jurisdictions, and their ability to deal with financial crisis situations on a national basis is diminished.
Figure 2: The gradual demise of ‘national banking systems’
Source: Bruegel based ECB (2005), based on 2004 data.
If problems emerge in a pan-European bank, there are no agreed rules on early intervention and remedial action. Because of different interests or a different assessment of risks, different national authorities may have different priorities, the more so as the crisis becomes acute. Speed, crucial in handling crises, might be hampered by coordination difficulties, compounded by the lack of agreement between countries on the role (if any) public funding should play in crisis resolution, and on the division of tasks between supervisors in ‘home’ (headquarters) and ‘host’ (local) jurisdictions. At every step, agreement may take so long to reach that it might be overtaken by events on the ground, with consequent increases in the cost of any remedies.
If a bank’s insolvency becomes a realistic scenario, minds will focus on the possible public cost of crisis resolution, which has been a factor in past crises, and countries will act to minimise losses to their own citizens. They may seek advantage by withholding information or otherwise delaying cooperation. Host countries may try to ‘ringfence’ subsidiaries or branches and limit their operational freedom, to prevent higher-quality assets from leaving the country or additional liabilities being imposed on the local level. In doing so, they may compound difficulties and prevent solutions at the group level. Conversely, home authorities may be unwilling to spend their taxpayers’ money for the benefit of depositors in host coun-
tries, or lack the capacity to do so. Depositors may have to face the consequences of decisions made by foreign authorities, who are not accountable to them and will be naturally suspected of being primarily concerned about their own citizens’ interests.
The economic literature on ‘mechanism design’ suggests that in such situations, national priorities will be incompatible with minimisation of the overall collective cost (Green and Laffont, 1979). In such dire events, non-binding supervisory MoUs or voluntary mediation mechanisms may not have much impact when weighed against the potency of national mandates. Crises are known to require concentration of responsibility, but in the absence of clear ex-ante cross-border arrangements, it is unlikely that any authority, national or European, could emerge as an ‘honest broker’ to represent the common interest.
As Pauly (2007) put it, “the belief that financial institutions and national regulators will voluntarily and automatically collaborate to an adequate extent in the face of a financial panic and in the absence of central coordination seems a classic example of wishful thinking. Where is the historical evidence that could justify it?” Neither the Economic and Financial Committee, which brings together the EU’s finance ministries, nor the ECB, nor the Commission are likely to prove able to “provide the necessary services of multilateral coordination and political buffering” (Pauly, 2007). As a result, significant and unnecessary losses of taxpayers’ money would be likely, and this money may be spent in ways that create moral hazard among Europe’s banks.
No real precedent exists for a major cross-border banking failure, except perhaps the unhappy experience in 1991 when BCCI was closed down in London. Nonetheless, recent turmoil in credit markets has reminded the European public of the permanent possibility of financial crises, and of the inability of national borders to keep them at bay. Financial innovation and global integration not only distribute default risk – which, all things equal, tends to strengthen the system – but also create new risks of their own, including those linked to the increase in common exposures across systems, which could make crises even more severe when they occur.
As the examples listed in Table 4 illustrate, recent banking crises in the developed world have often resulted in major damage, both in terms of direct fiscal costs related to managing the crisis and loss of economic activity (the numbers remain high under any valuation methodology). More remote memories, including those of the 1930s in Europe and the United States, underscore the fact that disruption in the financial system, if not properly managed, has severe social and political as well as economic consequences.
Table 4: The high cost of banking crises
Source: Honohan and Klingebiel (2003).
4 A two-tier financial stability framework
Given the deficiencies of the status quo and the potentially severe impact of crises involving pan-European banks, an overhaul of Europe’s financial stability arrangements is overdue. Arrangements are needed that deliver solutions to crises that minimise crisis-induced collective losses at the European level – while remaining compatible with continued financial development, including financial integration and innovation. Handling crises involving pan-European banks efficiently and effectively is only possible when supervisory information can travel across borders confidentially but freely; efficient structures are in place that allow quick decisions involving multiple countries and agencies; sufficient operational flexibility is possible to deal with the unique nature of each crisis; all involved decision-makers share common basic views on how to proceed; and individual and institutional incentives are sufficiently aligned for decisions to serve the collective interest.
Relying on increasingly complex arrangements for voluntary cooperation among national financial stability frameworks is unlikely to deliver on these requirements, because of the practical coordination difficulties and more fundamentally because the interests of the decision-makers involved are not aligned. Actions intended to minimise collective costs are only likely to be on offer when cooperation is no longer simply voluntary, but a core part of the mandate.
It does not follow that all financial stability functions need to be EU-wide. Indeed, the subsidiarity principle and the differences in the risks of cross-border externalities present in the banking system suggest a two-tier setup, in which functions are fulfilled either at the EU level or at the national level, depending on where this can best be done given the objectives outlined above.
Some functions related to cross-border crisis management ought to be organised at least in part at the EU level, such a way that key decision-makers are responsible for the common best interest, and held accountable for safeguarding it. In addition, combining effective and collective-cost-minimising crisis management with the objective of allowing pan-European banks to operate freely across borders argues in favour of an EU-level regulatory and supervisory (prudential) regime for these banks.
Such a European prudential regime should be effectively focused on pan-European banks, a small subsample of Europe’s 8,000-odd banks. The European System of Central Banks has calculated that just 16 groups account for one third of EU banking assets. These groups hold on average 38 percent of their EU assets outside their home countries (Trichet, 2007). For nationally-oriented banks, including most cooperative, public and savings banks, the benefits offered by proximity argue for a decentralised prudential approach based on national vision.
A European prudential regime can best be established at the level of the entire EU rather than the euro area, because the EU offers an appropriate framework of law and democratic accountability and almost all pan-European banks have significant activities in London that cannot be isolated from their euro-area operations. It should be based on a single rulebook and entail EU-level responsibility over some supervisory functions, which could be transferred either to one or several new or existing agencies. To eliminate current information asymmetries with respect to pan-European banks, supervisory information would need to be centralised, with appropriate arrangements to allow the circulation of confidential data.
To help ensure collective crisis cost minimisation, a European prudential regime should be accompanied by a single set of pre-crisis sanctions and tools and specific, harmonised arrangements for deposit insurance. Bankruptcy procedures tailored to the characteristics of pan-European banks might also need to be considered. Because overall cost minimisation often tends to be to at least one party’s disadvantage, it is likely to require countries to commit to sharing the costs of crisis resolution. If well-handled ahead of time, this need not prompt moral hazard (Goodhart and Schoenmaker, 2006). Any EU-level arrangements should provide the clear prospect for failing banks to disappear as legal entities, to curtail moral hazard and strengthen banks’ incentives to manage savings carefully (Decressin et al, 2007).
An important and difficult question is determining to whom exactly a European prudential regime should apply. Filtering banks on the basis of specific thresholds of geographical risk diversification and/or size may be overly rigid and distort competition. Making adhesion to a European regime voluntary carries both the potential benefits and risks of regulatory competition, and there is no guarantee that all pan-European banks would join. A combination of both approaches could also be considered.
An EU-level approach for pan-European banks would facilitate coordination with non-European supervisors in the event of a crisis that extends beyond the EU’s borders, something financial globalisation makes ever more likely. It would increase Europe’s influence in international discussions on banking. It would reduce compliance and opportunity costs for pan-European banks. It would level the playing field on which pan-European banks compete, whatever their country of incorporation, and may accelerate the ongoing convergence of national-level banking regulation. It could hamper the protectionist bent of national policies. And it would probably contribute to an acceleration of European financial integration, with positive growth and competitiveness impact. These ‘side effects’ would not be negligible.
Discussions about pooling decision-making and building new institutions that defend Europe’s collective interest raise many legitimate concerns. These include the desire to keep institutions close to citizens and market players; the need for effective accountability, especially as crisis management may lead to using taxpayers’ money; the risks of mission creep and unchecked overregulation; and the risk that new institutions may be difficult to reform if they prove inadequate. Also, there is a natural desire to maintain the mandate of existing national institutions and related jobs – not to mention other possible obstacles to reform such as turf protection, regulatory capture, and institutional inertia.
The European regime should rely on extensive delegation of operational tasks to national agencies; and arrangements on the funding, governance and public accountability of EU-level organisations to be involved in it will be crucial for creating trust and legitimacy. Under current arrangements, EU citizens are subject to decisions of foreign authorities that are not at all accountable to them. The two-tier framework would thus restore accountability in an area where it is currently not provided.
Given the magnitude of the challenges, an ‘evolutionary’ approach, based on consensus-building among national agencies, is unlikely to deliver. Political commitment at the highest level will be needed, as has been the case for previous major European reforms. The severe potential impact of inadequate management of potential pan-European banking crises justifies a high degree of engagement by principals.
Until recently, it was acceptable to downplay the importance of cross-border prudential issues, but the recent and likely future rise of pan-European banks changes the situation. If a major banking crisis, triggered by events inside or outside the EU, catches Europe unprepared, the risk would be an extraordinarily costly outcome, possible regulatory overreaction and the rushed adoption of poorly prepared reforms. Seen in its wider context, swift and proactive adaptation of financial stability arrangements in response to the emergence of pan-European banks is in the interest of all market participants.
References
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