Giving supervision a European voice

The supervisory structure has to follow the market. As integration of the single European financial market has been driven forward in many areas during the past few years within the framework of the Financial Services Action Plan, banking groups’ business operations are usually managed largely centrally. That goes particularly for groups operating EU-wide. Risks are consequently captured and managed at group level.

Weaknesses of the status quo
While a bank’s risk management is thus geared to the group level, supervision can only pursue this approach to a limited extent. Although the solvency of banking groups has also been overseen at group level for many years by the supervisory authority of the parent institution, solvency supervision of individual banks (solo supervision) remains in place at the same time. This is the responsibility of the national supervisors of the countries in which the subsidiaries are located. These national supervisors are also in charge of all other areas of supervision.

The establishment of European supervisory structures has failed to keep pace with market integration and the resulting changes in banks’ business processes. Chiefly because of specific national interests, integration of supervision has not been driven forward far enough, so that there is now a crass disparity between market integration and nationally fragmented supervisory structures.

Moreover, the parallel operation of group and solo supervision leads to a duplication of work not only at banks but also at the responsible authorities. The saying that “two heads are better than one” unfortunately does not apply here, as clashes of competences mean that, if the worst comes to the worst, there is actually the danger of supervisory gaps. The financial crisis was undoubtedly helped along by the absence or inadequacy of information-sharing between supervisors who actually ought to feel responsible for jointly supervising an entire banking group. This was made obvious by the HRE debacle. In its case, supervisors had the information they needed, but failed to take any resolute, cross-border action.

Competence-related issues aside, it is also true that we still have a patchwork of different supervisory cultures and even different supervisory rules in the European Union. Even in strongly harmonised areas of EU law, e.g. capital backing, requirements still often differ at national level because European legislators allow a whole number of national options. As the interpretation and application of EU law by member states is drifting apart, this adds to the difficulties supervisors have – besides the aforementioned clashes of competences – in assessing the risk exposure of banks operating EU-wide. Banking supervision in Europe is thus still far from having a common supervisory language and culture, supported by harmonised data formats, to ensure a straightforward and, above all, understandable dialogue between supervisors.

But it is not as if nothing at all had happened at European level before the financial crisis.  One hesitant, but right step a few years ago was the establishment of the so-called level 3 committees. These constitute a forum for cooperation and dialogue between European supervisors and comprise the Committee of European Banking Supervisors (CEBS), the Committee of European Securities Regulators (CESR) and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS).

Their job is to help ensure uniform implementation of EU directives and harmonisation of supervisory practices. To do so, the level 3 committees issue interpretative guidelines, although, as recommendations, these have no binding effect on national supervisors. Some progress has also been made in ongoing supervision of EU-wide banking groups: colleges have been set up to improve the exchange of information between supervisors. These colleges are made up of the supervisors responsible for overseeing group subsidiaries and the parent institution and consult on supervisory issues at group level.

The main weakness of the status quo is obvious: there is still no system of one-stop European supervision to concentrate competences for ongoing supervision and enforce group-wide supervisory strategies. This is the only way to synchronise integration of markets and supervision, avoid supervisory gaps and make progress towards common supervisory practices.

The European Commission proposals
The European Commission responded swiftly to the financial crisis, setting up in 2008 an Expert Group chaired by former French central bank governor Jacques de Larosière. Its job was to draft proposals for further developing European supervisory structures. In September last year, the Commission unveiled a comprehensive legislative package for future European financial supervision based on the findings of the de Larosière Group.

This legislation creates three new European supervisory authorities, which are due to start operating in 2011: the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA). They will not only replace the existing level 3 committees (CEBS, CESR and CEIOPS), but will also have additional powers. Besides non-binding guidelines, the new European Supervisory Authorities (ESAs) will be authorised to issue, in consultation with the European Commission, binding technical standards for specific areas of supervisory regulation. These will then be directly binding on market participants and supervisors and strengthen harmonisation of both the legal framework and supervisory practices. In addition, supervisory reporting formats are to be further harmonised and data management centralised with the ESAs.

Besides these competences for harmonisation of supervisory law and practices, the ESAs will be given powers in relation to ongoing supervision. In this area, national supervisors will be the main addressees of instructions issued by the ESAs, since the Commission blueprint provides for a two-tiered division of responsibilities between European and national supervisors: national supervisors remain responsible for ongoing supervision, with the ESAs having authority to issue instructions to them in certain cases. To lend these instructions sufficient weight, the ESAs will have – purely subsidiary – powers to take direct action against financial institutions (Grafik 1).

ESAs will have authority to issue instructions to national supervisors in three cases: firstly, if national supervisors apply European supervisory law inadequately or incorrectly; secondly, in crisis situations; and thirdly, if there is disagreement between supervisors of different member states. The authority granted in the third case is designed to foster efficient supervision in the European colleges and will take the form of a binding mediation procedure.

If a supervisor fails to comply with instructions in the event of a crisis or disagreement, the ESA can take the measure required itself as a sort of “substitutive act”, which is then directly binding on the market participants concerned. Where European supervisory law is applied incorrectly, the European Commission will, at the recommendation of the ESA, be given the power to impose appropriate sanctions.

Action taken by the ESAs is, however, not to be allowed to impinge in any way on member states’ fiscal responsibilities. European government leaders saw to this at a summit held before the Commission’s legislative proposals were presented. This is why the Commission drafted a protective clause giving member states which believe their budgets are affected by any ESA action a sort of veto. This veto can, however, be overridden by a qualified majority of votes in the European Council.

The Commission proposes retaining the locations of the level 3 committees, so that the new ESAs will be based in London (banking supervision), Paris (securities supervision) and Frankfurt (insurance supervision). They are to be funded by contributions from national supervisory authorities, from the EU budget and by fee income. The budget to be allocated to, for example, the European Banking Authority for 2016 will be around € 24.6 million.

Macro-prudential supervision – European Systemic Risk Board
The financial crisis has shown that, firstly, the scale of macroeconomic risk was not always recognised properly and, secondly, even it was, it was not taken into account sufficiently in supervisory strategies. Difficulties caused by financial market participants all acting in the same manner were, for instance, systemically underestimated along with their financial entwinement and its impact in a crisis. So that more consideration is given to this macro level in supervisory action taken in future and to measures taken by political decision-makers, a European Systemic Risk Board (ESRB) will be set up.   

The ESRB’s mission will be to collect the information needed to assess the stability of the financial system, identify macro-prudential risk, issue warnings and recommendations and monitor compliance with these. Warnings and recommendations may be addressed to the European Union, one or more member states, and European or national supervisors. Recommendations aimed at amending the European legal framework may be addressed to the European Commission. Furthermore, every warning or recommendation will be notified to the European Council. To ensure proper coordination with national supervisors, a so-called “act or explain” mechanism will be put in place, requiring the addressees of recommendations to state reasons justifying non-compliance with these.

The ESRB, which will be headed by the president of the European Central Bank, will be made up of the vice-president of the ECB, plus the chairmen of the three new ESAs, a representative of the European Commission and delegates from the 27 national central banks. Unlike the ESAs, it will not have any independent legal personality.



The positions adopted by the Ecofin Council and the European Parliament
The coming months promise to be an interesting time politically, as the European Council and the European Parliament favour widely differing approaches. In December last year, the Ecofin finance ministers agreed on a compromise that sharply curtails the powers of the future ESAs. The – merely subsidiary – authority given to them by the Commission to take action against market participants will be dropped for crises or disagreement and retained only for incorrect application of European supervisory law.

The European Parliament’s Economic and Monetary Affairs Committee has, on the other hand, set a clear European counterpoint by going further than the Commission proposals. It actually proposes having EU-wide banking groups overseen directly by the European Banking Authority. At the same time, it recommends setting up a European deposit guarantee fund and suggests having all three ESAs located jointly in Frankfurt.

Assessment and outlook
The three EU institutions – Commission, Council and Parliament – now need to reach agreement by way of “trilogue” talks, and they need to do so relatively soon in fact if the ESAs are to start operating on schedule, i.e. in January 2011.

At the insistence of the UK and not least Germany, member states have unfortunately been reluctant to make any clear commitment to transfer competences to European level. The European Parliament is therefore right to take a clear European stand in order to put negotiating pressure on the Council. It is, after all, important that the future ESAs do not simply become “toothless tigers”. The consequence would be European bureaucracy just for the sake of it. Falling short of the Commission proposals should therefore not be an option, as these promote stronger legal harmonisation, a common reporting system and more efficient supervision of EU-wide banking groups. The lessons learned from the financial crisis should thus be used to establish European supervisory structures that merit the label of “EU financial supervision”.

Nevertheless, the European Parliament goes too far on some points at the present time: it is too early for direct supervision of banks by a European authority as long as no rules on joint burden-sharing have been established. And the time will only be ripe for the additional ESA powers of direct action against market participants proposed by the Parliament once further legal harmonisation has been achieved. Only then will a European authority have a sound legal footing on which supervisory measures can be based.

So a few years after implementation of the Commission proposals, once the ESAs have been performing their new functions and built up a strong personnel base, further discussion based on the experience gathered in the meantime should take place. It should be ensured that the question of a further transfer of supervisory competences for cross-border banks to European banking supervisors is included in this discussion.