POLICY DOSSIER

Spring 2008

by Markku Pohjola

Markku Pohjola calls for a single EU supervisor to take over key national powers

The European Union lacks an efficient supervisory framework for its vast and expanding financial industry. The gap between what is needed and what in reality is implemented is widening all the time.

Over the past 20 years, the drive to develop Europe’s single market has been flanked by a number of financial innovations. Economic and Monetary Union (EMU) created the single currency. Then, to pave way towards European financial integration, the Financial Services Action Plan (FSAP) was launched in 1999 with the aim of creating a regulatory framework for a single financial area. A White Paper on financial services policy covering 2005-2010 was published by the European Commission in the hopes of speeding things up.

Clear progress has been made; financial institutions across Europe have begun to realise the benefits to be had from economies of scale. In the Nordic countries particularly, overcapacity in the banking sector and improvements in cost effectiveness have led the industry to consolidate. This consolidation started within individual Nordic countries and in the 1990s, after national markets became more or less saturated, crossed borders. The speed at which the industry itself acted soon overtook that set by the regulators and supervisors.

Elsewhere in Europe there have also been great steps forward. The European wholesale market for financial services to large companies has been largely unified. A whole range of financial services, including the bond market, now functions well, and the capital requirements for European banks have been unified. The Single Euro Payments Area (SEPA) is making progress, so the challenge that still lies ahead is to extend these benefits to small and medium-sized companies and the consumer sector. So far, the retail-banking sector has remained outside the integration process, but once that happens and retail banking starts to enjoy all the opportunities of the single market, liquidity will be enhanced and GDP growth levels in Europe will improve.

The changes in the financial industry are particularly evident in banking, where large European and global banks have reaped impressive results. At first, their cross-border operations were still small compared to their home country activities. That meant that that they were mainly supervised in their own countries. But over the last decade, major European banks have acquired foreign banks through such mergers as the acquisition by Spain’s Banco Santander of the UK’s Abbey National, Italy’s UniCredito of Austria’s Hypovereinsbank and lately the takeover of Holland’s ABN-AMRO. All these have raised questions about prudential supervision, chiefly whether there are sufficient resources to check whether at this level the institutions are financially sound. In the Nordic countries, Nordea was created by merging four major national banks, and some 70% of its business is outside its native Sweden. This is a process that is likely to accelerate.

Changes in the way these banks are now organised have put extra pressure on supervisors. Among other measures, banks have begun to de-centralise essential functions to be carried out in different countries, such as market and treasury operations, liquidity and capital management, and risk management have been re-located. Banks nowadays create products and IT platforms to serve their customers in all the different countries where they operate, so it is hardly rational to make separate prudential assessments of units in these cross-border groups, be they subsidiaries or branches.

More than 60% of banking assets in Europe are now in the hands of fewer than 50 multi-national European banks. In eastern Europe, the banking sectors in most of the new EU member states are owned by banks domiciled elsewhere in the EU. In short, the main part of Europe’s banking assets, liabilities and risks are concentrated in these large banks. The current de-centralised supervisory framework for financial institutions, with several independent ”host” supervisors for subsidiaries, and the parent bank’s home supervisor as primus inter pares, is clearly unsatisfactory. Capital adequacy and liquidity risks have to be assessed on a group level, rather than country by country, and how capital and risks are divided between countries is less important.

Under EU law, the home supervisor deals with a bank’s operations as a whole – meaning the parent company and its subsidiaries. But the tools and powers available for home country supervisors are deplorably inadequate. Recent attempts to remedy this under the Capital Requirements Directive have been disappointing from a banking point of view, even though it was quite plainly the best that could be achieved politically. For different EU countries hold a variety of views on prudential supervision, and their financial institutions are far from unanimous about what should be done. The European Commission seems to be doing its best, but progress so far has been all too slow for Europe’s competitiveness to be well served.

Host community supervisors look at business units in isolation from the international group to which they belong. They have their own national rules and regulations to apply, and every financial supervisory authority (FSA) in Europe has its own practices and traditions. And even when implementing directives, EU member countries are often tempted to “gold-plate” them by introducing some extra rules. This adds to their complexity and cost and compounds inefficiency. Even where there is good communication and understanding between national supervisors, as in the Nordic countries and the Benelux, improvements still need to be made. Europe should have a single supervisor with the sole right to make decisions on a consolidated level.

The recent history of Nordea shows that real integration is likely to take time. The regulatory banking infrastructure includes such building blocks as supervision, deposit guarantee, the lender of last resort and emergency liquidity assistance. These are interlinked and stakeholders include central banks, FSAs, national treasuries and deposit guarantee funds. Nordea tried to get the deposit guarantee rules changed with the aim of creating a level playing field in which a cross-border merger would not distort competition between banks. The Brussels Commission showed sympathy and understanding, but the outcome was, as expected, that it passed the problem on to national governments to search for a solution.

Commission officials also implied that no major changes to these building blocks should be expected in the next 5-10 years, as they are so interlinked that change to one affects all the others. For instance, the supervision of deposit guarantees can be improved gradually or through a “big bang” together with other major issues. But whichever route is taken would need several years, and from a commercial standpoint this would be unacceptable. From a pan-European perspective, though, it means that market integration in financial services will continue to be slow and that the competitiveness of European banks will suffer accordingly.

Europe’s financial industry wants a supervisory framework that will foster market integration and create greater financial stability. It should be cost-effective, transparent and competitively neutral, while also providing for crisis management. So what would such a model look like and how would it be achieved, when it is only the EU’s member governments that have the power to bring it about?

Money talks, of course; taxpayers’ money. EU member governments obviously want to minimise the risk of being called on to save a cross-border bank in trouble, so who would have to take the lead in such a situation? Would it be the home country FSA, with its responsibility for consolidated supervision, even though it would have only limited powers? What should be the role of the host supervisors? Would they try to ring-fence the losses to mean only those in their own country? What role should central banks and national treasuries play in a cross-border European banking collapse, and is it even possible to deal with such a situation on a purely national basis?

There appears to be no practical alternative to a European FSA whose duty would be to supervise multi-national financial institutions. It would have the sole power to pursue prudential supervision of multinational banking groups, including all their subsidiaries and branches within the EU and globally. This would not spell the end of national supervisors, as in all likelihood many national FSAs would work as partners of the European supervisor. National banks would continue to be supervised by national FSAs, and consumer protection would also remain local and be subject to national supervision. The problem is that at present there is a lack of convergence and coherence between national supervisors, with the gap between what is needed and what in reality is being implemented widening all the time. And that’s because perceived national interests still have the upper hand over the wider interests of an integrated European marketplace.