The initial agreement amongst eurozone members – and subsequently amongst all EU member states – on the common elements for their banking sector's rescue packages, represented a major breakthrough. It was also urgently needed. But it is also worth recalling that the EU countries only managed to present that common front after earlier measures by individual nations had in fact exacerbated the crisis. The Dublin government’s guarantee for deposits held only at Irish banks was merely the most blatant example.

While EU member states have agreed on the core principles for their national rescue packages, it is worth remembering that between countries the details differ markedly, and that is a recipe for longer-term competitive distortions. More fundamentally still, the failure of several cross-border financial groups has also raised significant doubts about the viability of Europe’s current structure of financial supervision. Essentially, the present approach has failed to provide an effective system of on-going prudential supervision for financial firms and a suitable structure for effective crisis management. Nor are the current arrangements doing much to help preserve the EU’s single market for financial services.

Against this background, the EU has reached a fork in the road. Either the financial crisis will finally provide an impetus for building a pan-European financial supervision structure that helps to support the political objective of building a single market for financial services – or the progress achieved so far in building that single market will begin to unravel and the EU will move backwards into a collection of fragmented national financial markets.

For many years, academics, international organisations (including the IMF), and many market practitioners, have pointed to the deficiencies of Europe’s current supervisory structure. To its credit, the European Parliament has been increasingly responsive to these calls. By contrast, the European Commission – fearing political opposition from the member states – and, even more so, member states have largely turned a blind eye to this challenge. As a result any progress on this front has been haphazard and piecemeal.

It is true that, with the establishment of the Lamfalussy process, there is now greater emphasis on encouraging coherence amongst Europe’s national supervisory bodies. It is also true that with the establishment of the so-called level 3 committees – Committee of European Banking Supervisors (CEBS), Committee of European Securities Regulators (CESR) and Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) – supervisory cooperation amongst EU regulators has improved, even though this cooperation is merely based on intergovernmental cooperation. But any improvements to Europe’s system of supervision that may have emerged from these measures have so far been minimal and, as the financial crisis has now demonstrated, wholly insufficient.

In response to the crisis, the European Commission and the member states have indicated that they will use the upcoming revision of the Capital Requirements Directive (CRD) to make some amendments to the existing supervisory structure. These proposals are essentially aimed at establishing supervisory colleges for all cross-border groups and at strengthening the role of the consolidated supervisor. But unfortunately even these minor improvements appear to be too much for the majority of member states to digest. If the fate of the similarly designed Solvency II proposal is any guide – it met with opposition after proposals to strengthen the role of the consolidated supervisor alarmed a number of member states – then the analogous provisions in the CRD may never see the light of day.

This situation cannot continue. If Europe is serious about building an integrated market, then it must be ready to build a supervisory structure that is commensurate. As an interim first step, the revision of the CRD must be used to strengthen the role of consolidated supervisors. To support this, supervisory colleges must become more than mere talking shops, which is so far what they often are. Instead, they need to deliver a full operational integration of supervision designed to deliver greater financial stability, greater efficiency, better quality – and at a lower cost for financial firms. A single group-wide supervisory process is required that is based upon close cooperation and, ideally, a joint work approach in supervisory colleges that cuts across individual supervisory agencies.

To make this happen, however, it will be necessary for consolidated supervisors to have the final say and also the power to act. So a legal review may also be necessary to ensure that the decisions of a consolidated supervisor are legally binding for all of a financial firm’s operations in the European Economic Area. This may require some form of European administrative act to ensure that integrated supervision has the appropriate legal clout.

We will also need to ensure that setting-up supervisory colleges and strengthening the role of consolidated supervisors doesn't exacerbate the inconsistencies of approach between national supervisors. For this, centralised governance is needed in the form of a stronger role for the Level 3 committees to ensure competitive neutrality as well as an equality of approach amongst the colleges. An annual review mechanism should be established, into which financial groups should be allowed to provide input.

As a second step, we need to build a truly pan-European system of financial supervision. A European System of Financial Supervision (ESFS), modelled on the European System of Central Banks, would comprise a new EU-level institution – a European Financial Services Authority. This would supervise those systemically relevant financial institutions that operate on a pan-European basis, and it would be the final authority for interpreting and implementing EU financial market rules whenever there is a conflict between national regulators. Small and domestically-oriented institutions should continue to be supervised by member states’ national authorities, acting on the basis of common rules and subject to the final say of the pan-European supervisor. Such a European supervsisor would collaborate closely with the European Central Bank, which has an important role in the area of macroprudential supervision.

Only this sort of comprehensive, supranational approach can overcome Europe's present supervisory deficiencies, and only such a system can be competitively neutral and institutionally stable. What’s more, from a political perspective the ESFS system – even though difficult to agree on in the first place – would have one significant advantage over the regime of lead supervisors. While smaller countries would essentially lose direct supervisory authority under the latter system, they would regain influence in the running of a pan-European structure. Creating a pan-European system of financial supervision would thus bear some resemblance to the way European monetary policy developed. Small countries that had passively followed German monetary policy prior to EMU, managed to regain a voice in setting monetary policy as a result of the creation of EMU.

It is also worth bearing in mind that developing an appropriate European institutional structure for financial supervision is not just a European issue. Political foot-dragging on this vital matter risks damaging the EU's international standing. There can be no doubt that Europe’s obvious inability to deal effectively with the failure of large cross-border financial institutions, and the fall-out from the ensuing systemic crisis, has already damaged the reputation of the EU’s financial markets.

Yet many decisionmakers in the EU are still not sufficiently aware of the international dimension, even though Europe collectively represents the second largest financial market in the world and, for this reason alone, has a responsibility for maintaining global stability and security. Moreover, both in competition and cooperation with third countries – whether it is the U.S. or upcoming financial centres – Europe must be able to demonstrate convincingly that it has world-class regulation and supervision right across the EU. Otherwise, Europe’s negotiating power and it trustworthiness as a partner risk being seriously undermined.

In building this sort of new supervisory structure, Europe needs pragmatism and vision. Vision without pragmatism will not be enough, while pragmatism without vision lacks direction. The High Level Group appointed by European Commission President José Manuel Barroso and chaired by Jacques de Larosière will hopefully deliver the blueprints for this. Yet even if it does, the EU’s legislators must still find the political will to act, and act quickly.

Bernhard Speyer is Director at Deutsche Bank Research. Norbert Walter is Chief Economist of Deutsche Bank.