EUROPE
Europe’s reform of financial supervision is headed in the right direction
Autumn 2009
The ‘moral hazard’ of some EU governments’ bank bail-outs must now be counter-balanced by tough regulations and more effective supervision, says Hans Hoogervorst, Chairman of the Netherlands Authority for the Financial Markets. He sets out the key targets for reform
Economic liberalism seems to have been shaken to its foundations now that intervention by governments in the financial sector is no longer a dirty word. Yet a closer look at the origins of the credit crunch quickly reveals that the crisis is not rooted in liberal economic orthodoxy, but stems instead from activist macro-economic policies that originated in the toolboxes of market sceptics.
The excess liquidity that undermined the world economy during the past decade was to a great extent caused by highly activist, old-fashioned “Keynesian” monetary and fiscal policies around the world. Monetary policy has been too accommodating, with the result that very low real interest rates led to asset bubbles. Fiscal policy in the U.S. was lax as the result of America’s expensive wars in Iraq and Afghanistan, coupled with the Bush Administration's huge tax cut. At the same time, many European countries chose to ignore the Stability Pact, even though times were good.
It will be interesting to see what effect the crisis is going to have on orthodox thinking about financial supervision. For although the financial sector may look the pinnacle of capitalism, it is in essence one of the most sheltered parts of a market economy. The financial sector is, after all, “blessed” by a huge safety net precisely to contain systemic risks to the economy. Recent years have shown that this safety net in fact gives incentives to take on too much risk. Once a sector knows it will be bailed out if things go wrong, it has a huge incentive to privatise gains and socialise losses. Policymakers around the world all underestimated the degree of ‘moral hazard’ involved, sharing a naïve belief in the self-correcting mechanisms of the free market.
The lesson is clear: a public safety net of central bank lending and government intervention in the financial sector is of course necessary. But the moral hazard it creates must be counter-balanced by strong regulation and adequate supervision.
There is widespread support from economists and policymakers around the world for greatly improved financial regulation. The focus needs to be on structurally improving regulation nationally, regionally and on a global scale. Initiatives like the reform plan put forward by U.S. Treasury Secretary Tim Geithner, various European Commission initiatives and the G20 agenda reflect the international sense of urgency that all appropriate measures must be taken. Multilateral organisations like the Financial Stability Forum, the International Organisation of Securities Commissions (IOSCO) and the IMF play an important role in the reform of financial supervision. But yet more supervision will be needed in areas like credit rating agencies and over-the-counter derivatives. The market for credit default swaps would benefit from enhanced transparency and clearing by a central counter-party.
All this is both necessary and urgent, but in addition there needs to be a fundamental reform of the institutional regulatory structure. Currently much attention is being given to the introduction of macro-prudential elements of supervision, both in the U.S. and in Europe. However, the nature of the crisis makes it clear that any review of the institutional regulatory structure must not only include prudential supervision but also conduct-of-business supervision. This covers various financial activities and requires different levels of supervisory cooperation. For example, a more centralised European supervision of credit rating agencies (CRAs) would constitute the most effective and efficient way to oversee companies that provide ratings worldwide. Likewise, the supervision of financial documentation such as prospectuses and financial accounts could be made subject to more centralised supervision by the competent European authorities. It also needs to be acknowledged that some financial services providers covered by conduct-of-business supervision are primarily active in just one member state, and so should go on being supervised by the competent national authority. In other words, what all this adds up to is that when making changes in the EU to the present financial supervisory architecture, attention must be given to the sheer variety of types of business involved, and the sort of supervisory cooperation that will entail.
Conduct-of-business supervision clearly plays a crucial role in consumer protection, and ideally this needs to be recognised by making a single supervisor responsible for this. The so-called “twin peaks” model of supervision was introduced in the Netherlands in the early years of this decade, and we consider it to be appropriate to the current circumstances where the boundaries between the traditional financial industries of banking, insurance and securities trading have become more and more obsolete. Now that market development no longer occurs along traditional sectoral lines, supervision should follow that and be organised along functional lines. The added benefit of a “twin peaks” model of supervision is that not one type of supervision can dominate the other, because both the prudential and the conduct-of-business supervision are taken care of separately.
A closer look at the present European regulatory structure shows that regulation as well as supervision are still very fragmented. Although regulation is based on harmonised EU law, there are considerable divergences in the way this body of law has been implemented by national legislation, and in the way it is applied by national supervisors. This lack of harmonisation, together with the competition that exists between national supervisors in the ways they apply the rules, has led to a persistent danger of a regulatory and supervisory race to the bottom. And recent history has shown that it is very difficult for national supervisors to prevent this sort of downward spiral. Policy responses to the financial crisis show that many reactions remain national in origin. National governments have had to take the lead in the bail-outs of banks, but there has been a lack of coordination among securities supervisors regarding short-selling. There was no coordination of the national decisions to prohibit short-selling last September, nor was there a joint approach to abolish these rules in the spring of this year.
It is now abundantly clear that the global financial crisis has shown that concerted action on a pan-European level is urgently needed. The report on supervision of the De Larosière High-Level Group offers the basis of such action and there are some very promising aspects in the EU’s plans such as the creation of a European Systemic Risk Board and the establishment of a European System of Financial Supervisors that would help move the EU towards a single rule book while also transforming the various EU supervisors’ committees covering securities, banking, insurance and pensions into European Supervisory Authorities (ESAs) with a legal personality under Community law. National supervisors will remain responsible for day-to-day oversight, but the ESAs will ensure that a single set of harmonised rules and consistent supervisory practices is applied by the national supervisors. They will, for instance, develop binding harmonised technical standards in areas specified in Community legislation, and they will also promote a common supervisory culture and consistent supervisory practices across Europe, while at the same time collecting micro-prudential information and ensuring the consistent application of EU rules. This latter role of the ESAs will apply especially when there is disagreement between national supervisors or within a college of supervisors. The ESAs will also have full supervisory powers for pan-European entities like credit rating agencies and EU central counterparty clearing houses, and most important of all, perhaps, they will be responsible for ensuring a coordinated response in any future crisis.
This all sounds very promising for the improvement and harmonisation of regulation and supervision of financial institutions across the EU. It is definitely a positive step, although critics can still point to the differences of opinion among EU governments on such issues as fiscal burden-sharing for saving troubled banks. On the whole, though, the crisis has created the pre-conditions for political agreement on wide-ranging reforms of the institutional structure of financial supervision. New institutions like the ESAs should be up and running in the course of 2010, which means that the Commission will need to present its legislative proposals by next autumn. Without the urgency of the crisis, the speed of regulatory reform would clearly have been much slower.
Genuine reform of financial services supervision and closer cooperation within the EU is indispensable for our future economic well-being. The crisis is too important and far-reaching to waste the opportunity to take appropriate action. We can discuss how and to what extent we need to cooperate more closely, but it is beyond doubt that we need to find effective arrangements for more harmonised regulation and supervision of the financial market and its players.