How big a watchdog?

The banking crisis has raised the debate about cross-border supervision up several notches. Nicolas Véron weighs the case for a pan-European body, which Malcolm Levitt rejects in a separate box.

Debates on how to organise banking supervision in Europe have tended to degenerate into abstract theological arguments in the past decade. But the financial crisis has made them more concrete. Everyone is aware that the quality of crisis prevention and crisis management, tasks in which supervisors hold centre-stage, has a direct impact in terms of taxpayers’ money expended or pledged by governments.
The dramatic days of early-October last year made clear that, at least in the short term, there is no willingness by European countries even in the most extreme circumstances to pool significant financial resources at federal level.
An alleged plan to set up a European rescue fund, mirroring the ill-fated “Paulson plan” simultaneously being discussed on Washington’s Capitol Hill, was slammed down by Germany, after which France denied having proposed it. Emotional appeals by prominent economists for a shared pile of money to recapitalise ailing banks went unheeded. The EU may find new resources of its own to help member-governments, as it did with Hungary in late-2008 (on the basis of a little used provision of the Maastricht Treaty), but not on a really large scale and not to help private-sector financial firms. However, crisis prevention and management is not only about the money.
Long before – and, if need be, after – public funds are spent on banks, supervisors have to assess the risk these pose to the system, and minimise that risk either by moral suasion or more vigorous methods.
Individual countries have experimented with various models to organise supervision and its relation with the local government and central banks. No model is perfect, andmany would advocate that different models are suited to different countries depending on the specific features of their financial sectors.

But banking activities are not confined to national boundaries. Banks have expanded across EUborders. Inmany countries, including but not only the newer member states, foreign-controlled players are a key component, in many cases the largest part, of the banking landscape. Think of Finland: of the largest three banks there, one reports to headquarters in Sweden and another inDenmark, while the third is a local co-operative group.

Each supervisory authority has a territorial remit that stops at the national borders; none has a comprehensive understanding of the financial situation and risks of large cross-border financial groups, most of which now have over half of their activity outside the home country. The discussion on how to supervise such groups largely predates the crisis.

In 2004, member states agreed to create a Committee of European Banking Supervisors (CEBS), with 42 members (some countries have two representatives, from the supervisor and the central bank) and a permanent secretariat in London. More recently, the European Commission and some member states, including the UK and France, have proclaimed their hope that appropriately organised “colleges” of supervisors, bringing together all national authorities in charge of a particular banking group, would provide an appropriate way to address cross-border issues.
Supervisory colleges were seen as a convenient fix, as they seemed to respect both the need for consistent decision-making and the sovereignty of each national authority. Alas, this is too good to be true.

Either the home supervisor is given the possibility to overrule the college’s other members, and its role becomes supranational; or no such possibility exists, and the college servesmainly to share experiences and good practices. Countries which are host to big non-domestic players cannot be expected to delegate full responsibility to those players’ home supervisors. This reluctance was obvious in the discussion on the Solvency 2 insurance directive in December, when the French presidency was unable to reach a consensus on its proposal to empower home supervisors on group support. In effect, this would mean that in most cases European colleges cannot be much more than glorified talking shops. Global supervisory colleges, the idea of which was included in the declaration of the G20 summit meeting last November, can naturally be only looser still.

If cross-delegations among national authorities do not do the trick, could a pan-European watchdog provide an adequate solution? Many in Europe – not least in the UK – are sceptical about the possibility of pooling decision-making beyond the national level while remaining efficient and reactive. However, the honourable track record of the ECB during the financial crisis suggests that supranational agencies can work, and even in some cases make decisions at least as adequate as national counterparts. That said, supervision is different from monetary policy, and its assumption at European level would raise daunting questions.
Among them is an issue of territorial scope, which is also linked to the future role of the ECB. In early-January, senior ECB figures including Loukas Papademos, Lorenzo Bini Smaghi and Jean- Claude Trichet, the president, suggested the Frankfurt-based institution should take a leading role in supervising Europe’s largest cross-border banks. But most central and eastern European countries (unless they adopt the euro) as well as the UK would be outside the remit, which limits the potential effect of such a change. Specifically, it would mean the European supervisor would have only limited clout as regards the wholesale operations of the large universal banks,most of which are (and in all likelihood, will continue to be) located in London. Moreover, this would create additional pressures on the independence of the ECB, as a banking supervisor normally has a much closer relationship with governments than has a monetary authority. The alternative would be the creation of a brand-new supervisory authority covering all the EU’s 27 countries, but that would suppose unanimous support which is obviously lacking.

A different question is which banks would be considered large enough, or sufficiently cross-border, to be covered by a supranational regime. Giving banks the choice of national orEuropean supervision would have the advantage of flexibility but may entail competitive distortions and be considered too lax. If specific criteria or thresholds are set, they would be about how much activity is done inside Europe but outside the home country. Most large UK banks, which tend to have little activity on the continent, could possibly remain supervised by the FSA under such a scheme, while the London-based activities of many large continental banks would be supervised at European level.

Creating a European level of banking, and conceivably also insurance, supervision would be an immense challenge with widespread consequences in terms of regulation and corporate law, deposit insurance, insolvency legislation, and crisis prevention mechanisms. It would have a transformative effect on Europe’s banking industry, and the crisis has concentrated policy-makers’ minds on the dangers of having no working framework for supervising Europe’s largest cross-border banks.

For the UK financial community this poses a dilemma. As the financial hub of Europe, London would havemuch to lose from a refragmentation of Europe’s banking and financial landscape, a possible consequence of the national bank rescue plans if no credible supervisory model emerged for cross-border banks. By the same token, taking a proactive attitude in this debate would mean shedding the traditional priority of keeping Brussels at bay – even though one possible prize could be ensuring a London location for a European supervisor.
A report by a group headed by Jacques de Larosière, the former IMF and EBRD chief, is expected shortly and will feed further EU discussion. This high-stakes debate could see interesting developments in the course of 2009.

Nicolas Véron is a research fellow at Bruegel

Defects of centralisation

Nicolas Véron argues that supervision of cross-border banking groups cannot be adequately performed by national authorities but that supervisory colleges are not the answer because host-country authorities will not delegate responsibility to homecountry supervisors; colleges failed to get European Council backing during the Solvency 2 negotiations and there is no means of enforcing consistency across colleges.
But their political prospect is no worse than centralisation, whereby host country supervisors will lose the powers they hold under a college approach.
The issue of consistency is an awkward one: consistency across the US did not help; moreover, EU consistency would have prevented Spain from imposing
its prudent restrictions on offbalance sheet vehicles and its contra-cyclical capital requirements. Véron supports creation of a European – although in places he seems to mean a eurozone-only – supervisor, based on the ECB for cross-border groups. But he notes difficulties: limited territorial scope, as it would exclude UK groups; and limited clout, because wholesale operations of large groups are based in London.
Having noted lack of agreement for federal financial pooling he ignores the negative implications of this for supervisory centralisation. He does not discuss the division of labour with national regulators (including colleges of group regulators) and their relative staffing levels and roles. And what of national response to a centralised regulatory failure? Could national fiscal authorities sue the ECB for redress? Part of his case for centralised supervision is avoidance of “refragmentation” of the single market under purely national responses to the crisis. He thereby ignores the existence of market opening directives and the Treaty itself.

Are they really under threat?
He suggests the City of London faces an existential choice: participate in the birth of a new supervisory regime or face the consequences, despite all the problems of centralisation.How institutional centralisation can tackle the root causes of the crisis: gross irresponsibility, chicanery, ignorance and failure of regulators to understand andmitigate the risks so created?

We need to consider capping/deterring excessive leverage, imposing tight liquidity requirements, capping loan to value/income, and rigorous regulatory testing of executives’ understanding and management of risk. Centralising structures is no solution by itself and strengthening the substance of regulation makes such centralisation irrelevant at best.

Malcolm Levitt is formerly of the Treasury, the European Commission and Barclays Bank