Fledgling referee of systemic risk

Following the recommendations of the de Larosière report of February 2009, the EU put in place a new European System of Financial Supervision (ESFS). It has been fully operational since January this year and consists of the European Systemic Risk Board (ESRB) and three European Supervisory Authorities (ESAs). Together they should address the shortcomings in supervision that were revealed by the financial crisis.

The ESRB is located in Frankfurt and is responsible for the macroprudential oversight of the financial system of the 27 EU member states so as to prevent or mitigate systemic risk and distress. Its warnings and recommendations will be issued to the EU and member states, as well as national and European super-visors, whenever it sees a risk to financial stability. The follow-up to recommendations is based on a simple comply-or-explain principle; apart from the publication of warnings and recommendations, no sanctions are foreseen. The ESRB will report to the Council of the European Union and the European Parliament annually and is held accountable by the  Parliament.

The ESRB consists of five bodies. The General Board is the decision-making authority and meets at least four times a year. The chair of the General Board is the president of the ECB (at least for the first five years). The first vice-chair would typically be from a non- euro -area member state and is currently Sir Mervyn King, governor of the Bank of England. Overall, the General Board has 66 members, of which 37 have voting rights, with national central bank governors constituting the largest group.

The Steering Committee consists of a smaller group of members of the General Board and carries out preparatory work to aid the board’s decision-making process. The Advisory Scientific Committee brings together 15 independent experts with different skills and experience. It provides advice and assistance on issues relevant to the work of the ESRB and is chaired by Martin Hellwig. The Advisory Technical Committee is an advisory and assistance body, which is composed of  delegates from the institutions represented on the General Board and will have 62 members. Its chair is Stefan Ingves, governor of the Swedish central bank. The Secretariat is responsible for the day-to-day running of the ESRB and is located at the ECB.

It remains to be seen how the different bodies that make up the ESRB will interact with each other. Clearly, the Steering Committee will play a key role in preparing the policy discussion for the General Board. While the board is the final decision-making body, it appears unlikely that in-depth policy discussions in such a large forum will be feasible. Similarly, the Advisory Technical Committee would like to play a key role but its size will render effective discussions difficult.

It is likely that the Steering Committee will be the key body of the ESRB. The power of European institutions in this committee is significant. Here, the challenge will be to foster agreements to which the General Board will subscribe. Clearly, in the board the balance of power is tilted more towards the national representatives, even though all members are expected to act impartially and solely in the interest of the Union.  

The Scientific Advisory council will also play an important role as it will bring in independent and unbiased external expertise. Especially in the foundation phase, it could play a crucial role by influencing the direction of the ESRB’s work.

Thematically, the ESRB is still in the process of defining its role clearly and significant pressure exists to keep its mandate limited.

In this regard, first, the European Banking Authority will play a vital role for bank-level supervision. It appears that the ESRB does not intend to venture into the microprudential field and it remains to be seen to what extent the ESRB will issue warnings and recommendations to systemically important financial institutions.

Second, the ESRB will avoid venturing too greatly into the area of macroeconomic developments, where conflicts of interest with the ECB and the national central banks of non-euro-area member states could arise.

A further line of conflict could arise between the ESRB and the European Commission’s new surveillance procedure to address macro-economic imbalances.

Clearly, macroeconomic imbalances often are of major relevance for the stability of the financial system. Both the Commission and the ESRB may, therefore, wish to issue recommendations – on real estate bubbles, for instance.

Overall, the ESRB could play a leading role in the financial stability discussions of the EU but it will be important to take up difficult topics forcefully early on. For example, it could establish itself now by preparing policy options for decision-makers on how to deal with sovereign risk.

A version of this op-ed has been published in Financial World.