The challenge of regulating Europe’s banks

The well-publicized troubles of Portugal’s Banco Espírito Santo this summer have reminded us that the Eurozone’s financial problems are by no means resolved. There are, no doubt, idiosyncratic factors behind the bank’s problems, stemming from its exposure to other parts of the Espírito Santo family’s empire. But when the bank announced a first-half loss of €3.6 billion ($4.7 billion), the sudden collapse of confidence was alarming, and nervous investors are asking whether there are similar time bombs ticking elsewhere.

All eyes are now on the European Central Bank’s asset quality review, due to be completed in the next couple of months. The AQR is the key element in a “comprehensive assessment” of Europe’s banks before the ECB formally takes on supervisory responsibility for more than 80% of the Eurozone banking system in November.

The ECB, quite sensibly, wants all of the potential horrors to be visible before the takeover – so that it cannot be blamed. With national supervisors, who are often inclined to present a rosy picture of their countries’ institutions, no longer in charge, we can hope that the assessment will be more robust than the earlier stress tests carried out under the auspices of the European Banking Authority (EBA). Those tests, unlike their equivalent in the United States, failed to rebuild confidence. Several banks that passed with flying colours were soon obliged to raise new capital.

But the creation of the European banking union has not been the only important change to Europe’s financial regulation since the crisis. The events of 2007-2009 made it clear that there were serious gaps and inconsistencies that needed to be addressed. So, following the recommendations of a report prepared in 2009 by former IMF Managing Director Jacques de Larosière, the European Commission created three new pan-European authorities charged with ensuring “consistent application” of European directives.

The deal was done with a large helping of political fudge: the three biggest European Union economies – the United Kingdom, France, and Germany – were persuaded to cede some control to the centre, but only if each could host an authority. Thus, the EBA was established in London, the European Securities and Markets Authority (ESMA) is located in Paris, and the European Insurance and Occupational Pensions Authority (EIOPA) found a home in Frankfurt. Collectively, they are known as the ESAs (European supervisory authorities).

The road to pan-European regulation over the last two decades has been winding and rocky. In the early stages, it was assumed that the single financial market could work on the basis of mutual recognition: each country would accept the others’ regulation as broadly equivalent to its own and allow cross-border business to proceed on that basis. That proved inadequate, as standards and rules remained very different from country to country, and gave way to an approach based on minimum harmonization, whereby core rules were to be the same across Europe, but local variations and additions remained permissible.

When that, too, proved ineffective at promoting competition, as countries used their national rules to block new entrants, the emphasis switched to maximum harmonization, with directives spelling out exactly how local rules must be applied across the EU. That caused great concern in the City of London, but has been grudgingly accepted. Since the global financial crisis, London has become less able to argue that it is special and must be left alone.

Now, with the establishment of central regulatory authorities, the EU has moved to the next stage of financial integration. But, so far, these agencies’ responsibilities are very limited. ESMA supervises rating agencies directly; but, outside banking, national authorities retain their day-to-day oversight responsibilities.

Integration-minded officials at the European Commission clearly do not regard this as a satisfactory end-state. So they commissioned a thoughtful review of the three ESAs from Mazars, an accounting firm, which was published earlier this year. The verdict, roughly, was “so far, so good.” Now the Commission has followed up by publishing its own assessment.

The Commission was perhaps unlikely to be hypercritical of its own creations, and it is not. Its report maintains that the ESAs have “quickly established well-functioning organizations aimed at contributing to restoring confidence in the financial sector,” and that market participants seem broadly satisfied with their work.

But the report’s authors believe that there is a need to expand the current mandates, develop a comprehensive approach to consumer protection, and reduce further the influence of national authorities. The ESAs should have more power to impose their will in the interests of the EU as a whole. Their chairs should have wider discretion to act on their own initiative. The ESAs also need more money, which probably can come from fees levied on financial firms, and consideration should be given to merging them in a single location, presumably Brussels.

The general direction is clear. Unless the new internal market commissioner takes a different view, the European Commission plans to move further along the road to genuine pan-European regulation. The report now goes to the European Parliament, which can be expected to push harder for more integration, as it usually does.

A single authority, or perhaps two or three working closely together, is a logical arrangement for the Eurozone, and perhaps for the entire EU financial market. It would usefully complement the ECB’s new supervisory role. But will London fall into line this time?

The British government, after all, has embarked on a path that runs in precisely the opposite direction – reducing the functions of central bodies and repatriating powers to national capitals. Given the central role of London in EU financial markets, and its political sensitivity in the UK, there is bound to be trouble ahead.

Published in collaboration with Project Syndicate

Author: Howard Davies, a professor at Sciences Po in Paris, was the first chairman of the United Kingdom’s Financial Services Authority (1997-2003).

Image: A sign for Bank Street and high rise offices are pictured in the financial district Canary Wharf in London in this October 21, 2010 file photo. REUTERS/Luke Macgregor