Rules and Supervision
Sergio Lugaresi, Public Affairs
Milan, 6 December, 2012
AGENDA
 What is supervision
 Supervisory failures
 Rules and supervision
 The EU reform
 Supervision and discretion
 Supervision and crisis management
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Supervision
 According to the “representation hypothesis” of Dewatripont-Tirole (1994), prudential
regulation aims at replicating the corporate governance of nonfinancial firms, that is, at
acting as representative of the “socially relevant” debtholders of banks (depositors)
 There are two reasons for this:
1. there are many more stakeholders in banks than in non-financial firms;
2. the business of bank is opaque, complex and can shift rather quickly (MehranMorrison-Shapiro 2012).
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Supervisory failures
 In this respect as far as the crisis has been a bank corporate governance failure leading
to excessive risk taking (Dewatripont-Freixas 2012), it has been also a supervisory
failure.
 Three major failures,
1. the lack of independence (capture and lack of skills).
2. the lack of macro-prudential or systemic supervision;
3. the lack of international (and sometimes even infra-national) coordination;
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Supervisory governance failures
The supervisory authorities is the agent of depositors and bank customers represented by
politicians. As in many Principal-Agent relationships there is an information asymmetry.
 Political capture
 Different policy choices:
1. regional or global financial centre” (read USA and UK);
2. ‘national champions’ in the financial sector” (read France, Italy and Spain);
 Political and cultural pressure on supervisors
 A “race to the bottom” among supervisors to create institution-friendly regimes (e.g.
innovative Tier 1 capital).
 Industry capture
 An inadequate understanding of financial institutions and markets. Two factors
contributed to this: little or no direct financials sector experience and underresourcing.
 Absence of real, on-site supervision.
 Political and industry capture
 The “madness crowd”;
 Self capture
 Weak supervisory cultures: some supervisors…] are more reactive and passive,
waiting until evidence of problems accumulates to the point of certainty before
contemplating action”.
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International supervisory coordination
 International cooperation in supervision is based on colleges of supervisors for cross
border banks where the home supervisor is supposed to carry out supervision at the
consolidated level.
 The colleges are set up on the basis of Memoranda of Understanding (MoU), which are
non-binding, between relevant authorities.
 Only in the European Union colleges of supervisors were given a legal status in the
Capital Requirement Directive which also introduced the concept of “joint decision” and
“task delegation” between different national authorities.
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Lack of coordination…
 There are two broad forces working against effective cross border consolidated
supervision:
 national governance failures (political, industry and self capture) are amplified in a
cross-border context leading to competition and distrust among national agencies;
 supervisors do not take into account the externalities in the other jurisdiction. Host
supervisors may be inclined to inflate their risk assessment and require a higher
capital buffer with the objective of encouraging the parent company to provide
additional capital or resources.
 On top of these two broad forces confidentiality concerns, legal constraints, lack of
common metrics and terminology, the geographical risk profile of the cross-border
banking group exacerbate the obstacles to effective cross-border cooperation.
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…particularly in crisis times
 The lack of an effective mechanism to resolve failing financial institutions that are active
in multiple jurisdictions, including ex ante burden sharing mechanism, and the absence
of a mediation or conflict resolution mechanism make cross-border supervisory
cooperation even more difficult in crisis times.
 When problems occur in the parent company, home and host incentives conflict: the
consolidating supervisor gives priority to its local stakeholders and the national interest,
delaying, denying and minimising the relevance of concerns and potential remedial
actions as to avoid ring-fencing. The host supervisor has incentives to ring fence.
 When problems occur in a systemically important subsidiary, the host supervisor has an
incentive to overstate concerns to the home supervisor, so as to attract attention, capital
and liquidity. At the same time, the host supervisor still keeps an incentive to ring-fence
the assets he can save.
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Rules and supervision
 Financial regulation includes
 prudential rules and
 financial supervision.
 Complementary: supervision need rules to implement, rules needs supervision to be
implemented
 Trade-off. Tarullo (2008), for example, argues for removing detailed rules in favour of
national agencies’ supervision of complex, internationally active financial institutions.
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Short-termism
 Rules, with emphasis on transparency and market discipline, tend to favour investors
and subordinated debt holders,
 Supervision, which can interfere directly with corporate governance, tends to favour the
interests of depositors.
 Investors pursue short term objectives
 Depositors are more interested in the long term sustainability,
 Financial regulations based on rules (US and UK) eventually led to short-termism (a firm
behaviour aimed at maximising short-term objectives),
 Financial regulations based on supervision (e.g. France and Italy) were more effective
in pursuing business sustainability so avoiding short-termism and procyclicality.
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Supervision: EU Reform (1)
 In September 2009, following a public consultation, the Commission issued its
proposals: to establish a macro-prudential European Systemic Risk Board (ESRB); and
replace the existing consultative (Lamfalussy) Committees with new European
Supervisory Authorities (ESAs) for the
 banking (European Banking Authority – EBA),
 insurance (European Insurance and Occupational Pensions Authority - EIOPA) and
 securities sectors (European Securities and Markets Authority - ESMA).
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Supervision: EU Reform (2)
 The political agreement reached by the three EU negotiators – Commission, Parliament
and Council - was approved by the ECOFIN Council on 7 September 2010 and by the
EU Parliament on 22 September. The reform came into effect on 01/01/2011.
 The ESA’s powers are substantial. They will generally decide according to the majority
rule and take binding decisions.
 Specifically for the banking sector, the EBA will establish
 A single rulebook and interpretations and
 have the power to directly address a bank in cases when the national authorities
fail to implement the rulebook.
 It will be a full participant in colleges of supervisors with
 the power to settle differences between national supervisors.
 Furthermore, EBA will have a key role in crisis management and in the development
of cross-border banks’ Recovery and Resolution Plans.
 The reform was clearly a compromise. However, it is a good compromise, in part due to
the role of the European Parliament. It was the EP’s first test, under the Lisbon Treaty,
and with a new Commissioner for the Internal Market, Michel Barnier.
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Strong Supervision
 There is a now consensus on the fact that supervision needs to be more intrusive,
proactive, comprehensive, adaptive, risk-based, and result oriented (Viñals-Fiechter
2010),
 The industry add also the need for proportionality and predictability and for avoiding
excessive regulatory reporting (IIF 2011).
Supervision and discretion
 However, predictability cannot prevent judgemental discretion:
“…the blunt truth is that limiting the supervisor’s ability to react against and excessive
build-up of risk in one institution or across the financial system to the application of
mathematical formulae will undermine the very objective that the rules are designed to
achieve…regulators will need the flexibility to react to the unexpected both at the
systemic and the institutional levels”. (Palmer-Cerruti 2009)
Supervision and crisis management
 To be effective in preventing banking crisis, supervisors should have the power to take
charge of troubled banks before they endanger their deposits and/or the stability of the
financial system and of the real economy.
 Effective supervision is best able to assess the emergence or occurrence of a crisis. The
Authority should be credible and be able to act quickly to avoid panic spreading in the
market. It faces the crucial dilemma of either supporting the bank in difficulty by
arranging for medium term financing or leading the orderly resolution process in the
public interest. The decision-making process is crucial and should be rapid in order to
restore confidence.
The Gap Between The Financial Market Reality and EU Regulation
and Supervision
 The presence of cross-border financial groups had increased substantially in the EU:
 ‘The current supervisory framework may limit the incentives to work toward a common
EU-wide stability framework: a “scramble” for assets in a crisis, involving a large and
complex financial institution, is likely to occur.’
 ‘The current legal framework does not ensure that national authorities take into
account the effect of their decisions on the financial stability of another member state.
The lack of incentives to cooperate might be detrimental not only to creditors, but also
to shareholders and employees of cross-border banks (and ultimately to tax payers in
the instance of failure).’ (IMF)
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Crisis management: the European Commission proposal
 A parent institution and its subsidiaries may enter into financial support agreements for
the case that one of the parties of this agreement experiences financial difficulties
(Article 16(1)). The agreements are drawn up on a voluntary basis and can provide for
financial support in the form of a loan, the provision of guarantees, or the provision of
assets for use as collateral in transaction between the beneficiary of the support and a
third party (Article 16(1) and (2)).
 Where there is a significant deterioration in the financial situation of an institution or
where there are serious violations of law, regulations or bylaws and other measures
taken in accordance with early intervention are no sufficient, competent authorities may
appoint a special manager to replace the management of the institution (Article 24)
References
 Palmer, John – Cerruti, Caroline, “Is There a Need to Rethink the Supervisory Process?”,
paper presented at the International Conference on Reforming Financial regulation
and Supervision: Going Back to Basics, Madrid, June 2009.
 D’Hulster, Katia, “Cross Border Banking Supervision. Incentive Conflicts in Information
Sharing between Home and Host Supervisors”, The World bank, Policy Research
Working Paper 5871, November 2011.
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Next
 Th. 11 Oct. h 10.30-12.15, aula 3
1. Introduction. Cross-border banking and regulation
 Wed. 17 Oct. dalle 14.30 alle 16.15, aula seminari
2. Prudential Regulation: Lessons from the Crisis
 Fri. 26 Oct. h 10.30-12.15 aula 3
3. From Basel 2 to Basel 3
 Thu. 8 Nov. h 10.30-12.15 aula 3
4. Moral hazard
 Thu. 15 Nov. h 10.30-12.15 aula 3
5. Crisis Management and Resolution
 Thu. 22 Nov. h 10.30-12.15 aula 3
6. Shadow Banking
 Thu. 29 Nov. h 10.30-12.15 aula 3
7.
 Thu. 6 Dec. h 10.30-12.15 aula 3
8. Rules and supervision
 Thu.13 Dec. h 14.30-16.30 aula 20
9. Overall assessment of the regulatory reform
 Mon.17 Dec. 10.30-12.15 aula seminari
10. The Euro debt crisis and the Banking Union
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