Reconfiguring Financial Regulation in the
European Union
ESRC World Economy and Finance
programme
28 January 2010, London
Professor Kern Alexander
University of Zurich Law Faculty &
Specialist Adviser to the European Parliament
Committee on Economic and Monetary Affairs
Main points
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International regulatory redesign
European financial markets and systemic risk
EU financial legislation and regulation
The new EU institutional structure
International Developments
 The G20 Washington Action Plan and the London & Pittsburg
Summit Statements on strengthening the financial system
 FSF’s April 2008 and 2009 Reports
 A roadmap on financial supervision and regulation
 A more robust supervisory and regulatory framework based
on new rules not only for financial institutions but also other
actors, markets and supervisors
 Macro prudential to complement micro prudential
regulation
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FSB Initiatives
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Off-balance sheet activities
Trading book
Valuation
Credit Default Swaps
Credit rating agencies
Short selling
Supervisory co-ordination for LCFI (large complex financial
firms)
 Standards for Sound Compensation Practices
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4
Further international initiatives
 By January 2010
 the IMF, BIS and FSB will have issued a paper setting out for use
by national authorities guidelines to assess whether a financial
institution, a market, or an instrument is systemically important;
 regulators working through IOSCO and the FSB will have agreed a
consistent regulatory framework for hedge funds oversight;
 consistent frameworks for registration, regulation and oversight of
credit rating agencies for consideration by legislatures
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EU & US Institutional regulatory settings
In Europe
In the US
 Federal Deposit Insurance Corporation
 European Central Bank
Banking Stability Committee
WGMA
WGBD
 Level 3 Committees :
CEBS (Committee of European Banking Supervisors)
Banks
 Federal Reserve
 Office of the Comptroller of the Currency
CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors)
CESR (Committee of european Securities Regulators
 27 EU National Central Banks
Thrift
 Office of Thrift Supervision
Insurance
 States
Securities
 SEC
and/or EU National Supervisors
and/or banks, insurance, securities
 Bank of International Settlement
 Basel Committee - BCBS (Basel Committee of Banking Supervision)
 CGFS (Committee of Global Financial System)
 CPSS (Committee on Payment and Settlement Systems)
Worldwide
FSB
 On vulnerabilities assessment
 On supervision and regulatory corporation
 On standards implementation
IMF
Joint Forum
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European financial markets
• Increasing financial integration
 Cross-border capital flows and payments
 Cross-border establishment of banks & financial firms –
thru group structures
Financial regulation and crisis management have not kept
pace with increasing integration of wholesale capital
markets and growing cross-border operations of EU
financial institutions. How to regulate most efficiently the
cross-dimension of systemic risk?
Defining systemic risk
G10 Report (2001) defined systemic risk as:
the risk that an event will trigger a loss of economic value or confidence
in, and attendant increases in uncertainty about, a substantial portion of
the financial system that is serious enough to quite probably have
significant adverse effects on the real economy. Systemic risk events can
be sudden and unexpected, or the likelihood of their occurrence can
build up through time in the absence of appropriate policy responses.
The adverse real economic effects from systemic problems are generally
seen as arising from disruptions to the payment system, to credit flows,
and from the destruction of asset values.’
Note the negative externalities extend into the real economy
with relatively high probability. However, no generally
accepted methods for identifying and measuring before a
crisis event occurs. Financial innovation over time changes
the nature of the sources of systemic risk and how it can be
measured.
Financial Innovation
• Technical developments in data analysis,
statistical theory and in finance theory have
transformed risk management, pricing, and the
range of financial products.
• Disintermediation: credit risk transfer &
securitization led to originate, rate, relocate model
(ORR)
• Financial regulation and crisis management have
not kept pace with these changes.
Financial innovation and the risks of interconnectedness in financial markets – 1990s
• Bank of England Board of Banking Supervision
‘. . .the Bank should explore ways of increasing its
understanding of the non-banking business (particularly
financial services businesses) undertaken by those banking
groups for which it is responsible for consolidated
supervision... It should also seek to obtain a more
comprehensive understanding of how the risks in those
businesses interrelate to one another and to such groups’
(Bank of England, 1995, para. 14.35).
EU financial legislation & policy
 Pre-1986 – unsuccessful efforts to approximate and make
equivalent financial law and regulation across EU states
 1985 White paper and 1986 Single European Act
Home country control, mutual recognition based on minimum
standards – the EC passport
 EU legislation is a tool for liberalisation with little
oversight of member state regulatory practices
 Lisbon Council Decision (post 2001)– FSAP &
Lamfalussy: Harmonisation of laws and coordinated
regulatory practices based on market-based models
(Bolkestein & McCreevy eras)
The EU Lamfalussy structure
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Council
Commission
Parliament
L1
L2
Legislation
EBC¹
EIOPC¹
ESC¹
FCC¹
Implementing details
L3
CEBS²
CEIOPS³
CESR³
Convergence
L4
Enforcement
Commission
EBC = European Banking Committee
EIOPC = European Insurance and Occupational Pensions Committee
ESC = European Securities Committee
FCC = Financial Conglomerates Committee
CEIOPS = Committee of European Insurance and Occupational Pensions Supervisors
CESR = Committee of European Securities Regulators
¹ Finance ministries
² Supervisors and Central
Banks
³ Supervisors
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Incremental change in EU Legislation
• Art. 122a – originators/arrangers retain 5% of risk on
balance sheet (but not affect originator’s 1st loss exposure)
• Arts. 49/50 enhance flow of information from supervisors
to central banks/finance ministries
• Art 42a host supervisors more say in model approval. Art
42b – CEBS obligatory
• Art 129, 131a – colleges of supervisors (soft law)
Commission’s response – more of the same and not
recognising risk of interconnected firms and markets
The future of EU financial supervision
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From De Larosière Report (Feb 2009) to the EU Commission’s proposed
Regulations (Sept 2009)
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On the microprudential: the European System of Financial Supervisors (ESFS).
 It will consist in the current Level 3 Committees of supervisors, which will
be transformed into new European Supervisory Authorities (ESAs)
responsible for banking, insurance and securities respectively.
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On the macroprudential side, a European Systemic Risk Board (ESRB) will be
established.
 It will be composed of EU central bank governors, including the ECB
President, the chairpersons of the ESAs, a representative the European
Commission, as well as representatives of national supervisory
authorities and the Chair of the EFC (the latter two without voting rights).
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The future of EU financial supervision
European Systemic Risk Board (ESRB)
[Chair elected by ESRB Board]
Macroprudential
supervision
Members of
ECB/ESCB
General
Council (with
alternatives
where
necessary
+
Chairs of
EBA, EIOPA
& ESA
Information on micro-prudential
development
+
European
Commission
Early risk warning
European System of Financial Supervision (ESFS)
Micro-prudential
supervision
European
Banking
Authority
(EBA)
National
Banking
Supervisors
European
Insurance
Occupational
Pension
Authority
(EIOPA)
European
Securities
Authority
(ESA)
National
Insurance
Supervisors
National
Securities
Supervisors
European Supervisory Authorities
• Ensuring that a single set of harmonised rules
and consistent supervisory practices is applied
by national supervisors;
• Ensuring a common supervisory culture and
consistent supervisory practices;
• Collecting micro-prudential information;
• Ensuring consistent application of EU rules,
and resolving disputes in cases such as the
manifest breach of EU law or ESA standards
and disagreement between national supervisors
or within a college of supervisors.
Legal basis
• Article 114 (TFEU) as the legal basis for the
establishment of bodies that are vested with
responsibilities for contributing to the harmonisation
process and facilitating uniform implementation by
MSs (Case C-66/04, C-217/04, Enis case)
– Actually and objectively apparent from the legal act creating the
body in question that its purpose is to improve the conditions for
the establishment and functioning of the internal market
– Tasks conferred on such a body must be closely linked to the
subject-matter of the relevant harmonizing legislation
The European Systemic Risk Board:
organizational structure
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General Board, Steering Committee and Secretariat; supported by an Advisory
Technical Committee
General Board: decision making body of the ESRB; 61 voting & non-voting
members
Voting members (29)
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governors of national central banks
president and the vice-president of ECB
European Commission representative
Chairpersons of the three ESAs
One-member, one-vote; simple majority (2/3 for public warning /recommendation)
Chair/vice-chair
Non-voting members
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MS competent authorities
president of the Economic and Financial Committee
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Duty of impartiality
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Too big? Too dominated by central bankers? Steering committee and non-eurozone
representation?
ESRB: building credibility – challenges
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Central bankers not legitimate politically for making decisions
that involve important trade-offs between political and economic
objectives and that such decisions should be left with finance
ministries and other elected officials (Buiter)
Lack of diversity/unwieldy size (Sibert)
Technical competence re systemic risk (Treasury
Committee/Buiter)
And also re interpretation of data at both the micro and macrolevels (Treasury Committee/Danielsson)
Price stability and financial stability objectives pull in opposite
directions (Buiter)
Liberalised and integrated financial markets → increase financial
fragility (Dungey & Tambakis)
Legal basis and ESRB mission
• “The ESRB shall be responsible for the macro-prudential oversight of the
financial system within the Community in order to prevent or mitigate
systemic risks within the financial system, so as to avoid episodes of
widespread financial distress, contribute to a smooth functioning of the
Internal Market and ensure a sustainable contribution of the financial sector
to economic growth”
• Tasks conferred on the ESRB must be undertaken for the purpose of
discharging overarching responsibilities with respect to macro-prudential
oversight and containment of systemic risk
• “Macro-prudential”/”systemic risk” and existing EU law – can the link
between subject-matter of the harmonizing laws and the tasks delegated to
the ESRB be established?
• Stability and soundness as pre-requisites for the smooth operation of any
financial market
• ESRB within the room for innovation in harmonization techniques that
article 114 provides
Summing up - analysis of financial law
& regulation
• An excessive reliance on markets to deliver
systemic stability!
• Far reaching re-appraisal of the role of EU
financial law/regulation and the institutional
design of EU regulation for controlling
‘externalities’.
Conclusion
• Evolving financial risks and increasing integration in EU financial
markets along with globalisation of financial risk (ie., US subprime)
• EU legislation has evolved from liberalisation, to harmonisation of
law, to uniform rulebooks and supervisory practices and EU bodies
• Recent Commission proposed regulations on ‘micro and macro
prudential supervision’ address the need for more institutional
coordination in monitoring and controlling systemic risks in EU
financial markets but gaps.
• EU legislation still remains excessively focused on micro-prudential,
while role for ESRB/ECB presently lacks clarity.
• ESAs rulebooks, standards and guidelines enhance member state’s
ability to achieve regulatory objectives, but legal risks remain.
Further readings – EP Parliament Reports
• Financial Supervision and Crisis Management
in the EU’ (Dec. 2007), K. Alexander, J. Eatwell,
A. Persaud & R. Reoch
http://www.europarl.europa.eu/activities/committe
es/studies/download.do?language=en&file=26588
• ‘Clearing and Settlement in the EU’ K. Alexander, J.
Eatwell, A. Persaud and R. Reoch (Sept. 2009) IPA ECON
2009/001.
http://www.europarl.europa.eu/activities/committees/studie
s/searchPerform.do?page=2&language=EN