The financial crisis has been a catalyst for regulatory reform. In the UK, changes proposed by the government do not alter fundamentally the tripartite system. More radical proposals made by the Conservative party include abolition of the Financial Services Authority (FSA) and transfer of responsibility for regulating insurance companies to the Bank of England.

Proposed changes to the European regulatory framework are expected to take effect in 2010.We question whether pushing change through so quickly allows for proper debate about the substance of the reforms, consistent with the European Commission’s “Better Regulation” principles.

Mervyn King, the Governor of the Bank of England, has commented that “global banking institutions are global in life, but national in death”. The same can be said of insurance companies. The absence of a cross-border framework for dealing with failing financial institutions means that national interests come to the fore in a crisis. While there is nomechanismfor sharing the burden of failures across Europe, reformof the regulatory architecture may do little to change this.

Commission proposals for reform

  • Two new bodies, the European Systemic Risk Council (ESRC) and the European Systemof Financial Supervisors (ESFS), will assume responsibility formacro-prudential supervision andmicro-supervision respectively. The ESFS will be a network of financial supervisors that will work with three new European Supervisory Authorities (ESAs).
  • The ESAs will replace the existing Level 3 Committees. They will havemore “teeth”, and thereforemore “bite”, than their predecessors.
  • National supervisors will continue to carry out day-to-day supervision of regulated firms, including insurers. However, the new European bodies’ increased powers will undoubtedly affect supervision at the domestic level:
  • A single rulebook for EU regulated institutions will limit howmuchmember states can take national considerations into account when they implement EU rules into domestic law.
  • The ESAs will have binding powers ofmediation over national supervisors in specified circumstances and even the power to adopt emergency decisions in “crisis” situations.
  • The ESAs will have full supervisory responsibility for some pan-European entities, such as credit rating agencies and clearing houses.
  • Much of the detail of the new framework remains to be settled and the Commission expects to publish draft legislation in the autumn. Anyone wishing to influence the final reforms should attempt to do so now, rather than waiting for that draft.  

Reforms are intended to address failings in current framework

Changes to the regulatory framework proposed by the Commission aimto address failings that have contributed to the financial crisis. In particular, they are intended to plug the gap found to exist between supervision of individual institutions (micro-prudential supervision) and identification of systemic risks that threaten the stability of the financial systemas a whole (macro-prudential supervision).

Many of the Commission’s proposals are taken fromthe de Larosière report and are similar to UK recommendations coming out of the Turner Review. De Larosière envisaged that the reformed architecture should be in place by 2012. The Commission believes that changemust happenmore quickly, by 2010. President Barroso has been clear that Europe should be first to implement G20 commitments on cross-border supervision tomaximise its influence in future global negotiations.

The proposals

As recommended by the de Larosière report, the Commission proposes the creation of two new bodies, the ESRC and the ESFS.

Macro-prudential supervision: ESRC

The ESRC will be responsible formacro-prudential supervision across the EU financial system. Its role will be to monitor and assess potential threats to financial stability. It will have no legally binding powers, but will be able to issue warnings and recommendations to policymakers and supervisors. On a case by case basis, the ESRC could decide tomake its recommendations public.

Membership of the ESRC will include, amongst others, central bank governors of allmember states and the President of the European Central Bank.

Reforms proposed by the UK government in its July 2009 White Paper include the creation of a new Council for Financial Stability. The role performed by this new body will need to be consistent with that of the ESRC, once finalised.

Micro-prudential supervision: ESFS

The ESFS will consist of a network of national supervisors working with three new ESAs:

  • European Banking Authority – replacing the Committee of European Banking Supervisors (CEBS)
  • European Insurance and Occupational Pensions Authority – replacing the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS)
  • European Securities Authority – replacing the Committee of European Securities Regulators (CESR)

The new ESAs will have greater powers than the committees they replace.Membership of the ESAs will include representatives fromthe national supervisory authorities and the Commission. Day-to-day supervisory powers will remain with national authorities, but their exercisemay be constrained under the new framework in various ways:

  • A single set of harmonised rules. The Commission hopes that the introduction ofmore directly effective legislation at the EU level could help the process of agreeing a single rulebook, reducing scope for differences in implementation of European requirements.

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A single rulebook would, however, limit the ability of member states to legislate in the way that is most appropriate to their national market.

  • Consistent application of the rules. ESAs will have a role in ensuring that EU rules are applied consistently. For example, they will have binding and “proportionate” powers to decide whether supervisors are meeting relevant EU requirements. They will also be able to investigate possible breaches of EU legislation and issue recommendations to national regulators. ESAs will be able to refer continuing breaches to the Commission for enforcement action.
  • Resolving disagreements between national supervisors. ESAs will facilitate a dialogue between national supervisors when there is disagreement over the proper enforcement of EU legislation. Where agreement cannot be reached, the Commission envisages that the ESAs should be able to settle the matter. How this would work remains unclear.
  • A coordinated response in crisis situations. The new authorities are expected to be given power to adopt emergency decisions in specific crisis situations (eg on short selling).
  • Full supervisory powers for some specific pan-European entities. ESAs will be responsible for authorising and supervising certain entities that have pan-European reach eg credit rating agencies and EU central counterparty clearing houses.

The extent to which the new authorities should be given the powers described above is particularly controversial, as there is a concern that their exercise may put taxpayers’ money at risk. The Council has therefore directed the Commission to ensure that its draft legislation does not undermine the principle that fiscal matters are the sole responsibility of member states. It will be interesting to see whether an appropriate balance can be achieved.

Conclusion

The future European regulatory landscape will be very different from the one we have today. Although day-to-day supervision of firms will (mostly) remain a matter for national supervisors, it is likely that exercise of their powers will be affected by the introduction of the ESAs. A single rulebook will also limit member states’ ability to take national considerations into account when implementing EU rules domestically.

The failure of the Icelandic banks highlighted a number of problems associated with the current regulatory regime, including how exposed retail depositors were, particularly in the UK, to losses in the absence of a harmonised deposit guarantee regime. To preserve consumer confidence in the banking system, the UK government decided it must agree to protect deposits, even though the cost of providing such support would be borne by UK taxpayers. Similarly, it is anxious to ensure that powers given to the new European authorities are consistent with member state responsibility for fiscal matters. It is unsurprising that the Conservative party’s recent “Policy White Paper” makes the same point.

Formal consultation on the detail of the proposed reforms is expected to begin in early autumn. The reality is, however, that it will be difficult to influence the shape of the reforms once draft legislation has been published. Attempts to do so should therefore be made now.