Today, the EU released a report by the high-level group on “Financial Supervision in the EU.” The report discussed the balance between supervision and regulation in the EU:

“the present crisis results from the complex interaction of market failures, global financial and monetary imbalances, inappropriate regulation, weak supervision and poor macro-prudential oversight. It would be simplistic to believe therefore that these problems can be ‘resolved’ just by more regulation. Nevertheless, it remains the case that good regulation is a necessary condition for the preservation of financial stability.”

The report comes on the heels of a meeting of European leaders of the G-20 this week in Berlin, and it anticipates issues likely to be discussed during the meeting of the entire G-20 this April in London. The report also echoes concerns raised by the ECB earlier this week on the future of European financial regulation and supervision. In the report, the high-level group endorsed numerous recommendations covering ways the EU can repair financial supervision, including:

  • A fundamental review of the Basel 2 capital adequacy rules.
  • A common definition of regulatory capital should be adopted for use throughout the EU, clarifying whether hybrid instruments should be considered as tier 1 capital.
  • A fundamental review of credit reporting agencies’ business models and financing and whether rating and advisory activities should be separated.
  • A wider reexamination of mark-to-market accounting principles, including a specific recommendation that the IASB and other accounting standard setters clarify and agree on a common, transparent methodology for the valuation of assets in illiquid markets where mark-to-market cannot be applied.
  • Adopting the Solvency 2 directive and include a balanced group support regime, coupled with sufficient safeguards for host Member States, a binding mediation process between supervisors and harmonizing insurance guarantee schemes.
  • Providing competent authorities in all Member States with sufficient supervisory powers, including sanctions, to ensure the compliance of financial institutions with the applicable rules and strong, standardized sanction regimes to counter all types of financial crime.
  • Improving transparency in all financial markets - and notably for systemically important hedge funds - by imposing, in all EU Member States and internationally, registration and information requirements on hedge fund managers, concerning their strategies, methods and leverage, including their worldwide activities.
  • Imposing appropriate capital requirements on banks owning or operating a hedge fund or being otherwise engaged in significant proprietary trading and closely monitoring them.
  • Simplifying and standardizing over-the-counter derivatives and requiring the use of at least one well-capitalized central clearing house for credit default swaps in the EU.
  • Guaranteeing that issuers of securitized products retain on their books for the life of the instrument a meaningful amount of the underlying risk (non-hedged).
  • Member States and the European Parliament should avoid in the future legislation that permits inconsistent transposition and application.
  • Better aligning compensation incentives with shareholder interests and long-term firm-wide profitability by basing the structure of financial sector compensation schemes on identified principles.
  • Making the risk management function within financial institutions independent and responsible for effective, independent stress testing.
  • Creating a coherent regulatory framework for crisis management in the EU, including equipping all relevant authorities in the EU with appropriate and equivalent crisis prevention and crisis intervention tools and removing legal obstacles standing in the way of using these tools in a cross-border context, with adequate measures to be adopted at EU level.
  • Harmonizing Deposit Guarantee Schemes in the EU and preferably requiring that the schemes be pre-funded by the private sector (in exceptional cases topped up by the State) and providing high, equal protection to all bank customers throughout the EU.
  • Creating a new body called the European Systemic Risk Council (ESRC), to be chaired by the ECB President, under the auspices and with the logistical support of the ECB, with responsibility for pooling and analyzing all information relevant for financial stability, pertaining to macro-economic conditions and to macro-prudential developments in all the financial sectors and ensuring a proper flow of information between the ESRC and the micro-prudential supervisors.
  • Creating an effective risk warning system under the auspices of the ESRC and of the Economic and Financial Committee (EFC), with the ESRC prioritizing and issuing macro-prudential risk warnings (for which there should be mandatory follow up and, where appropriate, action taken by the relevant competent authorities in the EU).
  • Establishing a decentralized European System of Financial Supervisors (ESFS) consisting of existing national supervisors who would continue to carry-out day-to-day supervision and and three new European Authorities (a European Banking Authority, a European Insurance Authority and a European Securities Authority) that would replace CEBS, CEIOPS and CESR and have responsibility for coordinating the application of supervisory standards and guaranteeing strong cooperation between the national supervisors.
  • Strengthening national supervisory authorities with a view to upgrading the quality of supervision in the EU.
  • Develop a more harmonized set of EU financial regulations, supervisory powers and sanctioning regimes.
  • Charging a group of high-level representatives of the Finance Ministries, the European Parliament, the Level 3 Committees, and the ECB, to be chaired by the Commission, with coming forward before the end of 2009 with a detailed implementation plan.
  • Putting the Financial Stability Forum (FSF), in conjunction with international standard setters like the Basel Committee of Banking Supervisors, in charge of promoting the convergence of international financial regulation to the highest level benchmarks.
  • Charging the colleges of supervisors for large complex cross-border financial groups that is currently being set up at the international level with the responsibility to carry out robust comprehensive risk assessments, paying greater attention to banks' internal risk management practices and agreeing on a common approach to promoting incentive alignment in private sector remuneration schemes via pillar 2 of Basel 2.
  • Putting the IMF, in close cooperation with other interested bodies, notably the FSF, the BIS, central banks and the ESRC, in charge of developing and operating a financial stability early warning system, accompanied by an international risk map and credit register.
  • Intensifying coordinated efforts to encourage currently poorly regulated or "uncooperative" jurisdictions to adhere to the highest level international standards and to exchange information among supervisors.
  • Calling for Member States to show their support for strengthening the role of the IMF in macroeconomic surveillance and to contribute towards increasing the IMF's resources in order to strengthen its capacity to support member countries facing acute financial or balance of payment distress.
  • Organizing coherent EU representation in the new global economic and financial architecture and intensifying the EU’s financial regulatory dialogue with key partners.