Nobody saw it coming: this was the EU’s – and the world’s – grand failure in the run-up to the default of Lehman Brothers, the massive US investment bank. No supervisor predicted that credit bubbles and bankruptcy in one part of the system would lead to a crash that is to result this year in a 4% drop in the EU’s GDP, the worst results in its history. So what caused the economic downfall and how can we avoid repeating it? The accepted wisdom, according to the European Commission, is that before the crisis credit risk was being hugely underestimated and underpriced (blame the rating agencies), asset prices were ballooning, banks were pooling debt into complex structured products ('securitisation'), accounting for many of them off balance sheet, and were over-relying on borrowing to make gains ('leverage'). Coupled with the growth of privately traded ('over-the-counter') derivatives, a shadow banking system was growing up. “Supervisors in the EU failed to detect, warn and act upon major risks that were accumulating in the financial system,” says the Commission in a September report, entitled ‘Economic crisis in Europe’. “Supervisors did not sufficiently take account of global macroeconomic and microeconomic developments and as the crisis developed, supervisors were often not prepared to discuss with appropriate frankness and at an early stage the vulnerabilities of financial institutions that they supervised.”

Efforts to remedy the crisis have included massive support for banks worth €3.5 trillion (a third of the EU’s GDP), public spending on the real economy worth about 5% of GDP and monetary easing by the European Central Bank, which has lowered its borrowing rates to record levels and pledged to buy up €60 billion worth of covered bonds. A slew of regulatory missives from the EU executive - on capital requirements, credit rating agencies, hedge funds, bankers' pay and securities - has attempted to bring the shadow banking system out into the open. But the grand failure to look at the bigger picture is what brought EU policy makers in September to propose the creation of a set of EU-level watchdogs to make sure the continent is never again caught unawares. This is damage limitation: we may never be able to prevent another crisis, but we can certainly plug the holes between individual regulatory moves and oversee how they are implemented, at least stemming another system-wide crash.

On 25 February this year, a group of 'wise men' came up with a plan they hoped would eliminate the blind spots in the internal market. Led by former International Monetary Fund Managing Director Jacques de Larosière, the group said that because too much attention was being paid to individual firms (the microeconomic level) and not enough to the market as a whole (macroeconomic), a link needed to be made between the two.

The result, published on 23 September (COM(2009)499-503), is a two-level system of supervision consisting of, in effect, four authorities: three to supervise individual banks via national supervisors, which are being built from already existing advisory committees, and one watchdog to guard against future crises.

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The big picture

Overseeing the financial system as a whole - the macroeconomic picture - will be a new watchdog called the European Systemic Risk Board (ESRB, see diagram).

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This structure - which will be staffed in part by the European Central Bank, and its decision making mainly done by European central bankers and regulators - will have the unenviable task of collating and analysing information received from banks via the three new micro-level authorities (see micro machines below). Its task is to use the data to warn governments and supervisors of potential asset price or housing bubbles, for example, and advise them to take certain measures. However, it will not have any legal powers to do this; it will rely instead on a moral weapon, obliging supervisors that do not comply with its recommendations to justify themselves.

But Roger Acton, director-Europe at ACCA, the global accounting body, warns that “There is a danger that too much reliance will be placed on the ESRB to ensure that regulatory failure does not happen again. It is important to note that the ESRB is influential but lacks real clout in that it will not have any executive power to impose its will on national governments”.

However, the ESRB’s moral pressure is stronger than it might seem because the board will have the right to make recommendations public (although this will depend on a qualified majority voting in favour of the move in the decision making General Board). But naming and shaming could cause problems for member states, as Luxembourg’s Prime Minister Jean-Claude Juncker recently told Europolitics: “I would not want this body to make recommendations to member states publicly before we have a chance to discuss the problems among eurozone finance ministers. I would not like for technocrats, who are far removed from daily realities, to issue recommendations confidentially – and in fact publicly, because everything will be made public – and for certain eurozone member states to have insurmountable problems as a result of the recommendations”.

The ESRB’s recommendations can be issued to member states, national or EU supervisors (the European supervisory authorities or ESAs), and will be formulated by the body’s 61-member General Board. They will all pass via the Council. The ESRB will likely be headed up by the ECB President (Jean-Claude Trichet), although he will have to be supported by a majority on the General Board. However, European Conservatives feel that the organ is still too eurozone-heavy. UK MEP Kay Swinburne said at the release of the proposals, “The safeguards the Commission claims to have drafted into the plans will be insufficient to prevent the ECB from usurping risk-taking on a pan-European level. There is a serious question about the role of the ECB in the ESRB, given that 11 countries are not in the eurozone”.

A Commission official told Europoliticsthat the legislation has gone far to outline the limits of the ESRB. But still, the ESRB, says Bruegel’s Jean Pisany-Ferry, and its proximity to the ECB, mark a new era for central banks, who were traditionally concerned only with price stability.

“The ESRB won’t legally be a central bank but it will be a central bank’s subsidiary and its public face will be undistinguishable from that of the ECB,” Pisany-Ferry wrote in a Bruegel report earlier this month. “The strict separation between the domain of the central bank and that of government bodies is likely to be challenged – and perhaps with it the intellectual and institutional edifice that has been painfully built over the last three decades.”

So why was the ECB chosen as the sponsor of the new body? For Irish MEP Gay Mitchell, who sits on Parliament's new Financial Crisis Committee, “The ECB has come out of the crisis quite well”. The ECB already interacts with the 27 central bank heads via the European System of Central Banks (ESCB), which Mitchell says would be a good model for the board’s relations with national supervisors (via the three new micro-level authorities).

Despite the various reservations, however, the board has been given the green light by the European Council, which is keen to get a political agreement on the whole package by December.

Micro machines

The Commission has decided to leave day-to-day supervision with national supervisors, but for the first time, they will be answerable to three new EU-level authorities, which are being separated according to their market segments: banking, securities and insurance. The three ESAs will be given binding powers to enforce EU rules.

But they are not fully new structures. They already exist in a watered down form, headquartered in London (the Committee of European Banking Supervisors), Frankfurt (Committee of European Insurance and Occupational Pensions Supervisors) and Paris (Committee of European Securities Regulators). These three committees draw up guidelines on how to implement EU financial services law as part of the Lamfalussy process – and are commonly known as the Level 3 committees (see table).

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The three will gradually be transformed into the ESAs – the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA) – over the next year. CEBS’ Secretary-General Arnoud Vossen says his committee is hiring at least ten new staff and is preparing to turn the non-binding guidelines it now issues into binding technical standards.

The Commission will, however, have to endorse all the standards before they become law, but it effectively gives the three ESAs joint enforcement powers with the EU executive – on very specific rules, defined by the Commission.

Each authority – and they have deliberately been created according to the same template – is to be governed by a chairperson and will make decisions via a 32-member board of supervisors (27 of which are national supervisors, the only members with voting rights). They have two tasks other than issuing binding standards (which the Commission wants to collate and develop into a single EU 'rulebook'): mediating in cross-border disputes between supervisors and taking the reins in emergency situations (should there be another Lehman Brothers, for example).

This is where political battle lines are being drawn because ESAs - as a last resort - have the power to take decisions relating to individual banks. Although European Council conclusions in June stipulated that the authorities will not be able to take a decision that “impinges on the fiscal responsibility of member states," a contingent of countries – including the UK, Spain and several new member states – are concerned that the EU could effectively go over member states’ heads in ordering bank bailouts, for instance.

UK Chancellor Alistair Darling said at a finance ministers’ meeting, on 20 October, “Our concern has been to ensure that we respect the individual sovereignty of countries. A bottom line for us is that we couldn’t have a situation where a European supervisor could make an order relating to an institution in our country that might have fiscal consequences [...] A number of detailed proposals came from the Commission that we can't accept. The upshot is that it’s a work in progress.”

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The fear in Brussels is that if member states disagree with a ruling by one of the authorities, they could become entangled in lengthy legal battles. Under the proposed rules, member states that have a problem may appeal to the authority concerned ('safeguard clause'). The authority will have a month to consider the complaint, and can revoke, amend or stand by it. If there is still a problem, the Ecofin Council can step in and make a ruling by qualified majority.

If the member state or bank concerned fails to accept the ruling, there is of course the possibility of a court settlement. But David Wright, the Commission’s deputy director-general for internal market, warned at a conference in Göteborg, in October, that “The new supervisory authorities must not end up in a situation where everything heads for the European Court of Justice if there is no agreement. We want those authorities to be able to take decisions in an emergency. We have seen what happens when there is hesitation and indecision in European financial supervision,” he added.

Poland, on the other hand, is all for the transfer of powers to the authorities, as it plays host to many foreign-owned banks and is keen to avoid potential conflicts between domestic regulators and their counterparts abroad. Jan Rostowski, the country’s finance minister, said in Sweden recently, “Those powers that are jointly exercised by home and host countries should be transferred to the European supervisory authorities in an evolving and balanced way – as more authority is transferred from the home country, the more will be transferred from the host country as well”.

There is also the role of 'colleges' of supervisors to consider. The Commission proposals call for the setting up of cross-border colleges to make large banking groups more accountable in home and host countries, but the texts are not clear on what the colleges' role will be, especially in dispute resolution - and whether they will defer to the ESAs (which will sit as observers on the colleges and be privy to data shared between its members). Banking industry insiders say they need clarity on whether a club of national authorities within the college could overrule home supervisors in disputes.

The debate over how much power the ESAs will have is still raging in Council working groups, and should be finalised by the 2 December Ecofin Council - in time for the entire package, macro and micro, to be given the green light at the December European Council. However, the banking industry is concerned at the pace of diplomatic work. Noémie Francheterre, an adviser with the European Banking Federation, said, “We should duly and carefully examine the content and practical functioning [of the authorities]. Speed shouldn’t come at the expense of quality”.

BusinessEurope agrees. Marc Stocker, chief economist at the industry grouping, told Europolitics, “A general message is that the urgency of moving with financial market reforms should not be at the price of a thorough impact assessment”.

The European Parliament has been more realistic about the timetable, saying March 2010 is a possible deadline for agreement. However, much will depend on horse trading between the political parties. Most broadly support the Commission’s proposals, although to varying degrees. The Liberals, backed up by the Greens, are most critical, and say the proliferation of authorities in the Commission’s structure is confusing. “The proposed structure currently lacks coherence, as not only the operational, but also the geographical fragmentation between Paris, London and Frankfurt will endanger an efficient coordination and flow of information between the different entities," ALDE leader Guy Verhofstadt said recently. "A single European financial services authority would be more effective in the coordination of market oversight and crisis prevention than three separate bodies in three different countries and a fourth body dealing with wider systemic risks”.

The Socialists are also calling for a system with “real power” that does not degenerate into a “club of regulators”. French MEP Pervenche Berès wants a reorganisation of the Commission to aid macroeconomic supervision, with responsibility for financial markets moved from Charlie McCreevy's internal market portfolio to Joaquín Almunia's economic affairs directorate.

The EPP is reserving judgement on the package for the moment, but does hint that the set-up could infringe national hegemony. Dutch MEP Corien Wortmann told Europolitics, “We have to make sure these authorities can really play a supervisory role, but on the other hand, we must respect the treaties”.

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According to sources in the Council, there is also a question mark over how the ESAs will be financed. Under the Commission’s proposals, they are to have their own budgets, but whether this comes from EU coffers or European governments is moot. Net contributors to the EU budget, like the UK and Germany, are not in favour of the Community shouldering the entire burden, while net beneficiaries of EU funding want to pass the buck to the Commission. The Commission suggests a 60-40 split, with the majority coming from member states. The European Banking Authority's estimated budget for 2011 is just over €13 million, which would mean that just under €8 million would come out of national pockets.

And then what?

The major concern for many banks – and something that goes beyond the EU’s remit – is how to wind up institutions that have failed, and how to share the costs of bailouts (burden sharing).

The de Larosière report states: “The absence […] of a sound framework for crisis management and resolution (with sufficiently clear principles on burden sharing, customers’ protection, assets transferability and winding up) complicates the introduction of an effective and efficient supervisory system to avoid financial crises in the first place. Any proposals to modify the organisation of supervision in the EU therefore have to be accompanied by the setting up of a more convincing framework for crisis management in the EU”.

Monetary Union architect Alexandre Lamfalussy this summer slammed de Larosière report, calling it “vague” on crisis management. The Commission’s September proposals contain only a short reference to burden sharing, which they say should be developed in parallel to the functioning of the ESAs.

In a June report for the Belgian government, Lamfalussy suggested the creation of a European bank guarantee scheme, pre-funded mainly by large cross-border groups, and managed by a new European deposit insurance company. “This is a small step but could be of major importance to smaller countries,” he said.

This is one of the major obstacles, banking industry sources told Europolitics,to the effective functioning of the Commission's proposals on microprudential supervision (the ESAs): if there is no corresponding EU-level contingency fund, how can banks and national supervisors be expected to cede their decision making power to EU-level authorities?   

On 20 October, the Commission launched an investigation on how best to create an EU 'framework' for crisis resolution (COM(2009)561/4).

BusinessEurope has long been calling for work on the issue, and the group’s financial services spokesman, Erik Berggren, has suggested that EU countries sign mutual agreements as soon as possible, laying down who should be forced to pay in the case of a default of a foreign bank on their soil. “It is an element that is vital for any supervisory system to function,” he told Europoliticsin July.

It remains to be seen whether the nature of the European banking system - with banks’ national biases and reliance on their own governments' funds - will be fit for a pan-EU crisis response framework.

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