Nicolas Véron

The First Step in Europe’s Banking Union: Difficult but Achievable

This column was published by Bruegel and the Peterson Institute, and also by Vox, the Globe and Mail (Canada), Caixin (China), El Economista (Spain), and RBC Daily (Russia).

The leaders of Eurozone countries made an unprecedented commitment when they issued on June 29 a statement starting with the words “We affirm that it is imperative to break the vicious circle between banks and sovereigns.” This statement officially acknowledged their intention to break the “doom loop” of mutually reinforcing deterioration of credit conditions afflicting weaker member states and banks headquartered in them. Spain is a prime example of the problem. Severing that feedback loop requires a transfer of vast parts of the banking supervision and policy apparatus from the national to the European level, or banking union. It is probably a prerequisite for maintaining the integrity of Europe’s monetary union in any crisis resolution strategy. Equally important, a failure to deliver on this clearly articulated pledge would severely impair investors’ already damaged confidence in the ability of the Eurozone governments to act collectively.

The action plan outlined in the June statement defines a sequence of two explicit steps. The European Central Bank (ECB) should first be endowed with broad supervisory powers and become the anchor of a “single supervisory mechanism” for participating member states. Then, once this mechanism is deemed “effective,” the European Stability Mechanism (ESM), which is the Eurozone’s newly-established intervention fund, would be able to recapitalize banks directly. Corresponding instruments remain to be clarified but would probably include common equity.

This sequence is unsatisfactory. Making European-level crisis management action (including bank recapitalizations by the ESM) contingent on the establishment of a permanent institutional infrastructure (i.e., an effective single supervisory mechanism) looks like a delaying tactic, in denial of the urgency of the present situation. Moreover, the leaders’ proposed sequence avoids essential elements of a credible banking union, such as a European banking charter, resolution authority and federal deposit insurance. This leaves the policy framework incomplete.

In spite of these frustrating flaws, however, the June statement is the boldest reaction so far of European leaders to the Eurozone crisis. They must now urgently transform this pledge into concrete decisions. The European Commission has done its bit by publishing a legislative proposal for the establishment of the single supervisory mechanism, on September 12. Three major issues of contention have emerged in the negotiations among member states.

First, the geographical perimeter: the June 29 statement identifies article 127(6) of the European Union’s Lisbon Treaty as the legal basis for the initiative, which means the new supervisor will be part of the ECB. But some non-Eurozone member states, including in Central Europe and Scandinavia, may legitimately want to join it, and they have a veto over decisions under article 127(6). They should be entitled to a voice in the new system’s governance, and to appropriate safeguards of their taxpayers’ interests. Even though one important member state, the United Kingdom, has unambiguously declared it would not join the single supervisory mechanism, the approach should be as inclusive and flexible as possible.

Second, monetary policy independence: banking policy and monetary policy are linked but ultimately different, which also justifies different geographical perimeters within the EU for currency union and banking union respectively. There is a legitimate concern that adding supervision, a politically charged task, to the ECB’s responsibilities, may compromise its cherished independence. The supervisory function should be strictly separated from the rest of the ECB, with full institutional autonomy possible in future reform steps.

Third, German savings and cooperative banks, which are local banks subject to a different policy regime from commercial banks, oppose their being brought under the new European supervisor’s authority. Given Germany’s pivotal position in all Eurozone discussions, some of its idiosyncrasies may have to be accommodated. There could be a separate European supervisory framework for systems of local non-commercial banks that would meet adequate conditions, for example.

Negotiators also need to ensure that the new supervisor’s governance is less dysfunctional than that of the ill-fated European Banking Authority, whose clumsy decision-making process was hampered by its reliance on diplomatic compromises among member states, in spite of a high-quality staff. Effective supervision requires that controversial decisions be made quickly, while guaranteeing genuine accountability to democratic institutions. At the same time, the legal basis for new arrangements must be robust and include mechanisms for judicial review. Further legal debate is needed on whether this is best achieved under article 127(6) or other Treaty provisions.

Creating Europe’s single supervisory mechanism is only one step on a much longer path towards crisis resolution and banking union. Compromise on it will be difficult but possible. Leaders must not lose the momentum created by their June 29 commitment, and should try to reach a final legislative decision before the end of this year.

Is Europe Ready for Banking Union?

This column was published by Bruegel and the Peterson Institute, and separately by Vox, the Australian Financial review, the Globe and Mail (Canada), Caixin (China), FT Deutschland (Germany), El Economista (Spain), Les Echos (France), Il Sole 24 Ore (Italy), Publico (Portugal), and RBC Daily (Russia). 

Systemic fragility in the European banking sector predates the Greek fiscal crisis. It was revealed by the subprime/Lehman shock of 2007-08, and has never been properly addressed since then in spite of successive “stress tests.” In recent weeks, several senior policymakers have become more explicit on the need for a “banking union” – in other words, a federal framework for banking policy. Among them is Christine Lagarde, managing director of the International Monetary Fund (IMF), who on April 17 said, “To break the feedback loop between sovereigns and banks, we need more risk-sharing across borders in the banking system. In the near term, a pan-euro area facility that has the capacity to take direct stakes in banks would help. Looking further ahead, monetary union needs to be supported by stronger financial integration, which our analysis suggests should be in the form of unified supervision, a single bank resolution authority with a common backstop, and a single deposit insurance fund.” The European Central Bank President, Mario Draghi, echoed these words at the European Parliament on April 25, declaring that he saw “financial stability clearly as a common responsibility in a monetary union” and that ”ensuring a well-functioning Economic and Monetary Union implies strengthening banking supervision and resolution at European level.”

Many academic observers now agree that a banking union, together with some form of fiscal union, is a necessary condition for a sustainable Eurozone monetary union and for a resolution of the current crisis. But in spite of the creation of a European Banking Authority last year, the action taken so far has been modest. Spain is a case in point: Madrid could have appealed to the European Financial Stability Facility (EFSF) for a loan specially targeted at recapitalizing its banks, but it has preferred to go it alone with the nationalization of ailing champion Bankia, and a new round of property-related write-downs that have provoked much market skepticism.

Several reasons explain why banking policy integration is difficult. The UK, Europe’s dominant financial hub, is not a Eurozone member and resists any encroachment on its supervisory sovereignty. Some member states remain committed to bolstering national banking champions or to protecting links between local banking and political communities – links that effectively make the banks instruments of the state’s industrial policies. The ability of debt-burdened governments to pressure domestic banks into buying their sovereign debt, also known as financial repression, is another impediment to change. Of course, a banking union would potentially involve controversial financial risk-sharing or cross-border transfers.

These constraints prevent Europe from moving in one step to a consistent architecture for its banking union. European leaders eager to discuss how to prevent the next crisis are often in denial about the current one. Their rhetoric tends to evoke an imaginary world in which finance is stable, economic incentives are aligned with social responsibilities and moral sentiments, and public authorities understand the financial system perfectly. From a policy perspective, such flights of fancy are an increasingly unaffordable luxury, especially in light of the urgent need for crisis management and survival.

Three priorities are obvious. First, the banks must share risks as widely as possible. It is unreasonable for European governments to reimburse all creditors of failed banks, including senior unsecured creditors in all cases to date (except for two banks in Denmark and a few very tiny ones elsewhere) and subordinated creditors in almost all cases in Continental Europe. In the US, by contrast, almost all restructuring processes have forced creditors to take heavy losses, except for a handful of prominent cases (Bear Stearns, Fannie Mae, Freddie Mac, AIG, and the carmakers). A European approach should avoid the perverse incentives that have held taxpayers hostage to failed banks’ creditors. There are many complex legal and financial issues at stake, but ultimately the choice is political.

Second, Europe needs an operating capability to restructure banks without having to rely on national authorities that have failed their supervisory duties. This objective requires building up an effective temporary task force of restructuring professionals who can intervene quickly on behalf of the entire Eurozone and manage corresponding legacy assets. Such tools do not currently exist. The Swedish Bank Support Authority of 1992, or in a different context Germany’s post-unification Treuhandanstalt, are relevant precedents.

Third, and most urgent, retail bank runs must be prevented. The best way would be for the EFSF or its successor fund to explicitly guarantee all national deposit insurance systems in the Eurozone. Such “deposit reinsurance” would bolster the integrity of the Eurozone and immediately enhance trust in its banks. Of course, strong European-level supervisory structures should eventually be built to prevent moral hazard. It will take more time to combine these different pieces into a consistent European banking policy framework. The current moment calls not for perfect fine-tuning, but for swift and bold commitments.

Europe Needs to Drop its Resistance to Non-Bank Credit

This column was published earlier this month by Bruegel and PIIE, as well as the Globe and Mail (Canada), Caixin (China), El Economista (Spain), Les Echos (France), Il Sole 24 Ore (Italy), Dziennik Gazeta Prawna (Poland), Publico (Portugal), and RBC Daily (Russia). 

The financial systems in the United States and Europe have long differed on an important aspect. In Europe, most of the credit flows through the banks. In the US the bank channel is less dominant, and borrowers gain access to capital directly by issuing bonds or through “non-bank” intermediaries that do not take deposits and are not regulated as banks. An oft-quoted measure is that in Europe banks represent more than two-thirds of total credit, whereas in the US the proportion is less than one-third.  In the past few years of crisis, this difference has mattered decisively.  

To begin with, the securitization of residential mortgages in the US went wild in the mid-2000s and was the initial trigger of market turmoil in the summer of 2007. Many continental Europeans have concluded that their bank-based system was less risky or more virtuous. But the subprime securitization debacle, severe as it was, has been one part of a more complex story. Many European banks have made risk-management mistakes just as massive as the reviled originators of US securitization deals. Spanish or Irish banks anticipating a never-ending property boom, or failures such as Dexia in France and Belgium, Hypo Real Estate or WestLB in Germany, or RBS in the UK, are sad reminders that Europeans have no grounds to feel complacent about their own system.

Another less visible point is at least as important. Systemic banking crises are almost inevitably followed by a scaling-back of many credit activities by most banks, a process known as bank deleveraging. In the US, this process has not been traumatic largely thanks to the flexibility and versatility of the system: while banks reduced their exposure, other channels of credit stayed active or expanded, and the credit squeeze was mitigated. By contrast, in many European countries, when banks started applying more restrictive lending standards, there were few substitutes to help even to creditworthy borrowers. Thus, in much of Europe credit provision is impaired, and the situation is likely to worsen further in the near future.

To some extent, governments can intervene to provide incentives via targeted guarantee schemes or to extend credit with direct lending. The UK is creating a Business Finance Partnership to lend to medium-sized enterprises, and both leading French presidential candidates want to create new public banks. But this kind of intervention also entails big drawbacks. Not only are many sovereign balance sheets strained; past experiences of government-directed lending have generally been sobering, as the process tends to be prone to capture by politically-connected special interests, resulting in large misallocations of capital. Therefore, encouraging non-bank credit provided through the private sector should be a major public policy objective.

Unfortunately, in much of Europe and at the EU level, policymakers seem unaware of this need. Instead, the European Commission has frequently appeared to take a punitive approach to non-bank credit channels, particularly in its regulation of investment funds and its latest project to regulate credit rating agencies, which play an enabling role in corporate bond issuance. The Commission also wants to tighten the regulatory screws on “shadow banking,” which the Financial Stability Board has defined as “the system of credit intermediation that involves entities and activities outside the regular banking system.” Some aspects of shadow banking, including securitization but also other types of entities or transactions, can contribute to systemic risk. But that risk does not justify repressing shadow banking in general. Some segments need to be regulated through rules of business conduct rather than of capital or liquidity. Other segments simply need better transparency and monitoring.  In some cases, existing regulations should be dismantled: it makes no  sense, for example, for several EU countries to prohibit leasing services offered by non-banks.

Making the transition from a bank-dominated system to a more diverse one in which non-bank credit plays a bigger role is difficult. Issuing bonds or other fixed-income securities requires high standards of financial disclosure, which is resisted by the culture of many medium-sized companies or banks in a number of European countries. Legal and regulatory differences across borders inside the EU also do not help because they contribute to fragmentation of some financial market segments.

But such legacies must be overcome if the goal is to minimize the risk of credit crunches in large parts of Europe, particularly the struggling southern Eurozone periphery. Incumbent banks are skillful at opposing diversification of credit channels as unfair or dangerous, but their lobbying should be seen as merely self-serving. After all, the financial crisis has been primarily a banking problem, and private equity or hedge funds have been proven to pose less systemic risk than was feared before 2007. The majority of European policymakers who still see finance and financial regulation through the prism of traditional banks need to expand their horizon, so that non-bank credit channels stop being unduly repressed. This is not about financial doctrine, but about long-term growth and jobs. 

 

A New Era for Global Financial Standards

This column was published by Bruegel and PIIE, and separately by Vox, the Globe and Mail (Canada), Caixin (China), Les Echos (France), FT Deutschland (Germany), Kathimerini (Greece), Il Sole 24 Ore (Italy), Dziennik Gazeta Prawna (Poland), El Economista (Spain), and the Bloomberg Financial Regulation newsletter. 

Even as headlines remain dominated by the Eurozone crisis, the financial world is transforming itself along multiple other dimensions. One intriguing but so far little-noticed development is the gradual shift in the role of global financial standard-setters, which are becoming more assertive in looking at how their standards are adopted and implemented around the world.

Global financial standards have emerged since the 1970s as a by-product of global financial integration. While some global bodies set norms for small and arcane corners of finance, two cases stand out for the magnitude of their impact on financial firms’ operations and incentives: the successive agreements reached by the Basel Committee on Banking Supervision, or Basel Accords; and International Financial Reporting Standards (IFRS), which govern the preparation and presentation of listed companies’ financial statements and are set by the London-based International Accounting Standards Board (IASB).

Until recently, both the Basel Committee and the IASB, like other global financial standard-setters, felt their role was to publish and update standards of high quality, and to a certain extent to promote their adoption and use, but not to control how they were used. (There was some sharing of experiences among public authorities in the Basel Committee, but no corresponding public disclosures.) This is now changing. The Basel Committee is creating a whole new framework of direct oversight over how its standards are made into law in individual jurisdictions, and how they are being applied by individual financial institutions there. Crucially, the committee has announced that its findings would be made public. In October 2011, it duly released for the first time a table comparing the state of adoption of the Basel II and Basel 2.5 Accords in its member jurisdictions and the European Union (EU).

These are no mere technical matters: the Basel III Accord on capital, leverage and liquidity is expected to result in curbs on banks’ profitability and additional constraints on the largest banks. Its transposition into EU legislation is currently the subject of furious lobbying, and US federal agencies’ proposal for its adoption in America has not yet been published. Stefan Ingves, the Swedish central banker who took the chair of the Basel Committee in June 2011, emphasized the effort by commenting recently that “setting rules without ensuring their implementation is akin to building a lighthouse without ever switching the light on.”

Last month, similar announcements were made regarding accounting standards with the publication by the IFRS Foundation, which hosts the IASB, of a landmark report on its strategy for the next ten years. This text specifies that “the IFRS should seek full disclosure where adoption of IFRS is incomplete or where there is divergence from the full set of IFRS as issued by the IASB,” and that “the IASB will work with a network of securities regulators, audit regulators (…) and other stakeholders to identify where divergence in practice occurs across borders.” This contrasts with the IASB’s previous stance, which claimed no responsibility for its IFRS standards’ actual implementation.

This assumption of new responsibility seems to have been motivated by the fact that inconsistent practice is bound to taint the perception of the standards themselves. The financial crisis has certainly accelerated a shift that was arguably long overdue. It put the spotlight on, among other things, different risk-weighting of similar assets by American and European banks under Basel II, or divergent accounting for writing down Greek sovereign debt among banks inside the EU.

It remains to be seen what exactly will be delivered on the basis of the recent announcements. The national supervisors who are members of the Basel Committee may not welcome external scrutiny of their practices. The IASB may struggle to enlist the cooperation of national public authorities in its monitoring effort. In both cases, the extent of disclosures to the public about potentially embarrassing findings remains largely to be determined.

Furthermore, global financial standard-setters have plenty of other pressing challenges. They need to regularly update their standards. The rapid negotiation of Basel III must be counted as a notable crisis-induced success, but by no means the end of the road. They need all jurisdictions to commit in principle to adopting their standards, which is far from universally the case for IFRS: large outliers still include the US and Japan. They also need to update their governance and management, not least to adapt to the rise of large emerging economies, and in the case of the IFRS Foundation, to find a stable and sustainable funding model, which it still lacks to a large extent.

For all these reasons, it is tempting to be cynical about the pledges to ensure proper implementation of global standards in what remains a very diverse financial world. Nevertheless, these commitments mark the beginning of a new era for the standard-setters, and potentially a step towards stronger governance of the global financial system. 

 

Europe's Fiscal Union Still Lacks a Blueprint

This column was published by Bruegel and the Peterson Institute, and separately by Vox, the Globe and Mail (Canada), Caixin (China), Les Echos (France), Kathimerini (Greece), Il Sole 24 Ore (Italy),NRC Handelsblad (Netherlands), El Economista (Spain), Radikal (Turkey), and the Bloomberg Economics Europe newsletter.  

The improvement of eurozone market conditions in January can be attributed to several factors, including the progress made by Prime Minister Mario Monti in Italy, and some constructive if Delphic signals coming from Berlin. It also suggests that a lot of bad news was already priced in in December, including a “credit event” on Greek debt that would trigger payment of credit-default swaps, as now looks very likely. But the eurozone’s fundamental design problems remain unresolved. Even the main positive driver of investor sentiment, the European Central Bank’s long-term refinancing operations offering cheap 3-year liquidity to banks, creates risks of its own. The ECB must have decided to open that window with a heavy heart. A few hard realities have not changed, and if anything have become more inescapable.

First, the core of the crisis is the gradual loss of reference status of the bonds issued by eurozone member states. Sovereign “risk-free” assets are the foundation on which complex financial systems are built. But as Eurozone sovereign bonds are perceived as carrying a risk of non-payment (or credit risk), the foundation becomes ever shakier and the rising tide of distrust engulfs ever more market segments and countries. As things currently stand, even Germany is unlikely to escape a credit downgrade for very long. Thus, the monetary union will become increasingly unsustainable unless a credible reference asset is created at the level of the eurozone, backed either by a joint and several guarantee of the member states (the various eurobond concepts) or a central tax-raising capacity as in most existing fiscal unions. The creation of the European Stability Mechanism (ESM) is but a baby step in this direction.

Second, the credit risk of sovereign debt creates problems in domestic banking systems that cannot be addressed by the toolkit for stand-alone banking crises. This is why the bank recapitalization plan of late October 2011, which assessed each bank’s capital needs on the basis of volatile sovereign yields, is bound to be a policy failure. The sad consequence is that Europe’s longstanding banking fragility cannot be resolved as long as the eurozone’s fiscal framework is not itself fixed. Absent such a resolution, the ECB is justified in providing indiscriminating liquidity support, even if that means prolonging the existence of “zombie banks” and the corresponding misallocation of credit. The same concern underpins the ECB president’s suggestion that there should be no new “stress tests” in 2012. Leaders should buttress the banking system by extending a eurozone guarantee to national deposit insurance schemes, to prevent any risk of retail bank runs, but they cannot hope to restore it to soundness before giving it a new foundation of eurozone-level bonds.

Third, crisis resolution primarily depends not on clever financial engineering, but on political and institutional breakthroughs at the European level. The eurozone’s nation-based political framework is cracking at the seams: the ECB has set the timetable of Italy’s change of government; Greece may formally lose its sovereignty on segments of its economic policy; Germany’s chancellor is becoming a principal player in France’s presidential election. But while national political systems lose their autonomy, existing European institutions remain too weak and not democratic enough to provide an adequate framework for political decision. They lack both executive decision-making capacity, and the ability to make Europe’s citizens feel properly represented. These two dimensions are mutually reinforcing, and major advances are needed on both. Equal representation of the Union’s citizens in the European Parliament (where larger countries are currently underrepresented) would be a good place to start, as the German Constitutional Court suggested in 2009. None of this can be achieved without significant treaty changes, and the considerable risks that come with them, but there is no alternative approach that would make the euro sustainable.

These challenges are reflected in the current central battlefield, namely Greece. The German government seems to have accepted that a Greek exit from the euro would trigger disastrous contagion, but the Greek political system is not delivering the necessary adjustment. If it comes to such a stark choice, most Greeks (though not all) are likely to prefer staying in the euro to a maximalist defense of their country’s economic sovereignty. But this sovereignty has to be transferred to a democratic entity in which Greeks have a stake, not Germany or “Merkozy,” for the trade-off to be viable. In other terms, a meaningful upgrade of EU institutions is a necessary condition for the eventual resolution of the Greek problem.

There is no easy or quick way to solve the eurozone’s complex equation, but one thing is sure: the status quo, even with ESM and fiscal compact, is unstable and unsustainable. The market lull must be used by leaders to prepare the next steps. Otherwise it will be another missed opportunity – with an ever higher price, financial and otherwise, to pay for the lost time.

Europe Must Change Course on Banks

This column was published on Monday by Bruegel and the Peterson Institute, and separately by Vox, the Globe and Mail (Canada), Caixin (China), Lidove Noviny (Czech Republic), El Economista (Spain), La Tribune (France), Kathimerini (Greece), Dziennik Gazeta Prawna (Poland), Publico (Portugal), and Radikal (Turkey), as well as GFS News and the Bloomberg Financial Regulation newsletter.

The Eurozone crisis keeps evolving along multiple dimensions. On the sovereign debt front, no deal is yet in sight on Greece’s debt restructuring, and Italy and Spain face major refinancing needs in early 2012. On the institutional reform front, the summit on December 9 fell short of delivering a true fiscal union, and tensions between the Eurozone and the UK have been brought to boiling point. On the growth front, a possible deep and prolonged recession looms.

As during previous episodes, however, the banking system is a crucial piece of the puzzle and epitomizes many of the contradictions of Europe’s experiment in monetary union. Almost continuously since 2007 that system has exhibited worrying gaps in risk management, compounded by massive supervisory failures in some countries. In the past two years, deteriorating sovereign creditworthiness has increased the system’s fragility. The combination of member states’ guarantees on domestic banks, and those banks’ outsized holdings of home-country sovereign debt in periphery countries, has accelerated the feedback loop between sovereign credit and bank funding conditions. The result is fragmentation: whether a euro held in a Greek bank is equivalent to a euro in a German bank is ever more in doubt. This could produce a slow-moving death spiral for a currency union.

Instead of fighting this trend, the recapitalization plan agreed on October 27 has reinforced it. More guarantees on banks are introduced at the national level, none at the European one. Moreover, when raising the minimum capital ratio to 9 percent, leaders decided that its assessment would rest on fair value (or mark-to-market) measurement of each bank’s portfolio of sovereign debt. The fair-value principle is sound for financial disclosure purposes. But it is dangerously pro-cyclical when applied to regulatory capital calculations, especially when extended to debt that is held to maturity – a radical move towards “full fair value” that accounting standard-setters have never dared to embrace. This is a recipe for massive credit rationing and misallocation, for which there is more and more anecdotal evidence.

The situation should be corrected before it runs out of control. The European Central Bank has introduced unprecedented liquidity support, but this step cannot correct the core problem of the sovereign-banking nexus. Both sides of the equation should be tackled. On the one hand, Eurozone-wide financial mechanisms should at least partly replace national backstops, arguably focusing on retail deposits for which the public guarantee is most harmonized and least discretionary or controversial. Such a move would go a long way towards preventing disastrous retail bank runs. On the other hand, leaders should work toward a partial substitution of national debt held by banks with common Eurozone debt, depending on the advancement of discussions on the fiscal front. Doing so would help reduce the current unreasonable home bias in the balance sheets of banks in periphery countries, especially Spain and Italy. These interventions could be overseen by an ad hoc entity dedicated to Eurozone bank restructuring, by delegation of individual member states.

Of course, such actions would require a political commitment that is currently nowhere to be seen. But there can be no sustainable monetary union without an integrated banking system, which would require an integrated policy framework in compliance with the subsidiarity principle. Two conditions add formidable hurdles on the path to a solution. First, as in fiscal matters, the difficult decisions to be made require proper accountability to Eurozone citizens, at least in the medium term. Establishing such accountability may entail reform and empowerment of the European Parliament, or the creation of an ad hoc chamber that would aggregate delegations from national parliaments, or both. Second, action in the Eurozone must be articulated with the existing instruments of the 27-member European Union, including the recently created European Banking Authority (EBA), which is located in London. This is made more difficult by the growing political distance between the UK and the Eurozone, widened after Prime Minister David Cameron’s veto at the December 9 summit. The pragmatic option is a coexistence of Eurozone and EU instruments, at least for some time, but it will add complexity and friction.

The political affirmation of the integrity of the Eurozone banking system does not require new treaties. But beyond the inherent aspect of financial solidarity, it would run against major political resistance, not least from individual banks that fear the loss of national privileges or protections. However, the creation of a “banking union,” parallel to the fiscal union now advocated by German Chancellor Angela Merkel, would not mean the end of all national and local specificities. In the United States, more than a century has separated the creation of a national banking charter (1863) from the achievement of a true national banking market. Interdependences between banking and political structures at the national and local level will remain. But a Eurozone-level banking policy framework that would transcend them is a necessary condition for the survival of the monetary union. 

Europe Needs Institutional Creativity

This column was published by Bruegel and PIIE, and also by Vox, the Globe and Mail, Caixin, FT Deutschland, El Economista, La Tribune, Kathimerini, Il Sole 24 Ore, Dziennik Gazeta Prawna, and Radikal, as well as by Bloomberg's Financial Regulation newsletter.

“I guess you guys have to be creative here,” US President Barack Obama was reported as exhorting German Chancellor Angela Merkel at the Cannes Summit on November 4. This is an apt tagline for the current moment in the eurozone crisis. The European Union needs to radically change its ways, or it may not survive.  

Beyond the headlines about Greece and Italy, the central problem is a crisis of decision-making at the European level. At no point since early 2010 has the contagion ever been seriously contained. This is an astounding policy failure, almost universally seen as such from outside Europe. Blaming the individuals would be unfair. Europe’s leaders may not be heroes but, from a historic or international perspective, most are reasonably competent, dedicated and honest. The problem lies not in them, but in the institutions.

At the core of Europe’s predicament is an obvious mismatch: the key decision-makers at the European level are leaders whose accountability derives exclusively from national electorates. Most have no mandate to work for the common European good. The European Commission is mostly powerless, except in specific areas of autonomy such as trade and competition policy. The European Central Bank (ECB) is a truly federal institution but its scope of action is limited, and rightly so. In the areas of fiscal and banking policy that have been made crucial by monetary union, there is no European executive branch.

Awareness of the mismatch leads to partial fixes such as leadership of the “French-German couple” or the more recent “Frankfurt Group” (José Manuel Barroso and Olli Rehn of the European Commission, Mario Draghi of the ECB, Jean-Claude Juncker of the Euro Group, Christine Lagarde of the International Monetary Fund, Angela Merkel of Germany, Nicolas Sarkozy of France, and Herman Van Rompuy of the European Council). But these fixes do not work. Most elements of the latest “comprehensive solution” agreed in the October 27 summit are unworkable.

Leaders must break this mold and empower individuals or entities to make decisions on behalf of European citizens and with adequate accountability to them. Some actions will require treaty change, others only a change of mindset. The latter category includes such vital moves as providing supranational guarantees to national deposit insurance schemes, to forestall the risk of catastrophic retail bank runs in troubled countries. A single European body should provide a consistent assessment of all Europe’s big banks’ capital position as the basis for a credible recapitalization plan. Member states should be prevented from using domestic financial firms as crutches to their own credit problems, to the peril of depositors and borrowers alike. In addition, treaty changes are required to provide proper accountability, starting with a different composition of the European Parliament to ensure that Europe’s citizens are equally represented, irrespective of their country. One recent piece of good news is Ms. Merkel’s explicit endorsement on November 9 of significant treaty change as part of the solution.

If the euro is to survive, a more federal framework for banking and fiscal policy is needed – what Jean-Claude Trichet, then ECB President, in June called a European Finance Ministry. But federations come in many shapes and sizes. The US is an obvious reference point but others may be more relevant. India, for example, shows that a continent-sized federation can be linguistically and religiously diverse, and politically fragmented into myriads of local parties, but still democratic and resilient. Some European countries are more at ease with the federal principle than others – Germany more than France, to name only those two. An additional major difficulty is to provide decision-making for the eurozone in a framework of EU institutions including countries that keep their national currency.

Such a transformation of the nature of European integration can neither be imagined nor delivered by national leaders seeking national reelection, or by exhausted civil servants. An open public debate is part of the answer; for all its parochialism, Germany has gone further in this respect than most other Eurozone countries. But ultimately a mechanism will be needed to propose institutional changes. A traditional intergovernmental conference is unsuited to the task, as diplomats are bound by old solutions and ossified national positions. A more diverse group of national delegates could perhaps do better, even though the convention chaired by former French president Valéry Giscard d’Estaing in 2002-03 failed to escape the traditional diplomatic game and to propose compelling solutions. Given the urgency, maybe a smaller group should be formed, on the model of the one chaired by former central banker Jacques de Larosière in 2008-09, which ushered in Europe’s most promising institutional innovation in this crisis so far, the creation of the European Supervisory Authorities.

A more federal Europe is not a straightforward proposition, but neither is it an impossible one. New ideas on how to shape it are urgently needed.

Global Financial Authorities Must Adapt to a Changed World

This column was published by Bruegel and PIIE as well as De Tijd (Belgium), The Globe and Mail (Canada), La Presse (Canada), Caixin (China), El Economista (Spain), La Tribune (France), Kathimerini (Greece), Il Sole 24 Ore (Italy), Radikal (Turkey), Dziennik Gazeta Prawna (Poland), and RBC Daily (Russia). 

The first G20 summits in 2008 and 2009 were dedicated to overhauling global financial regulation, empowering international financial authorities, and combating the economic downturn. Since then, progress has been uneven and priorities have shifted. The next summit in Cannes is set to be dominated by discussion of the policy chaos in Europe; financial regulatory matters will be little more than an afterthought. The world still needs a functioning international financial regulatory framework, however, if the vision of a globally integrated financial system is to be sustained – and there would be large economic costs from jettisoning that vision. The crisis has demonstrated the perils of unregulated or poorly regulated financial activities. Coordination among different jurisdictions does not happen spontaneously, and the technical nature of financial policy calls for specialized institutions.

This is why global financial authorities are so important. These include the Financial Stability Board (FSB), an umbrella group of national and international organizations, and the ten FSB member organizations not attached to a country or region. These include the Bank for International Settlements (BIS) in Basel; four bodies hosted by the BIS, respectively the Basel Committee on Banking Supervision (BCBS), the Committee on the Global Financial System, the Committee on Payment and Settlement Systems, and the International Association of Insurance Supervisors; the International Accounting Standards Board (IASB) in London; the International Organization of Securities Commissions (IOSCO) in Madrid; the Organization for Economic Co-operation and Development (OECD) in Paris; and the International Monetary Fund (IMF) and World Bank, in Washington DC.

They are not a homogeneous group, and additional international bodies may be needed in the future to tackle specific worldwide financial challenges. But a more immediate challenge is whether the eleven above listed institutions have kept pace with changes in the geography of global finance. All were created in the 20^th century, when Europe and the US (and for a brief period, Japan) dominated the scene. We are in a different financial world now. Based on the Financial Times Global 500 rankings, emerging economies now weigh more than Europe in terms of large listed companies’ aggregate value. Three of the world’s top five banks by market capitalization are Chinese, including the top two. Hong Kong and Singapore get closer to London and New York in financial centers’ league tables. The crisis has accelerated this shift, as the West enters a long cycle of deleveraging and slow growth, while emerging economies continue to catch up. At a less tangible level, the West’s model of financial development has lost much of its aura of superiority.

The new landscape has produced a growing discrepancy between the reality of global finance and the authorities intended to oversee it. True, most of these authorities have expanded their membership to include large emerging economies. But in only one does the chief executive come from the emerging world (OECD Secretary-General Angel Gurria, a Mexican). Among the seven that have a permanent non-executive chair, only at IOSCO is the position is held by a non-Westerner. They are all located in either Europe or the US, making it more difficult for non-Westerners to attend meetings or even conference calls.

As the succession of Dominique Strauss-Kahn at the IMF has illustrated, emerging countries remain unwilling to seize the initiative and force a readjustment. But time is on their side. Westerners should acknowledge that it is in their enlightened self-interest to give up some positions unilaterally, instead of defensively claiming incumbency rights. This requires a monumental change in their mental map, especially for Europeans, who are more overrepresented in this system than Americans, and who still often feel entitled to being at the center of world affairs.

Concrete changes could include the relocation to Asia of, at least, the secretariats of some of the Basel-based committees, including the FSB, and of the IFRS Foundation, which hosts the IASB. This would be logistically easy to achieve. A more ambitious plan could include the move of the headquarters of either the World Bank or the IMF away from the US. At least for some transition time, non-Western candidates should be given priority as heads and chairs of global financial authorities. Certainly, France’s Christine Lagarde and Sweden’s Stefan Ingves, recently appointed at the IMF and BCBS respectively, are highly qualified. But a lot of talent lies elsewhere. The next prominent appointments – at the FSB next month, the IFRS Foundation in the next few weeks, and the World Bank in 2012 – should go to non-Westerners.

Even so, there will be no guarantee of success for global financial authorities. But without some serious such rebalancing, they are assured of fading into irrelevance, even as the world needs them more than ever.

Euro Area Banks Must Be Freed from National Capitals

This column was published in September by Bruegel and PIIE, and also by Vox, the Globe and Mail, De Tijd, Caixin, El Economista, La Tribune, FT Deutschland, Kathimerini, Nikkei Veritas, Radikal, Publico, and the Australian Financial Review. 

Most of Europe has been engulfed by a systemic banking crisis for more than four years, even as policymakers and bankers themselves have strived to deny it. Even worse, the continuing banking system’s fragility is increasingly intertwined with the euro area’s sovereign debt crisis, as illustrated by successive patterns of contagion, from sovereigns to banks or conversely, from Greece to Ireland, Portugal, Spain, and more recently to Italy and France.

It is now plain that the crisis will not be resolved by a muddling-through approach that would allow a return to the status quo ante. If the euro is to survive, euro area citizens will have to accept pooling economic policy decision-making in unprecedented forms, a redefinition of the political pact that underlies European integration, and significant treaty changes.

An intense policy debate focuses on the options for euro area fiscal federalism, expansion of the role of the European Financial Stabilisation Facility (EFSF), eurobonds, or what European Central Bank President Jean-Claude Trichet, in a landmark speech in Aachen in June, called a ministry of finance for the European Union. But the banking side of the crisis also calls for far-reaching innovation. For it to be resolved, Europeans must define a model of banking federalism that would complement the existing monetary federalism and the objective of fiscal federalism. All are needed as components of European financial and economic policy.

The strong and multifaceted links that remain between national banking systems and member states are at the core of the contagion dynamics. These linkages also prevent the emergence of a true single European market for banking services. Economic and monetary union requires that these links be severed and replaced by a credible supranational framework for banking policy, building on the recently created European Banking Authority (EBA) and on the financial resources of the EFSF (or whatever replaces it). Some member states have already gone a long way toward decoupling themselves from their banking systems: Central and Eastern European countries have sold most of their banks to foreign groups, and such “older” member states as Belgium and Finland are moving along a similar path. But most large Western European countries remain largely closed to foreign-bank entry and protective of their domestic financial institutions, often in apparent denial of the moral hazard this protection creates.

The current rapid deterioration in the euro area calls for a radical approach to bank/state decoupling. For Europe’s ailing banking sector, a major shakeout and consolidation wave looms anyway. This must be anticipated with the right instruments and institutions. Any banking policy framework should include components of regulation, supervision, resolution, deposit insurance, and competition policy. For the crisis to be resolved, all must be credible at the European level. First, the EBA should be granted supervisory and resolution authority on all credit institutions, part of which it could in turn delegate to national supervisors as regards banks with a local scope and the local operations of pan-European banks. Second, the EBA’s own governance should be gradually reformed, in parallel with institutional change in the EU, to better align its decision-making with the European public interest. Third, the EFSF should explicitly guarantee the euro zone’s national deposit insurance schemes, in order to prevent sovereign crises from triggering catastrophic retail bank runs. Fourth, member states should agree to dismantle all mechanisms that prevent cross-border mergers, so that regional consolidation can proceed. Among other consequences, these measures would put an end to the “financial repression” strategies by which member states persuade local banks to overinvest in their sovereign debt, with now-obvious negative impact as their own sovereign credit deteriorates.

In parallel with these structural changes, euro zone countries should pass emergency legislation to create a temporary instrument to help crisis resolution, following the successful examples of the US in 1989 and Sweden in 1993. This “European resolution trust corporation” (or Banking Treuhand, to borrow from the German) should, in close liaison with the EBA, take over those banks that cannot meet their capital needs through market mechanisms, restructure their operations, and resell the resulting entities as soon as market conditions allow.

Admittedly, this program would involve huge challenges. One would be the growing tension between the euro zone and EU perimeters, underlined by recent controversies over the Vickers Commission’s recommendations and the ECB’s approach to clearing houses. More broadly, the political obstacles are massive. Calls for a European resolution fund or “euro-TARP” tend to downplay the need for a comprehensive underpinning of the entire institutional edifice of European banking policy.

These measures would not be sufficient to solve the current crisis. But they are necessary. Public awareness of the requirements of European banking federalism is still largely missing. The clamor by special interests tends to obscure this debate even more than on fiscal federalism. In the meantime, Europe is fast running out of alternative options.

 

An Accounting Perspective on Financial Globalization

Again, this is published late due to technical problems I had with TypePad this summer. This column was published in July by Bruegel, PIIE, Vox, the Globe and Mail, De Tijd, Caixin, La Voce, Nikkei Veritas, Radikal, and Dziennik Gazeta Prawna. 

Sometimes it takes a narrow lens to distinguish the true features of big objects. The future of financial globalization, whatever one’s perspective on its dangers or merits, is one of the biggest questions of our times. By contrast, accounting is often perceived as a boring technique. But the policy debate on accounting and especially on International Financial Reporting Standards (IFRS), which are replacing local accounting standards in an increasing number of countries, entails large stakes and important lessons for global financial integration.

Many observers have recently awakened to the importance of accounting because of the controversy over the mark-to-market principle (or fair value accounting, as accountants prefer to say) and its impact during the financial crisis. In late 2007 and early 2008, several prominent financiers and analysts protested that the rapid decreases in the market prices of US mortgage-based securities and other assets were meaningless and caused by liquidity shortfalls. According to them, marking these assets to reduced amounts in balance sheets would precipitate an unnecessary crisis. With hindsight, we know this analysis was wrong. The reason for the reduced market prices was not temporary illiquidity but permanent loss of value, and transparency was a better option than delaying the necessary recognition of losses. Regulatory capital ratios (set by banking supervisors) may be adapted to filter the short-term volatility of market prices and avoid pro-cyclical effects, but financial accounting should provide investors with a reliable reflection of market conditions at the time of measurement.

However, financial-industry executives and their lobbyists were able to obscure the debate to the extent that many people in Europe, and some in America, remain sincerely convinced that fair value accounting was a major aggravating factor in the crisis. A similar sequence had happened a few years earlier in the US, when corporate advocates managed to delay the accounting recognition of the cost of stock options for nearly a decade. This highlights a feature of accounting that extends to most other areas of financial regulation: because the issues are so technical and jargon-ridden, and the potential financial consequences are so large, public debates and policy decisions are often captured by special interests. Therefore, governance arrangements are crucial, and do not easily fit a clear-cut division of roles between the public and private worlds.

The governance of accounting standard-setting has widely varied over time and across countries. The general trend of the past few decades has been toward standard-setters that are more independent vis-à-vis governments and special industry interests. But the challenges related to IFRS are unprecedented because these standards are set at the global level. There is no global government to oversee the IFRS Foundation, the organization that sets IFRS standards, or to enforce consistent IFRS implementation across countries. Nor is there any coherent global representation of investors, whose information needs IFRS are primarily meant to serve.

Answers may lie in the IFRS Foundation making more efforts to organize the global investor community, and setting incentives for individual jurisdictions to adopt and enforce IFRS to foster genuine cross-border comparability of financial statements. At this point, it is still too early to judge whether the attempt to make IFRS the dominant global accounting language can succeed on an enduring basis. But there are already important lessons that have wide significance beyond the community of accounting professionals.

First, global financial rules are not a Utopian vision but a reality. The initial success of IFRS has been remarkable. Their adoption has been smooth and has generally improved financial reporting quality, starting in the European Union in 2005 but increasingly now in other countries as well. Given the right conditions, financial regulatory harmonization can work across continents.

Second, the crisis has increased the need for public oversight of financial rules, but it is not yet clear how this can be done effectively and consistently. A so-called monitoring board of public entities has been created in 2009 to control the IFRS Foundation, but its construction is awkward and raises concerns about its legitimacy and future effectiveness. For the foreseeable future we will have to rely on trial-and-error experimentation for international financial regulatory bodies, which in most cases cannot take existing national arrangements as a direct model.

Third, those global bodies that exist have yet to adapt to the ongoing rebalancing of the financial world. The IFRS Foundation is registered in America, its staff is in London, and it still caters largely to audiences in the US, European Union and Japan even as large emerging economies represent a rapidly increasing share of global finance. We don’t know whether or how China, India and others will take responsibility at a global level for transparency and integrity in financial reporting. But if efforts to empower them in formal global institutions are not accelerated, it is hard to see how such institutions can fulfill their potential.

 

Markets, Politics, and the Euro

This column was published by Bruegel and the Peterson Institute, as well as Vox, the Globe and Mail, De Tijd, Caixin, El Economista, La Tribune, Kathimerini, La Voce, Nikkei Veritas, Radikal, Dziennik Gazeta Prawna, RBC Daily, Publico, and NRC Handelsblad.

One of the most memorable quotes of the financial crisis was delivered by German Chancellor Angela Merkel in May 2010, when she declared that “in a way, it is a struggle between politics and the markets. We must re-establish the primacy of politics over the markets.” Though unusually stark, this formulation echoes a widespread perception in Europe. Disorderly market movements, such as the successive increases in Greece’s borrowing costs, are overwhelmingly blamed by political leaders on speculators, abetted by their dubious sidekicks, the credit rating agencies.

This depiction is both natural and misleading. It echoes centuries of uneasy relations between political leaders and financiers in both Europe and the United States, which oscillate between excessive proximity and excessive antagonism – sometimes both simultaneously. From Friar Savonarola’s anti-banker revolution in Florence in 1494 to Louis XIV’s crushing of France’s finance superintendent, Nicolas Fouquet, in 1661, to President Andrew Jackson’s undermining of the Second Bank of the United States in 1833, this is a running theme of Western history. At the same time, the anti-speculator rhetoric does not quite fit the facts of the euro crisis. Bond market investors are moved by fear more than greed. The problem now is that too few investors want to buy sovereign debt from the Eurozone periphery, and this “buyers’ strike” is driven by economic and policy uncertainty, rather than by market manipulation at the hands of unethical private-sector participants. This is not to say that the financial community is immune from conflicts of interest or reckless risk-taking, but only that these are not at the core of the current crisis episode.

But the Chancellor’s quip also mirrors specific tensions inherent in the institutions of today’s European Union. EU integration not only creates a supranational decision-making machinery that is structurally hobbled by its democratic deficit. It also disempowers national leaders from levers of action on an increasing range of issues, including most financial market policies that are now mainly governed by EU legislation, and whose supervision will increasingly move to the recently-created European Supervisory Authorities. As political scientist Ivan Krastev has put it, Europe increasingly has policies without politics at the EU level, and politics without policies at the national level. This mismatch creates an unstable, accident-prone environment.

The effects are highly visible in the euro crisis. The current context puts at the center of EU decision-making a country, Germany, whose fiscal soundness bond investors have never been seriously in doubt in living memory. Germany also no longer has a world-leading international financial center on its territory, as its financial groups’ wholesale market activities have largely migrated to London. And the German banking system is ridden with market distortions, idiosyncrasies and interdependencies with political structures at local level. As a consequence, most German policymakers lack financial crisis-management skills based on their own past experience. To the extent that they have a dialogue with the financial sector, their exchanges are predominantly with bankers rather than with bond investors; and these bankers have powerful specific interests of their own, which make their advice less than neutral.

In sum, German leaders’ domestic policy framework and their fellow citizens’ collective memories do not help them to meet the current challenges of managing the euro crisis. Observers of European negotiations may argue that this is partly mitigated by France’s input, to the extent that France’s finance ministry appears to have maintained more financial acumen, as far as sovereign debt issues are concerned at least. Perhaps this is due to relatively recent recollections of being put under heavy market pressure as during the 1992-93 European currency crisis, as well as the experience that comes from chairing the Paris Club that coordinates rich countries’ discussions of sovereign debt issues. But any such countervailing effect remains ostensibly insufficient to bridge the gap between the EU-wide issues that need resolution and the national political dynamics on which their resolution hinges. The recent weeks’ confusing public communication by European leaders on Greek debt restructuring, reprofiling, rollover, and/or private-sector participation has caused more damaging market volatility than any mischievous rating downgrade could possibly trigger.

For policy decisions to be rational, one would expect that European leaders acting at the EU level should take into consideration every stakeholder group that influences outcomes. But under the present institutions, the incentives are for them to focus on their home country’s constituencies to the exclusion of all others. As long as this is the case, it is natural for German leaders to view bond investors as akin to hostile foreign powers, rather than as a group that needs to be somehow embedded into the decision-making process. From this point of view, the euro crisis is as much institutional as it is financial or fiscal, and this makes its eventual resolution all the more difficult.

The Era of Corporate Split Personalities

This column was published by Bruegel and PIIE as well as Vox, the Globe and Mail (Canada), Financial Review (Australia), and translations in De Tijd (Belgium), La Tribune (France), Kathimerini (Greece), Nikkei Veritas (Japan), RBC Daily (Russia) and Radikal (Turkey).

The saga of securities exchanges consolidation is a vivid illustration of links between companies and nations in a state of flux. The likes of the New York Stock Exchange (NYSE) are national icons of capitalism. But they are also technology-enabled networks that connect market participants and seek a global reach to maximize economies of scale, just like Facebook or eBay. Thus, in the recent battle over NYSE Euronext Nasdaq envisaged moving one of its data centers from the UK to France to signal commitment to the place de Paris, but backed off under opposition from its London-based high-frequency-trading hedge-fund clients, illustrating the tension between symbol and business substance. New York Senator Charles Schumer said he would support Deutsche Börse’s bid only if the NYSE name came first in christening the merged entity. Canadian banks and Australian regulators thwarted bids on the Toronto and Sydney stock exchanges (by the London and Singapore Stock Exchanges respectively), seemingly on predominantly nationalist motives.

Debates on corporate nationality are nothing new. In 1967, George W. Ball, an American diplomat and financier, predicted that companies would increasingly escape their original home bias and acquire a stateless identity. In the early 1990s, a memorable controversy pitted Robert Reich, who argued that the US government’s attitudes to corporations should be nationality-blind, against Laura Tyson, who replied that "American ownership still matters" – both later became senior figures in the Clinton Administration.

The great globalization from the 1990s to 2007-08 gave credence to Ball’s vision. Most large European companies now have only a minority of their operations in their country of origin. Entire sectors, such as telecoms, utilities and banking, internationalized quickly following partial deregulation and privatization. After 2000, even R&D and headquarters functions, long seen as mostly tied to the home country, were gradually distributed around the world. Symbolic milestones included Wal-Mart’s relocation of its procurement function to Shenzhen in 2002, followed by IBM in 2006, the move of Halliburton’s CEO to Dubai in 2007, and that of HSBC’s CEO to Hong Kong in 2009. National labels were still routinely attached to companies, but by the late 2000s they looked increasingly like misnomers.

The past few years, however, have made things more complicated, for two main reasons. First is the breathtaking rise of large companies from emerging economies. These now feature as prominently as European ones in global league tables, compared with a ratio of one to ten a decade ago, and their share of the global total has surged from 10 to 25 per cent in the past five years (aggregate market values based on FT Global 500 rankings). They are often subject to hands-on state oversight, if not outright control, and generally carry a stronger sense of national identity than most Western peers, partly but not only because of their focus on high domestic growth at home. As there tends to be less geopolitical alignment with and among emerging countries than among advanced ones, their increased global presence also raises unprecedented national security concerns. Some analysts like Ian Bremmer from the Eurasia Group warn that emerging countries’ "state capitalism" threatens the core of the West’s business model and heralds an "end of the free market." Even with a less dramatic assessment, strong corporate national identities can no longer be seen as just a thing of the past.

The second factor is the recent financial crisis, and the unprecedented state intervention that resulted in the United States and Europe, confirming the dictum (diversely attributed to Charles Goodhart or Mervyn King) that "cross-border banks are international in life, but national in death." This at times extended to other industries, such as car companies in the United States or France. The internationalization of corporate identities suddenly looked like a mask that could easily fall. This apparent reversal chimes with uncertainties about the future of financial globalization, most acutely felt in the euro crisis but relayed by wider concerns about "financial repression" in massively indebted countries.

These conflicting trends are likely to result in policy volatility. On paper, most public policies do not discriminate according to corporate nationality, a principle on which the EU legal framework is particularly strict. But the attempt to impose "buy American" provisions in the 2009 US stimulus, or the recent debate in Italy on how to counter foreign takeovers, show that it cannot be taken for granted. More insidiously still, companies may find it increasingly difficult to give a clear vision of their national orientation, or lack thereof, to their own staff, clients, and other stakeholders. The personality split between national and global can easily lead to irresponsible behavior, as with those banks that practiced massive regulatory and tax arbitrage, and then hijacked home-country governments when the system came under threat. It has become received wisdom among foreign policy observers that the next decade will be one of divided sovereignties, unstable politics of interdependence, and conflicts between national constituencies and globalized elites. It would be naïve for companies to think they can easily escape these tensions.

Some Progress in the Banking Reform Debate

This column was published by Bruegel, PIIE, Vox, the Globe and Mail (Canada), as well as De Tijd (Belgium), La Tribune (France), Kathimerini (Greece), La Voce (Italy), and Radikal (Turkey). Click here for a PDF version.

The Independent Commission on Banking, set up last year by the newly elected UK government and chaired by Oxford economist John Vickers, published its much-awaited interim report on reform options for British banking on April 11. The policy proposals, to be confirmed in a final report in September, are a significant milestone not only for the UK, but beyond it for European and global banking reform.

Much of the comment has concentrated on whether the recommendations are too timid. The Vickers Commission wants to preserve UK competitiveness. It did not suggest radical moves such as, say, a break-up of UK-based banks or dramatically higher capital requirements. However, this does not impair the report’s value. The big banks’ political leverage is an undeniable impediment to financial reform. But equally important is the generally prevailing lack of analytical clarity on what should be done, independently of this constraint. On this count, the Vickers Commission makes two important contributions.

First, the report makes the clearest attempt to date to introduce some form of regulatory separation between domestic and international financial services. Wholesale and investment banking mostly consists of tradable services whose provision can easily be moved from one country to another while still serving the same clients, primarily large investors and large companies. This makes them fiendishly difficult to regulate in a single jurisdiction. By contrast, retail banking is essentially non-tradable: most households or small businesses will not go abroad to open a bank account or seek a loan. By differentiating between the two, the report introduces a credible framework for regulating retail activities in a UK-only context, while leaving internationally tradable financial services to the international negotiations, including ongoing ones at the Financial Stability Board, where they belong. No doubt setting a workable boundary between retail and wholesale operations within the same financial group will be a big practical challenge, not unlike the difficulties surrounding the US implementation of the “Volcker rule” prohibiting proprietary trading in deposit-taking institutions. But the report is probably right to see it as manageable.

The report avoids the flawed conventional wisdom that paints retail banking as a regulated “utility” function and investment banking as a deregulated “casino”: in reality, both segments are vulnerable to misguided risk-taking and relevant to systemic risk analysis (think Northern Rock for retail, and Lehman for wholesale). Both must be subject to adequate regulation. But corresponding regulatory frameworks can and should be differentiated. The core mistake of UK regulators before the crisis was to neglect this distinction: the decision to apply a supervisory “light touch” to the wholesale activities of the City of London was indefensibly extended to the oversight of large British retail banks, such as Northern Rock, Halifax Bank of Scotland and Royal Bank of Scotland, with disastrous results. By contrast, competing international financial centers such as Hong Kong, Singapore, and Switzerland (in spite of the problems at UBS) appear to have done a better job of applying conservative prudential norms to domestic retail banks, while making themselves attractive to internationally mobile wholesale financial intermediaries, at least in the decade preceding the crisis. The reason why this did not happen in London may be a form of financial mercantilism: the UK authorities liked the prospect of big domestic banks such as RBS becoming global champions, which encouraged complacency. In any case, the Vickers proposals could prove successful at correcting this imbalance.

The second important contribution is the way the report positions competition policy as a core component of banking reform – perhaps unsurprisingly, John Vickers being himself a former competition regulator. For a number of reasons, financial supervisors often have a bias towards concentrated financial systems and tend to downplay the potential role of competition in ensuring market discipline and financial stability. But more competition is an indispensable response to the challenge of too-big-to-fail financial firms. The interim report logically focuses its remarks in this area on the UK context and retail banking. An adequate cross-border competition policy framework, though politically difficult to create, would be equally vital to the proper regulation of wholesale and investment banking at international level.

The interim report is centered on the UK, but has broader relevance for the European Union. At first glance, the ring-fencing of UK retail operations appears to contradict the vision of a single EU market for financial services. But because the financial sector requires effective regulation to function well, this vision requires adequate institutions to be credible, i.e. centralized authorities for the supervision and, in case of failure, resolution of banks with a pan-European reach. As long as these do not exist – and the newly created European Banking Authority still falls well short – the single banking market must remain a fiction. By highlighting this contradiction, the Vickers Commission also provides a valuable public service to the EU.

Has Global Financial Reform Run Out of Steam?

This column was published by Bruegel and the Peterson Institute, as well as De Tijd (Belgium), the Globe and Mail (Canada), Caixin (China), El Economista (Spain), La Tribune (France), Kathimerini (Greece), Nikkei Veritas (Japan), RBC Daily (Russia), Radikal (Turkey), and Publico (Portugal).

Click here for a PDF version.

Just after the Lehman Brother collapse, financial regulatory reform was at the top of the global agenda, and it dominated the discussion at the first summit of G20 leaders in November 2008. By contrast, it was little more than an afterthought in the last G20 meeting in Paris last month. Many observers fret that the financial industry has reverted back to its pre-crisis business-as-usual mode. The financial regulatory agenda discourages most non-insiders because of its apparent intractable complexity, enhanced by barriers of jargon and multiple smokescreens put up by financial executives wary of public discussion, and public authorities eager to protect their turf.

Take a step back, though, and there is no reason to despair. The past two years have brought significant achievements. In the United States, the Dodd-Frank Act introduced numerous changes that are far from marginal, and most of its implementing rules are in the process of being completed. In the EU, crisis resolution and financial legislation have been generally slower, but the creation of the three European Supervisory Authorities, in effect the world’s first supranational financial supervisors, is a major breakthrough. Capital requirements are being substantially increased, with the Swiss authorities taking particular leadership. Authorities are also improving their ability to understand and monitor financial systems, including through the collection of relevant data.

Even so, the measures adopted so far stop short of an adequate global policy response to the unprecedented shock of the crisis and the chain reactions it triggered. Three monumental challenges require sustained and simultaneous attention.

The first one can be labeled “bad big banks,” those whose bankruptcy would be so disruptive that governments prefer to bail them out in a crisis. This problem of so-called too-big-to-fail financial institutions tends to be more actively discussed in the US, but is actually more acute in Europe, as national banking systems are far more concentrated and no consistent bank resolution framework exists at the European Union (EU) level. The United Kingdom has created an independent commission to address it, and the Financial Stability Board carries the discussion at the global level, but no obvious solution is in sight yet.

The second challenge is to avoid unintended consequences of reform in terms of financial fragmentation. Even though the economic impact of financial openness is multifaceted and difficult to quantify, a reversal of the pre-crisis momentum towards financial integration would certainly harm global growth prospects, and should be avoided. But this will require more global consistency in the regulation of key tangible and intangible infrastructures of capital markets. The unfinished saga of international accounting standards harmonization illustrates how difficult such an effort can be.

Third, the re-regulation of financial systems must be achieved without impairing their ability to foster growth. Contrary to much of the financial industry’s lobbying discourse, this aspect is not primarily about capital requirements, but rather about competition and innovation to deliver better and economically more productive financial services. In emerging markets, the overall provision of credit is generally insufficient and inefficient. In more advanced economies, credit is typically not directed to the borrowers that could make the best use of it, especially high-growth companies with no physical collateral to pledge. Financial stability concerns must be addressed without repressing useful financial development.

On each of these three dimensions, policymaking is hobbled by major analytical uncertainties, compounded by a surprising scarcity of relevant data and academic research. All three involve major issues of competition policy, which has generally been underdeveloped in finance compared to other industries. None of them can be expected to be comprehensively addressed any time soon.

Moreover, financial reform will be shaped by an increasingly unpredictable interaction with national politics. In many countries, public opinion and elected officials alike want the financial sector to pay a price for the crisis, which explains why so much of the debate is dominated by themes whose relevance is at best limited from a strictly financial stability perspective but which resonate with broader perceptions of unfairness, such as traders’ bonuses, naked short selling, rating agencies’ conflicts of interest, or the possibility of taxing financial transactions. An additional difficulty is the interplay between different geographical levels of reform. Of the previously mentioned challenges, the first involves a mix of local and global aspects, the second is mostly global, and the third mostly local. This set of issues creates multiple incentives for both public authorities and financial firms to shift responsibility and arbitrage the different levels, making progress considerably more difficult.

Financial reform is a never-ending effort, and the cycle that started with the crisis is far from completed. In furthering the cycle toward progress, policymakers should aim at maximizing the chances of a financial system that combines the desired attributes of stability, openness, efficiency, and fairness. This is likely to require even more policy vision and creativity than have been displayed so far.

Will the City of London Accept EU Financial Supervision?

This column was published by Bruegel and PIIE as well as by De Tijd (Belgium), The Globe and Mail (Canada), Caixin (China), FT Deutschland (Germany), El Economista (Spain), La Tribune (France), Kathimerini (Greece), La Voce (Italy), Nikkei Veritas (Japan), NRC Handelsblad (Netherlands), RBC Daily (Russia), and Radikal (Turkey). Click here to download a PDF version.

The City of London, Europe’s main financial hub, has benefited throughout most of the late 1990s and the 2000s from a peculiar combination of factors. It gained hugely from European financial integration, spurred by the European Union’s efforts to create a single market for financial services and by a worldwide trend towards removing cross-border financial barriers. At the same time, the entire UK financial system, including the City, went largely unregulated under the “light-touch” oversight philosophy then adopted by the Financial Services Authority (FSA), the UK financial supervisor. Tax conditions were similarly lenient. The UK government and public opinion did not object, as they largely saw the City’s prosperity as a boon for the entire country. And EU authorities in Brussels were generally happy to go along the deregulatory agenda to tear down national barriers within the Union.

This combination has been swept away by the financial crisis. The UK political consensus shifted sharply towards blaming bankers for the current economic hardship. The heads of the FSA and of the Bank of England have become leading voices in global calls to restrict the business models of financial firms, and the Independent Commission on Banking, set up by the Cameron government, may propose measures along such lines in its final report later this year. Meanwhile, a ruthless drive towards fiscal consolidation increases pressure to turn the tax screws on the City and all the wealthy individuals that surround it.

Simultaneously the UK is impacted by changes across the Channel. The EU has entered its own cycle of re-regulation. Three new European Supervisory Authorities (ESAs) have started operations on January 1, and are likely to affect London’s regulatory environment more directly than anything coming from the Continent before the crisis – including the European Securities and Markets Authority (ESMA) in Paris and the European Banking Authority (EBA) in London. They are tasked with creating a “single rulebook” that would harmonize financial rules further than the existing European directives. They would also directly supervise some market participants, such as rating agencies in the case of ESMA.

Britain endorsed this reform at a crucial summit in June 2009, when memories of the Icelandic crisis were fresh and there was a pervasive fear of its being left isolated in the cold. But now many in London seem to have second thoughts. An interesting parallel may emerge. In the early 1990s, Germany agreed to delegate its monetary policy as the price for the creation of the euro and the corresponding strengthening of the EU single market. But the current crisis has forced the European Central Bank, despite its Frankfurt location, to cease acting as a Bundesbank writ large. The reactions in Germany, including the recent saga of Axel Weber’s resignation, have illustrated how sensitive the loss of monetary sovereignty remains there. Similarly, the UK accepted the ESAs for the sake of EU financial integration, but may not be fully prepared for the consequences.

The City’s worst fear is to see its gatekeeper position bypassed in what remains the world’s most important transcontinental financial relationship, between the US and Europe. From this standpoint, a fight over the ESAs could prove a much bigger threat than, say, the merger between Deutsche Börse and NYSE Euronext. At this point the new agencies are small and fledgling. Their governance framework, which gives equal weight to all EU members, will probably lead to some dysfunction. The current stress-test process may dent the EBA’s credibility early on. But the ESAs are almost sure to grow over time. Large US financial firms will back their efforts to fight financial protectionism on the continent. The inevitable frictions with London will mean much more than ordinary turf wars.

Of course, much larger challenges loom ahead for London’s EU policy. In the euro crisis, the UK currently behaves – unlike, say, Sweden or Poland – as if it could remain unaffected by the consequences of new economic governance arrangements. This is implausible. For better or worse, the UK will not stay out of what is likely to become a major overhaul of the EU institutions in which the single currency is embedded. But the corresponding developments may take some time to unfold. For any British politician facing euroskeptical electors, hiding one’s head in the sand is the easiest approach in the short term.

In the meantime, controversies over the ESAs’ powers will remain a focal point of the UK’s relationship with its European neighborhood. The pre-crisis conditions, in which the City developed pan-European activity in the absence of pan-European supervision, were unsustainable and cannot be expected to return. But many City players are still unwilling to recognize the new state of affairs. The near-total absence of debate about the EU in Britain these days should be a concern not only to Brussels, but to London as well.

Europe Needs Consistency in Welcoming Foreign Investors

This column was published by Vox, Bruegel and PIIE, as well as De Tijd (Belgium), Caixin (China), Expansion (Spain), La Tribune (France), FT Deutschland (Germany), Kathimerini (Greece), La Voce (Italy), RBC Daily (Russia) and Radikal (Turkey).

One of the biggest questions of the coming decade is whether global economic and financial integration will continue or go into reverse as the consequences of the financial crisis unfold. Much public discussion focuses on trade and capital controls, but the outlook for foreign direct investment, including cross-border corporate acquisitions, is just as important. In this context a recent call by Antonio Tajani, the European commissioner for industry in Brussels, for the establishment of "an authority tasked with examining foreign investments in Europe" is an apparent departure from the commission’s traditional emphasis on openness to international investment and the dismantling of existing barriers.

Concerns about the implications of foreign acquisitions are certainly not all new. In America, the Committee of Foreign Investment in the US (CFIUS) was created in 1988 with an extensive mandate to review such transactions for their possible impact on national security. In the European Union, legal regimes are very diverse. The British government can veto virtually any deal but almost never does. France has stringent controls in the defense and security sectors but none in other industries. Germany in 2008 introduced a CFIUS-like framework. The Netherlands has no such process at all. At the EU level, the legal framework allows investment reviews to protect national security, but the European Commission also strives to prevent member states from blocking acquisitions for protectionist reasons, as in the case of Mittal Steel’s acquisition of Arcelor in 2006.

What is new, and has been accelerated by the crisis, is that such foreign investment will increasingly come from countries such as China and oil-rich economies, with which Europe’s geopolitical interests are not self-evidently aligned and which now hold much of the world’s current account surpluses. The consequence is a probable rise in legitimate security concerns. For example, one can understand why Central European countries would be cautious about Russian investment in their oil and gas distribution infrastructure. The European Union thus needs to find a new balance between two ill-advised extremes: absolute economic openness in denial of the reality of some risks, or a siege mentality that implausibly considers any acquisition by a non-Western company a threat to national security, often in fact as an excuse to shelter vested domestic interests to no advantage for the general public.

The reassuring truth is that the vast majority of companies are not indispensable from a strategic standpoint, and their acquisition by foreigners should not be opposed, even assuming the acquirer has politically hostile intent. Blocking such acquisitions is damaging both economically and politically, as it prevents access to useful capital sources, and needlessly curtails the creation of links of economic interdependence that may reduce the probability of future conflict. Many acquisitions by Chinese firms, such as that of IBM’s personal computer division by Lenovo in 2005 or of Volvo Cars by Geely in 2010, have raised some controversy but cannot be reasonably described as dangerous. The equity stakes taken in major European and American banks by various sovereign wealth funds in 2007–08 similarly caused concern, but have eventually proved a shockingly good bargain for the West.

What is needed is a clear and consistent legal framework that allows the protection of those few companies that are genuinely strategic because of their unique technological capacity, control of critical networks or infrastructures (for example in telecommunications or the internet), or other security considerations, without the process being exploited to block harmless transactions. This would help underpin both a stable and predictable investment environment and the completion of the EU single market, two key conditions for future EU growth and job creation. The catch is to minimize the friction that a review process inevitably creates, and this aim is made more difficult by the sheer diversity of attitudes to foreign investment throughout Europe. For example, French governments are generally obsessed by the defense of "national champions." By contrast virtually nobody in Denmark objected as one of the country’s largest companies, Danisco, was just acquired by a US chemical group. To smooth the impact of such differences, the process and criteria for the review of foreign acquisitions should be defined by EU legislation, rather than national initiatives as is currently the case. Implementation should remain the prerogative of individual member states, which remain at this point the only ones with the capacity to conduct credible security assessments, but with adequate coordination and monitoring at EU level.

Commissioner Tajani is right to express the need for vigilance and new thinking on foreign investment. But the scope and purpose of a "European CFIUS" should be rigorously defined, or it will risk becoming self-defeating. Reassuring Europe’s citizens—without forgoing the huge potential economic benefits of future investment from emerging economies—involves delicate trade-offs. The sooner the European Union brings a coherent response to this challenge, the better.

EU Bank Stress Tests: Third Time Lucky?

This column was published by Bruegel and PIIE as well as Vox, De Tijd (Belgium), Caixin (China), La Tribune (France), FT Deutschland (Germany), La Voce (Italy), Nikkei Veritas (Japan), Kathimerini (Greece), Publico (Portugal), and RBC Daily (Russia).

Systemic bank crises are always difficult to resolve. In Europe, the difficulty is compounded by cross-border interdependencies. Policy paralysis throughout 2009 and 2010 has resulted in a banking system precariousness that puts a serious drag on the old continent’s recovery. An even more dramatic consequence is to force the euro zone to systematically choose bail-outs over restructurings, whenever one of its members faces macroeconomic difficulties.

In April, there was a strong case for immediate sovereign debt restructuring rather than saddling Greece with unsustainable debt levels. But the resulting shockwaves might have toppled fragile Western European banks and gone out of control. Greece’s bail-out was chosen as the least bad option. Similarly, many voices in November called for imposing losses on Irish banks’ senior debt. But this might have impaired the ability to borrow for European banks whose balance-sheet strength is questionable, possibly causing a panic. Thus, bailing out senior bank debt was a big part of the Irish assistance package. Those decisions may have been inevitable in their respective circumstances. But their outcome is gross unfairness, as well as the precipitation of a debate on eurozone solidarity and fiscal federalism for which the European Union may not be politically ready. The major policy failure is the absence of firm action in calmer times to make the system more resilient.

Systemic banking crises are almost never self-correcting: even with low central-bank rates, retained earnings cannot plug all holes after a major shock. What is needed is a government-led process of ruthless triage, recapitalization, and restructuring of the system’s most important banks. This approach was pursued by the US in 1989-90 following the savings-and-loan crisis, Sweden in 1992-93, Japan in 2002-03, and again the US with its 2009 stress tests. The EU has not yet done anything comparable. A first round of Europe-wide stress tests in September 2009 went virtually unnoticed as the results were not made public. A much-hyped second round included public disclosures in July 2010, but ultimately failed to restore confidence. Now a third round is forthcoming in February 2011. European Commissioner Olli Rehn announced it will be “even more rigorous and even more comprehensive.” But the design flaws of the previous attempts must first be fixed for this to succeed. History suggests three components are essential.

First, triage: a public assessment of the real capital position of all important institutions in the system, on the basis of an intrusive, uniformly stringent review of assets and liabilities, because financial statements are unreliable in crisis times. Large cross-border financial linkages mean it must be Europe-wide. Last July, triage failed when each member state implemented the commonly defined methodology its own way. As national authorities cannot be trusted to place the EU common interest before their own, a central body must be empowered to double-check national assessments and make sure they are genuinely comparable.

Second, recapitalization: banks that have been found too weak must raise new capital. As last time, the next stress tests’s public results are likely to underestimate capital gaps, because EU policymakers cannot explicitly include sovereign default in a stress scenario for fear of this assumption becoming self-fulfilling. To compensate for this unavoidable flaw, policymakers should toughen other stress assumptions and impose a high threshold of a strict measure of capital, rather than the loosely defined “Tier-1” tested last July. They must add extensive disclosure of each institution’s sovereign risk exposure, with better explanation than in July of how to reconcile such numbers with otherwise published financial statements and with the Bank for International Settlements’ statistics.

Third, restructuring. Unlike in the US in 2009, some banks may fail to raise the needed capital. Such banks must be either forcibly sold, or orderly dismantled. This process must also be steered centrally to ensure fairness and efficiency. Potential difficulties abound. Banks that are widely seen as “national champions” may be acquired by foreign competitors. Jobs may be destroyed, in the banks and also in the non-financial companies they support. National authorities may be pilloried for their past failures to act and their links to failed financial elites. New legislation may be needed, with all the related uncertainties. Specifically, the newly created European Banking Authority may not have what it takes for such a tough job, and it might be preferable to create a temporary body specifically dedicated to crisis resolution. Public funds may have to be committed in significant amounts, to meet legal obligations and avoid dangerous contagion. Negotiations may be needed on sharing the burden among countries, and on possible cross-border assistance as in the Irish case.

All this can be very disruptive. But the alternative is a policy process held hostage by a sick banking system, and ever larger commitments of taxpayers’ money that may threaten the very political fabric of the EU.

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Time for Realism in Global Financial Regulation

This column was published by Bruegel, the Peterson Institute and Vox, as well as De Tijd (Belgium), Caixin (China), La Tribune (France), FT Deutschland (Germany), Kathimerini (Greece), Népszabadsag (Hungary), La Voce (Italy) and Radikal (Turkey).

While the noisy arguments about macroeconomic imbalances and exchange rates dominated the publicity at the recent G20 summit, the participants in Seoul also marked an important milestone for financial regulation. They symbolically closed a cycle of intense global discussions that started two years earlier with the first G20 summit in Washington. The most prominent item was the endorsement of the Basel 3 accord on bank capital and liquidity, which was completed in September. That agreement significantly tightens earlier requirements and provides a convenient opportunity for world leaders to declare “mission accomplished” and move on to other topics.

In many respects, the scope for global financial reform is becoming narrower. In the US, the adoption of the Dodd-Frank Act in July signaled the end of major legislative activity in this field. Most emerging countries are neither willing nor ready to take the baton of global leadership. Formally, several financial regulatory items remain on the agenda. But it was significant that French president Nicolas Sarkozy, who just took over as president of the G20 process, did not mention any of them, apart from commodities markets, in an August speech outlining his priorities. This stands in striking contrast with two years ago, when financial reform dominated the G20 agenda and many leaders, particularly in Europe, enthused about worldwide harmonization of financial rules.

Global finance cannot realistically be submitted to a single rulebook. The Basel accord itself sets a minimum standard, not an optimum one. Several jurisdictions, from Switzerland to China, are considering higher requirements. Processes for preventing and managing large banking failures remain heterogeneous, as the Financial Stability Board (FSB), which coordinates the world’s financial regulators, acknowledged in a report to the Seoul summit. Global accounting standards convergence is likely to be much more protracted and diverse than generally anticipated before the crisis. All this is not necessarily disastrous, even though it means that some competitive distortions and regulatory arbitrage will remain endemic. Not all regulation needs to be global, as many financial activities, particularly in retail banking, are mainly developed within national borders, or in the case of the EU, regional ones. In this somewhat constrained environment, the next phase of global financial regulatory discussions will be shaped by three broad requirements.

First, the system of global institutions needs to be strengthened and adapted. As in individual countries, the technical nature of financial regulation justifies its delegation to specialized expert bodies. But these can be effective only if their authority is accepted by their many stakeholders. As the financial world becomes more multi-polar, emerging economies must be better empowered in their governance. While public attention has focused on such reform at the International Monetary Fund (IMF), other important institutions such as the Bank for International Settlements (BIS) and International Accounting Standards Board (IASB) are even more behind the curve in giving adequate representation to China, India, Brazil and the like. Several actors also suffer from insufficient transparency or accountability. Thus, the IASB needs to regain the trust of the community of investors, whose concerns it has often appeared to neglect in recent years; the Basel Committee on Banking Supervision needs to open itself to more external scrutiny; and the FSB needs to clarify its role and status, including its relationship with the BIS, which at this point remains ambiguous.

Second, efforts are needed to sustain the worldwide integration of capital markets, a process that brings significant economic benefits to savers and borrowers alike. The ongoing re-regulation of key transactional and informational infrastructure, including trading and clearing platforms, rating agencies, and audit firms, was made necessary by the crisis but also carries risks of fragmentation. These risks are likely to become more apparent with time. The aim of cross-border market inter-operability suggests a higher degree of global regulatory and supervisory integration for these market players than, say, for retail banks. In this spirit, the FSB is right to suggest a specific regulatory regime for the most globally active investment banks, which play a crucial role in cross-border capital market intermediation.

Third, the capacity for public monitoring of the global financial system needs dramatic improvement. This is necessary both to keep track of vulnerabilities in the system, and to verify that global commitments are properly implemented. Strikingly, no appropriate process exists to guarantee that global standards on accounting or bank capital are consistently enforced by those countries committed to them. The IMF, BIS, and FSB all play a role but many loopholes remain, partly because of lack of adequate public disclosures by individual firms and governments.

The harsh realities of the post-crisis world leave little space for airy rhetoric about radical reinvention of the financial system. The above listed requirements may be seen as defining a fairly narrow agenda. Even so, G20 leaders will deserve much praise if they succeed in meeting them in the next few years.

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The European Union Has Not Yet Solved Its Banking Problem

This column was published in English by Bruegel and the Peterson Institute, as well as Caixin, Kathimerini, FT Deutschland, La Tribune, La Voce, Nikkei Veritas, Publico, Radikal, and Vox.

The chaos that followed Lehman Brothers’ collapse two years ago hit financial systems in the US and Europe with similar violence. But the consequences were not symmetrical. Several large financial institutions disappeared in the US, partly because of stringent disclosure requirements, leading to immediate restructuring of the financial landscape. In the spring of 2009, public “stress tests” forced weaker banks to recapitalize, and soon the institutions at the core of the US financial system started regaining investors’ confidence, in spite of much pain still to come among smaller local banks. The US faces major economic and social challenges, but its financial crisis appears to have essentially ended more than a year ago.

By contrast, the European Union collectively met the challenge with a succession of false hopes. It first seemed European banks could ride the trust wave initiated by the US stress tests. Share prices went up, and some banks took advantage to raise significant amounts of equity – however, these were typically the stronger ones, not the damaged institutions that most needed new capital. European supervisors conducted stress tests of their own in September 2009, but these had little impact as almost none of their results were made public.

The lingering fragility of Europe’s banks became impossible to hide when the Greek fiscal crisis unfolded in early 2010. Policymakers eventually realized that their banking systems were too weak to withstand the impact of a Greek default. This is now widely acknowledged to have been a major driver of the decision to bail out the Greek state and then to establish a large funding facility for all euro area countries.

In a fit of decisiveness, Europe’s leaders agreed in June 2010 to disclose the results of the next round of stress tests. The data published on July 23 represented progress of sorts: the small London-based staff that coordinated the process managed to persuade almost all 91 banks tested to publish details of their sovereign risk exposure, and Spain voluntarily provided additional transparency. Once again, at first it seemed to work, and initial market reaction was cautiously positive. But serious flaws became quickly apparent. The numbers, left at the discretion of national authorities that could be tempted to sugarcoat the situation, were not double-checked or audited. The chosen yardstick of capital strength, “tier-one” capital, was questionable. Some underlying profit forecasts were probably overoptimistic. Apart from Spain, specific exposures to risks other than sovereign went unreported. The stress tests’ bottom line, that 3.5 billion euros would be enough to adequately recapitalize the system, was not plausible.

Later developments further undermined confidence. On September 7, the Wall Street Journal pointed to serious inconsistencies between the stress test results and sovereign risk exposures separately published by the Bank for International Settlements in Basel, based on data provided by the same national authorities that conducted the tests. Policymakers claimed that there were technical reasons for the discrepancies but failed to explain them in a manner that would reassure investors. A few weeks later, the multi-billion-euro public bail-out of Allied Irish Banks, which had successfully passed the stress test in July, made the whole process a laughing matter.

Most importantly, the stress tests have failed to trigger the needed recapitalization and restructuring of Europe’s problem banks. Just as in 2009, those banks that recently raised fresh equity, such as Deutsche Bank or Standard Chartered, were among the stronger rather than the weaker ones. In Germany, some state-controlled Landesbanken are universally considered unviable, but their restructuring advances at a glacial pace. Jürgen Stark, an executive board member of the European Central Bank, was recently reported to have claimed that the much larger German savings banks sector was itself generally undercapitalized. In Spain, the central bank has engineered mergers among savings banks but it is not yet clear that the resulting entities are strong enough. In several countries, the authorities’ aim still appears to be to hide the bad news rather than to fix the problems.

The probable consequence of this paralysis is a substantial drag on growth, as in Japan’s “lost decade.” Moreover, in the event of further turmoil on the sovereign front, the EU could find itself confronted with the exact same banking fragility that so severely restricted policy options this spring. What is needed remains unchanged: a triage process that credibly identifies capital gaps among Europe’s most important financial institutions, and leads to adequate recapitalization and restructuring. The good news is that the creation of a European Banking Authority, due in January 2011, in principle provides a possible basis for a centralized EU-wide assessment process. But it is not enough. A solution to the EU’s banking problem would require a level of awareness and political commitment that has been sadly absent so far, especially in the largest euro area countries.

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Financial Newcomers Will Have Global Impact

This column was published by Bruegel and PIIE, as well as Caixin (in Chinese), De Tijd (in Flemish), La Tribune (in French), FT Deutschland (in German), Kathimerini (in Greek), La Voce (in Italian), NRC Handelsblad (in Dutch), and Referans (in Turkish).

The rise of emerging economies has long been recognized as a defining feature of our times when it comes to trade, manufacturing, and an increasing range of services businesses. Until recently, however, there was a widespread sentiment that international finance was somehow escaping the trend. A dominant share of financial assets, financial companies, financial centers and financial regulatory power remained concentrated in the North Atlantic. Even as the world’s economic center of gravity was moving away, the financial one seemed firmly anchored in the West. But this feeling was an illusion that is rapidly dissipating.

In this shift the crisis has had a powerful accelerating effect, even though cracks in the West’s financial dominance had appeared before its start. Since early 2009, financial institutions from emerging countries consistently weigh more than those from either the US or Europe among the global top 100 by market capitalization, and Chinese banks have dominated global rankings since late 2007. Their relative position has strengthened while that of Western peers was undermined by market turmoil and deleveraging. Non-Western financial centers such as Hong Kong and Singapore are similarly climbing up the league tables. Sovereign wealth funds make their impact felt on global markets. Increasingly, emerging economies produce not only huge savings but also investable financial assets.

It is not just the numbers. At a more intangible level, the crisis has hit the pre-eminence of Western models. Not only have icons such as Merrill Lynch or Citi bitten the dust. The world’s most influential financial bodies, such as the US Federal Reserve and Securities and Exchange Commission or the UK Financial Services Authority, have had to acknowledge major misjudgments. By contrast, the Chinese, Indian or Brazilian supervisors, long derided as underdeveloped, have successfully prevented domestic financial turbulence and even applied “macroprudential” instruments (such as limits to loan-to-value ratios) that were ignored in the West. Emerging economies feel no responsibility for the crisis, even as they suffered from it. The West’s moral authority is at a correspondingly low point.

These shifts will inevitably have an impact on financial regulatory policy. The Basel 3 capital accord, announced this month, may be the last prominent piece of international financial rulemaking whose negotiation took place mainly among (if not only) developed countries. Last year, several financial bodies, including the Basel Committee and the Financial Stability Board, enlarged their membership to include the largest emerging nations. A parallel transformation of their working processes is only a matter of time.

The “de-Westernization” of global finance is not a mechanical or uniform process. Some emerging stock valuations, especially of state-owned banks, may be inflated. Certain rising players, including China, are reluctant to engage in some global debates. Many have only a limited number of skilled officials, which limits their ability for global influence. Their levels of financial development often remain low. Some of them may face major financial instability in the years ahead. Even their strongest financial firms have capacity limits, and may focus on the rapidly-expanding domestic market for some time rather than going global. But none of these factors is likely to reverse the general trend.

This transformation is obvious to many, but not to all. Some Western players, perhaps especially in Europe, are still in denial. Conversely, some emerging actors are quick to see the opportunities, but not the new responsibilities it creates for them. The rapidity of the changes generates anxiety and mistrust. As they re-regulate their financial system as a consequence of the crisis, developed countries fear the newcomers will practice unfair competition based on less demanding rules, or “regulatory dumping.” Symmetrically, some in emerging countries suspect that Western-driven re-regulation might be a way for the more established financial centers and firms to freeze the competitive playing field and prevent the rise of new entrants. Some of the incumbents may shift quickly from a patronizing posture to seeking refuge in financial protectionism. Overcoming these attitudes will require a lot of effort and quick learning from all sides.

The existence of systemic risk means that international competitive dynamics are different in finance from what they are in other activities, as regulation plays a paramount role. But as in other industries, the rebalancing of the global landscape with the rise of emerging players will not condemn Westerners to irrelevance. Many established financial institutions can build on their skills base, organizational capacity and innovation track record to maintain a comparative advantage and develop successfully on a global scale. What is needed is a candid acknowledgement among policymakers of the irreversible alteration of global financial geography. A highly visible symbolic change, such as moving the headquarters of one of Bretton Woods institutions to Asia, may help accelerate the evolution of collective representations. Conversely, those incumbents who rely on what they may see as rights of inheritance are sure to become the next losers of the global financial game.

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Europe's Stress Tests: Only One Step Toward Banking Repair

This article was published by eurointelligence as well as on the websites of Bruegel and PIIE. Translations were published by La Repubblica (Italy), Kathimerini (Greece), Caixin (China), FT Deutschland (Germany) and La Tribune (France).

The European banking “stress test” results announced on July 23 combined encouraging features with disappointing ones, which explains the paradoxical mix of reactions: markets rose, even as many analysts denounced what they saw as a sham. Their publication is unlikely to single-handedly bring the interbank market back to soundness. But it may prove an important step, depending on what policy initiatives come next.

On the plus side, there is unprecedented data on sovereign risk exposures, individually and consistently reported by all tested banks except one Greek and six German institutions. The wealth of information adequately addresses investors’ biggest current concern. After having repeatedly called a sovereign default out of question, the authorities could not include one in their stress scenarios, but they have done the next best thing, as analysts can now do it in their place. Further good news is that, on first analysis, a Greek default would appear potentially manageable.

Also positive is that, for once, peer pressure has brought results. Spain effectively imposed transparency to reluctant fellow continental countries (the UK, Ireland and the Nordics were already ahead), apparently with substantial behind-the-scenes help from the European Central Bank, International Monetary Fund, and US Treasury. The whole process illustrates that some EU-wide systemic financial problems can only be addressed through EU-wide policy initiatives, a useful lesson for the future. Meanwhile, the Committee of European Banking Supervisors (CEBS) has proven its value added by steering the exercise within the imposed deadlines.

Sadly, bad news abounds too. The most obvious is the conclusion that only €3.5bn of additional equity would be sufficient to make Europe’s banking system sound again. Few will find this credible, even allowing for the improved macroeconomic environment since the US stress tests of May 2009 had identified a $75bn capital shortfall. The tests’ focus on Tier 1 capital, a questionable measure of strength, is also regrettable, and the argument that other ratios are insufficiently harmonized fails to convince. Supervisors should have tested core tier 1 under a more severe adverse scenario, to compensate for their assumption of no sovereign default. Furthermore, they should have provided more disaggregated information by asset class to shed light on risks other than sovereign. On these, the EU disclosure format is much less comprehensive than those used by the US last year, or by Spain on its own initiative.

The poor communication ahead of the disclosures is another negative. On 17 June, EU leaders rushed to the decision to publish test results without realizing that their end-July deadline was far too short given the complexity and diplomatic haggling involved. It would have been far better to set the deadline in September, and leave more time for coordination and preparation. Even after the deadline of July 23, 4pm GMT, CEBS could not make it clear that exposure to sovereign risk would be disclosed on a country-by-country basis, leading to unnecessarily negative first reports. This stands in stark contrast with the masterful channeling of market expectations by US authorities throughout late April and early May 2009.

Of perhaps more lasting concern is the absence of a clear commitment from the EU authorities to the data disclosed last Friday. Both CEBS and the ECB made it clear that the capital assessment belonged to individual national authorities. Respect for member states’ sovereignty is understandable, but it means that nobody actually stands for the full set of disclosed numbers.

Last but not least, Germany appears still in denial about its domestic banking crisis. Beyond the legal arguments, German authorities dragged their feet, resisted the call for disclosure, and eventually failed to deliver the full numbers provided by almost all others. Behind the bureaucratic inertia lies a deeper political quandary: German leaders have made too many proclamations of Teutonic virtue against shadowy Anglo-Saxon speculators and profligate Southerners to recognize that there is rot in the middle of their very own banking system, which incidentally happens to be uniquely interdependent with local party elites, left and right. As long as Chancellor Angela Merkel and her team do not amend this stance, Europe is unlikely to get rid of its lingering financial fragility.

Ultimately, history’s verdict will depend on what happens now. First, Europe’s banks still need to raise more capital, and authorities must find a way to encourage this even after having ostensibly given them a clean bill of health. The trigger for the publication was the eurozone sovereign crisis, and the aim remains to make the banking sector resilient enough to sustain a possible future public debt restructuring. Second, fragile eurozone countries must continue their efforts towards sustainable fiscal consolidation, so that if one eventually defaults, others can resist the contagion pressure. Third, it is crucial for the EU to replace the fledgling CEBS and similar committees on insurance and securities with more authoritative European Supervisory Authorities, as recommended last year by the Larosière Report. It would be disastrous if the ongoing discussions ended in stalemate. But, should adequate progress be made along these three dimensions, then the publication of stress test results may be judged to have been a success after all.

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Transparency is the key to stress-test success

This column was first published by eurointelligence, as well as translations in La Tribune (France), FT Deutschland (Germany), Boersen (Denmark), La Repubblica (Italy), Kathimerini (Greece), and Caixin (China).

By agreeing to publish stress-test results for the EU’s most prominent banks, European leaders have made a bold step that is both indispensable and ridden with execution risks. Even as the announced date of publication, 23 July, is approaching fast, several key aspects remain under discussion. For this unprecedented effort to be successful, a high level of transparency will be needed in order to force divergent national players into a consistent and credible process.

In the past, the key to resolving most systemic financial crises has been a system-wide “triage” of the most important financial firms, steered by public authorities and allowing market participants to identify which banks are strong enough to be relied upon – as in the US in 1989-90, Sweden in 1992-93, or Japan in 2002-03. The same arguably occurred in the US last year, when the publication of detailed stress-test results for 19 large financial firms helped the gradual return of trust.

The EU has long stayed deadlocked in refusal to address this need. Stress tests were conducted in September 2009, but with no quantitative data published the market effect was minimal. Only last month were EU leaders eventually prompted to action by a combination of market pressure, encouragement from the US and other outside parties, and Spanish leadership. The number of banks tested, initially set at 25, has been expanded to 91 banks from 20 countries, a welcome change given the large role banks play in financing the economy in Europe, which means that more must be assessed than was the case in America.

But many doubts linger, primarily because of the large number of players involved. In the US, only the Federal Reserve and two other federal regulators were at work under the mandate given by the Treasury Department. In Europe, each national authority has powerful incentives to protect “its” banks and sugar-coat the results, including reluctance to acknowledge past supervisory failures, capture by local interests, and economic nationalism.

This obstacle could have been overcome by centralizing the triage process and entrusting it to a supranational body with a temporary mandate, as Adam Posen, now of the Bank of England’s Monetary Policy Committee, and I had suggested in a paper published a year ago. However, this is not going to happen, at least not in this round. Thus, a disciplining device is needed to match national authorities’ impulses not to cooperate.

The best way to reach this aim would be a high level of quantitative detail in the disclosure of results. This would compel regulators to base their conclusions on testable facts, and would go a long way towards preventing them from manipulating the numbers. After a string of supervisory failures, the credibility of many of the authorities that will carry out the stress tests is at a low point. Transparency is the key if they are to convince investors and the public that their pronouncements can be relied upon.

Specifically, the results must allow external observers to understand the banks’ exposures to several different and relevant risk factors. In the US disclosures of May 2009, 17 quantitative parameters were provided for each of the stress-tested banks, including individual exposures along 8 different asset categories under a single, uniform template. At least as many line items should be provided in Europe, also under a single template that must apply uniformly in all participating countries.

As regards eurozone sovereign risk, which is central to current market concerns, it is understandable that authorities are uncomfortable with including national defaults in their stress scenario while they otherwise insist that none is going to happen. But rather than factoring in implausibly low discounts on troubled countries’ sovereign debt, as recent press reports suggest is their intention, they should disclose each bank’s exposure to each country risk, with due measures to ensure this does not result in instability in the period leading to publication. On this basis, market participants could use the data to test their own scenarios, and identify which banks are strong enough to withstand them.

The European decision to publish stress-test results is momentous. If its outcome is to be credible, it will necessarily reveal significant capital shortfalls in a number of banks. Otherwise, the gap with market perceptions, anecdotal evidence, and past top-down assessments by the International Monetary Fund and European Central Bank will be impossible to reconcile, and will increase market distrust and volatility. Not all the subsequent funding needs to come from the public purse. Last year, those US banks whose stress test indicated insufficient capital were able to convince market investors to plug the gap. Many European banks may succeed likewise. But if some fail, government intervention and restructuring will be indispensible, which is sure to prove politically controversial and financially painful.

These risks can only be managed if the stress-testing process is seen throughout the EU as comprehensive and fair. To ensure such fairness, a high level of detail in the disclosure of results, forcing national regulators to justify their eventual assessment of capital positions on the basis of facts not opinion, is a necessary condition.

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The G20 Needs to Refocus its Financial Regulatory Agenda

This column was published by Bruegel and PIIE as well as La Tribune, La Voce, Referans, Forbes Russia, and Caixin.

The G20 leaders meet again in Toronto on June 26-27, and hopefully will make progress on reform of the International Monetary Fund and other issues of global economic governance. But on one distinctive part of their agenda, financial regulation, achievements so far are less impressive than the initial ambition.

At the first G20 summit in November 2008 in Washington, shortly after the Lehman Brothers collapse, there was much rhetoric, especially from Europeans, in support of “global solutions to global problems.” The implied goal was global harmonization of financial rules to restore financial stability, eliminate regulatory arbitrage (banks shopping around for the most favorable regulations), and ensure fairer competition. Financial regulation represented no fewer than 38 out of that summit’s 47 action items.

Fast forward to the present and most flagship projects are in jeopardy. The Basel Committee’s negotiations on bank capital, leverage, and liquidity standards are proving difficult, and may not be completed this year as planned. Accounting standard-setters are not achieving convergence on key issues, including financial instruments, and have announced that they will miss the mid-2011 deadline set to them by the last G20 summit in Pittsburgh. Individual initiatives, such as the recent German ban on naked short-selling and credit default swaps, stand awkwardly alongside the commitment to global coordination. And the more recently suggested idea of a global banking levy is petering out in the face of unexpectedly strong opposition from Canada and others.

It is too early to call the G20 financial regulatory agenda a failure. But there is an inescapable sense that the vision of global financial harmonization, while certainly appealing, is incompatible with realities. Regulation is politics, and all politics is local. The idea that identical rules could be implemented identically around the world in an area as sensitive as finance remains, for now, a utopia.

To salvage its credibility, the G20 agenda needs to be restructured on the basis of clear first principles. The guiding concern should be better management of cross-border contagion risks, while safeguarding the efficiency of global capital allocation.

Some issues can be largely left to individual jurisdictions, as illustrated by the soon-to-be-adopted US financial reform bill, whose direct international spillover effects are limited. This applies prominently to regulations affecting retail banks, which typically intermediate within a single country, or in the case of continental Europe, within the EU. The Icelandic crisis has shattered the European concept of retail branches, as the home country was incapable of effectively insuring deposits in the UK and Netherlands. The EU must go much further in building a supranational prudential framework if it is to preserve its single banking market, for which the planned creation of a European Banking Authority should be a key milestone. But elsewhere in the world, the standard practice will be locally capitalized and funded subsidiaries even for global banks, as HSBC and others are already believed to be following. In such a model, uniform global prudential standards are desirable, but not indispensable.

Investment banking, however, requires more coordination, as one of its very purposes is to move capital across borders. The obvious alternative to local capitalization and funding is explicit support of local operations from the parent company. This implies enough homogeneity of home country standards to ensure that investment banks from different countries can compete fairly everywhere, and that the most harmful forms of regulatory arbitrage are discouraged. Furthermore, in the case of universal banks, government insurance of retail deposits should not unfairly subsidize investment banking. In this context, global investment banks may be increasingly headquartered in large countries (the Swiss case will be interesting to watch from this perspective); and the competitive effects of the universal banking model may increasingly come under scrutiny, especially as regards internationally active banks. These issues are extraordinarily difficult, and unlikely to be sorted out for several years.

Capital markets, by contrast with banks, benefit enormously from global integration and represent an area where the G20 should arguably be more ambitious than it has been until now, especially as this is an area where the crisis has especially shown the need for more effective regulation and where divergent national initiatives can be particularly counterproductive. A sustainable governance model remains to be found for international accounting standards-setting. For some financial participants that play a limited but crucial role in markets -- such as audit networks, rating agencies, clearing houses and information repositories -- the creation of global supervisors may be necessary even though there is no obvious precedent. Here too, the corresponding policy discussion has barely started, if at all.

The promise of the G20 has been to effectively reregulate global finance while avoiding its fragmentation along national lines. Getting this balance right must be the priority goal of G20 leaders. It will require more pragmatism and focus than has been the case so far.

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EU Inaction on Banks Grows Ever Costlier

This column was published by Bruegel and PIIE as well as FT Deutschland, La Tribune, La Voce, NRC Handelsblad, Kathimerini, Referans, Forbes Russia, and Caixin.

The European Union faces an existential crisis that results from three simultaneous challenges. The most visible one is fiscal. Several member states have poorly managed their finances, and the eurozone policy framework has been toothless in getting them to address their complacency. The second is about competitiveness. Property bubbles and a benign international environment have until recently masked the loss of economic fitness of countries that now require painful structural reforms, such as freeing labor markets and breaking corporatist holds on services sectors. But equally important is the third challenge – that of addressing Europe’s banking fragility, which has been at the core of the dramatic policy developments since the beginning of May.

In much of the public discussion, the concern about contagion from Greece has focused on the vulnerability of Spain, Portugal and other countries that might find themselves unable to refinance themselves at reasonable conditions. In fact, the fear that Greece’s difficulties could undermine the stability of Europe’s banking system, which holds most of its debt, is the main reason why the eurozone and International Monetary Fund have bailed out Greece without going directly for debt restructuring. Banks exposed to the Greek debt risk could become insolvent, sending shockwaves through the system just as Lehman did in 2008. The apparent seizing up of interbank markets at the end of the first week of May, more than anything else, is what prompted eurozone leaders and the European Central Bank to preempt market panic and announce their huge €500 billion backstop, plus half as much from the IMF.

The European banking system has been in a state of severe fragility since at least the post-Lehman shock; the ensuing public liquidity assistance had the perverse additional effect of encouraging the weaker banks to overinvest in high-yield debt such as Greece’s. If banks had started 2010 with stronger balance sheets, broader options could have been considered by policymakers, including a Greek debt restructuring which may need to happen eventually anyway, and whose cost could have been minimized if it had been engineered earlier.

Some European banks certainly have strong balance sheets. But the system is only as strong as its weakest links, and we don’t even know exactly where these are. A clear lesson of past systemic banking crises is that they can only be solved through a process of triage under which undercapitalized banks are publicly identified, and restructured or wound up by government if the market cannot provide them the additional capital they need.

A year ago, the US publicly “stress-tested” all its largest banks, spurring a wave of market-driven recapitalizations which is now seen as a major policy success. Sadly, the EU still has done nothing comparable, for a number of reasons. Political leaders, including those in France and Germany, are deeply captured by national banking establishments determined to preserve their perpetuation. Insidiously, the same leaders simultaneously adopted a virulent anti-finance, anti-market rhetoric, which makes it all the more difficult to explain to their voters how the banking system can be restored to soundness.

Meanwhile, national bank supervisors are unwilling to acknowledge the full extent of their massive oversight failures of the past decade. Furthermore, economic nationalism, combined with the EU legal framework, makes national officials fear that revealing the sorry state of some banking “champions” could make them takeover targets for “foreigners” from other European countries. Partly for this reason, the necessary triage and restructuring probably needs to be carried out at supranational level to be effective.

But as a result of existing treaties, the EU institutions lack the executive decision-making capacity  to defend the European common good against the demands of special interests – in spite of the best efforts of the European Central Bank, which has no supervisory duties, and of the European Commission’s competition services, which could only act on individual cases of state aid but without a system-wide prudential mandate. Barack Obama last year shrewdly remarked that “political interaction in Europe is not that different from the US Senate (…) everybody has their own particular issues and their own particular politics.” Alas, only centralized executive actions can restructure a banking system, a process that involves many hard choices that the diplomatic ways of EU decision-making have proven unable to deliver.

The EU must now find a way to clean up its financial institutions rapidly in order to strengthen themselves against the possibility of sovereign defaults, and also prepare the ground for a credible EU-level supervisory framework without which the aspiration to build an integrated market cannot be fulfilled. Banking reform has become as urgent as fiscal adjustment, and as important for stability as enhancing Europe’s growth potential and fixing the eurozone’s fiscal policy framework. Failing to achieve comprehensive EU bank restructuring before the expiration of the eurozone’s new three-year stabilization mechanism could have devastating consequences. The clock is ticking.

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The Challenge of Europe's Financial Redesign

This column was published by Bruegel and PIIE as well as by La Tribune, La Voce, Forbes Russia, Czech Business Weekly, and Caixin Online.

Even as it struggles to deal with Greece’s problems, the European Union is undertaking another vital effort – overhauling its framework for financial regulation, including establishment of the first EU-level financial supervisory authorities. The outcome of the European legislative process is uncertain, but it will have a decisive impact on the shape of Europe’s financial system.

The legislation under consideration by the European Parliament would create three new EU agencies to oversee banks, insurers, and securities and markets respectively. Unlike the committees they would replace, these agencies would have a formal decision-making process and binding powers on individual cases, making them in effect the world’s first supranational financial supervisors. In addition, a European Systemic Risk Board, mostly coordinated by the European Central Bank, would monitor major financial risks and issue recommendations to address them.

These proposals, based on a February 2009 report by a task force led by French former central banker Jacques de Larosière at the request of the European Commission’s president, received unanimous political backing at a summit of EU leaders in June last year. Their backing was truly remarkable, given the intensity with which some member states – most conspicuously the United Kingdom, but also Germany, Spain and others – had resisted similar attempts in previous years.

The importance of a breakthrough in this area cannot be overestimated. The EU aims to build a single financial market, but finance cannot develop without effective supervision. Entrusting the task to 27 different national authorities, with a track record of protecting local players or attempting to control them, creates constant pressure towards fragmentation. The existence of an EU level of financial supervision is a necessary, though not sufficient, condition for sustainable market integration.

Unsurprisingly, the proposed design is a compromise, and is vulnerable to legitimate criticism. Under the current version, adopted by member states last December, the new authorities’ powers are limited. Their rulemaking would be subject to approval by the European Commission. The proposed governance is problematic, consisting of supervisory boards in which the full-time chair has no vote, all but guaranteeing that only parochial national standpoints are represented. A clause that their decisions should not have fiscal impact on member states is seen by some as a portent of future paralysis. The division between banking, insurance and securities into separate authorities arguably overlooks the strong interdependencies among these segments.

Much of the discussion is now about the powers granted to the new authorities. In the current version, they would mostly act as arbiters between national watchdogs in case of disagreement, depending on the circumstances. The only players unambiguously subjected to EU-level supervision would be credit rating agencies, a small if important category. Some European parliamentarians understandably want to extend the authorities’ mandate -- for example, by making the European banking authority directly supervise pan-European banks.

But at least equally important is how good their decision-making will be. The current measures, though crucial, are not the end of the game: if the new bodies start with limited responsibilities but carry them out effectively and competently, they will gain trust and support from most stakeholders. Only from such a basis could they be granted, over time, the more sweeping powers needed to ensure the sustainability of an integrated EU financial system. Trying to achieve such a goal in one move is not politically realistic, and not sufficiently cognizant of the crucial role of such confidence-building.

From this perspective, the focus of the parliamentarians should be on improving the authorities’ hastily designed governance, possibly by expanding their boards to individuals who would represent a European-wide interest as opposed to national views, as at the European Central Bank, and perhaps by pooling national representatives into multi-country constituencies to reduce the boards’ size, as at the International Monetary Fund. Locating all three agencies in the same city, as European parliamentarians have suggested, would also lead to better performance.

The timetable could determine the outcome. Assuming the Conservatives win the UK election in May, this issue will be their first major European discussion. Their Euro-skeptic base is unsympathetic to delegating responsibility to the EU in an area as important to the UK economy as financial services. If the discussion is only about the new agencies’ powers, the European Parliament and the future British government may find themselves on a collision course. If it is about governance and effectiveness, a common ground may be found.

The stakes are high. If the attempt to create a more integrated supervisory framework founders, markets could lose faith in the prospects of pan-European banks, and encourage them to retreat to their original home market. Such a result could pose a bigger potential setback for European economic integration than anything that has happened in the crisis so far. The EU cannot afford failure in this reform. 

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