A new report to the European Commission has recommended reform of cross-border financial supervision in the EU to overcome flaws in national based supervision.
The report, which was drafted by a high-level group headed by former IMF managing director and ex-Bank of France governor Jacques de Larosiere, suggested the establishment of two new pan-EU bodies to monitor risks and co-ordinate the supervision of financial institutions in Europe.
However, existing national supervisors within the 27 member states of the European Union will still carry out the day to day supervision of the financial markets.
It said changes should be phased in over four years.
The report offers a two-level approach to reform - new oversight of broad, system-wide risks and a beefing-up of coordination among national supervisors in day-to-day oversight. Both would closely linked.
Under the proposals suggested in the report, a European Systemic Risk Council (ESRC) would be set up, chaired by the European Central Bank president. It would be composed of members of the general council of ECB, a member of the European Commission and chairs of the three existing pan-EU committees of banking, insurance and securities supervisors.
The report also calls for an effective risk warning system under the auspices of the ESRC and the existing Economic and Financial Committee, which is made up of national treasury officials. If the ESRC thinks a local supervisor is taking inadequate action to deal with risk, it could take further action.
The report also advocates making improvements in how a banking crisis is handled. For example, EU states should agree a more detailed criteria for burden sharing or who bails out a failed cross-border bank.
Under the report, creating a European System of Financial Supervisors and a decentralised network, with existing national supervisors continuing to carry out day-to-day supervision.
Three new European authorities would be set up to replace the existing three pan-EU committees of banking, insurance and securities supervisors known as CEBS, CEIOPS and CESR. Colleges of supervisors would be set up for all major cross-border insitutions.
The ESFS would be independent of political authorities but be accountable to them. It should rely on a common set of core harmonised rules, the report said.
Dublin Fianna Fail MEP Eoin Ryan, a member of the economics committee of the European Parliament, welcomed the report's publication.
"We must have regulatory and supervisory systems in place for the financial services sector that are rigorous and can withstand the toughest of scrutiny. We must strengthen European co-operation in the field of financial stability oversight. We must improve how EU supervisors should co-operate in a global context," he said.
"It is very important that the G20 agree at their next meeting to a set of standardised rules to govern the international financial markets. Confidence and stability in the EU financial markets system are the over-riding political priorities for all EU legislators."
The report says draft EU insurance industry rules known as Solvency II must be adopted and include a binding mediation process between supervisors and the setting up of harmonised insurance guarantee schemes.
The document says a fundamental review is needed for the globally-agreed Basel II rules on capital requirements for banks, such as stricter rules for off balance sheet items. A common EU definition of regulatory capital should be adopted, and national supervisors should collectively be responsible for registering and supervising credit rating agencies.
A wider reflection is also needed on mark-to-market accounting standards, blamed by some for exacerbating the impact of the credit crunch on banks, according to the report. The oversight and governance of the International Accounting Standards Board, which sets accounting standards used in the EU, should be strengthened.
It also says regulation should be extended to the so-called parallel banking system, and there should be registration and information requirements on all major hedge funds. There should be capital requirements on banks owning or operating a hedge fund or engaged in significant activity with a hedge fund.
Additional reporting: Reuters