THE EU should establish two new pan-European bodies to oversee and co-ordinate supervision of the financial system to ensure that the current crisis can never be repeated.
It also needs to regulate more effectively by setting tough new rules on executive pay, credit ratings agencies and hedge funds, according to an influential report published yesterday.
The High-Level Group on Financial Supervision in the EU, which was chaired by former Bank of France governor Jacques de Larosiere, makes 31 recommendations on how to strengthen supervision of financial institutions and markets.
It pinpoints the need for more co-operation between Europe's patchwork of national financial supervisors, although it stops short of recommending a single pan-EU banking and financial regulator.
"The regulatory response to this worsening situation was weakened by an inadequate crisis management infrastructure in the EU, both in terms of the co-operation between national supervisors and between public authorities," says the report, which concludes the current crisis is the worst the world has faced since 1929.
The report recommends setting up a new body called the European Systemic Risk Council under the aegis of the European Central Bank (ECB) to monitor risks to the financial system. EU central bank governors and national supervisors from the financial sectors would sit on its board. It would issue risk warnings, which if they are judged serious to disturb the economy as a whole or the financial system, would have to be followed up by national supervisors.
The ECB had lobbied for a role in supervising financial institutions such as banks and insurance firms to create a single pan-EU supervisor. But the report rejects this proposal because devolving such power to the bank could leave it open to political pressure and impinge on the ECB's crucial role of ensuring monetary stability.
Instead, the report recommends beefing up three existing financial supervisory bodies (the "level-three committees" composed of national supervisors in the banking, insurance and securities sectors) to create a European system of financial supervisors.
Under this model, national supervisors would continue to undertake day-to-day supervisory work, but they would have to attend regular EU-wide meetings, known as colleges of supervisors, to ensure proper scrutiny of cross-border institutions.
The new EU body would act as a form of decentralised network that ensures common high-level supervisory standards are followed by national regulators to ensure a level playing field.
The report pinpoints a failure of national regulation as a contributory factor to the current crisis.
"Strong international competition among financial centres also contributed to national regulators and supervisors being reluctant to take unilateral action," it says, noting that a lack of resources and inadequate skills also hampered regulators.
Many EU states such as Britain have opposed plans to devolve supervisory power over its financial sector to Brussels, fearing it could hurt their banks or undermine financial centres such as the City of London.
But Mr de Larosiere said yesterday he didn't propose any "unrealistic options" to ensure his report did not sit on a bookcase gathering dust.
European Commission president Jose Manuel Barroso said the report confirmed his belief that a European system of financial supervision was now indispensable. "If we do not take these steps now in this crisis, the decisions will never be taken," he added.
The report pins the blame for the global crisis on a number of actors: the US for fuelling a housing bubble and credit boom by keeping interest rates very low; China for pegging its currency to the dollar and contributing to global imbalances; financial institutions for designing ever more complex and risky products to pursue higher returns, management for incentivising greater risk-taking through poorly designed remuneration schemes and regulators for failing to properly assess risk or being willing to take counter measures.
It strongly criticises managers and directors of banks for not understanding the complex financial products that they were dealing with or being aware of the exposure of their firms.
It also concludes remuneration and incentive schemes at banks and other financial institutions "contributed to excessive risk-taking by rewarding short-term expansion of the volume of risky trades rather than the long term profitability of investments".
EU financial crisis: causes and remedies
CAUSES OF THE FINANCIAL CRISIS
Macroeconomic causes: For example, ample liquidity, low interest rates and too loose monetary policy, in the US in particular; accumulation of large global imbalances; mispricing of risk; and large increases in leverage.
Risk management: By firms, supervisors and regulators, and a lack of transparency, leading to the build-up of the shadow banking system, the originate-to-distribute model, and extreme complexity which few understood.
Credit rating agencies: Dramatic failures in the ratings of structured products; major conflicts of interest.
Corporate governance: Weak shareholders and management of firms; remuneration schemes providing the wrong incentives.
Regulatory/supervisory: Wrong incentives encouraging procyclicality; for example: the Basle process; mark-to-market accounting; lack of regulation of derivatives markets; and insufficient examination of macroprudential risk.
Global institutional weakness: International Monetary Fund (IMF), Financial Stability Forum (FSF), G20; and a lack of co-ordination.
POLICY AND REGULATORY REPAIR
Stronger macroeconomic policy and macroprudential analysis: Avoiding too loose monetary policy and excess liquidity; assessment of asset bubbles; and tightening monetary policy when money or credit grows in an unsustainable way.
Reforming expeditiously the Basle 2 capital requirement process for bank capital:Capital for banks and higher quality of capital; countercyclical approaches – capital buffers; higher capital for trading books; measuring and limiting liquidity risk; stricter rules for off-balance sheet vehicles; and a common definition of own funds.
Credit rating agencies: To be supervised by the new European Securities Authority; a fundamental review of the role of credit rating agencies in the financial system; and a distinct new approach to the rating of securitised products.
Accounting: Strengthened governance of the International Accounting Standards Board (IASB); reflection on the role of mark- to-market accounting necessary; and improved valuation techniques.
Insurance: Essential to deliver the new Solvency II rules before May; appropriate safeguards to be defined to ensure an effective an group support regime.
Sanctions/supervisory powers: To be strengthened throughout the EU so that sanctions are a deterrent.
Parallel banking system: All parts of the financial system that have a potentially systemic nature should be appropriately regulated and supervised; information requirements on hedge funds should become mandatory – through regulation of hedge-fund managers.
Securitised products/derivative markets:Derivative products should be standardised and simplified; at least one well-capitalised clearing house for credit default swaps should be created in the EU.
Investment funds: Common EU rules should be strengthened, including tighter control over depositories and custodians.
EU SUPERVISORY REPAIR
Macroprudential supervision – a new EU function called the European Systemic Risk Council (ESRC) should be set up: The group considers the new body should be set up under the auspices of the European Central Bank (ECB) and chaired by the president of the ECB. It will be composed of members of the general council of the ECB, the European Commission, and the chairs of the Committee of European Banking Supervisors (CEBS), the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) and the Committee of European Securities Regulators (CESR). Insurance and securities supervisors will be brought in where necessary. Its role will be to gather information on all macroprudential risks in the EU. It shall have access to all necessary macro and micro information and issue risk warnings, on which there would be mandatory follow-up and monitoring. If the risks were very serious, they should be taken up by the Economic and Financial Committee (EFC), working with the commission, to address the risks. The ESRC will work closely with the IMF, FSF and G20 at a global level.
There should be a new European System of Financial Supervision (ESFS), transforming the level-three (L3) committees into EU authorities: This covers microprudential supervision (the supervision of firms). The three L3 committees (CEBS, CEIOPS and CESR) will be transformed into three new authorities (the European Banking Authority, European Insurance Authority, and European Securities Authority). They will have a considerably expanded role, including some legal powers. The main additional tasks of the authorities will be: legally binding mediation between national supervisors; adoption of binding supervisory standards; adoption of binding technical decisions applicable to individual institutions; oversight and co-ordination of colleges of supervisors; licensing and supervision of specific EU-wide institutions (for example, credit rating agencies and post-trading infrastructures); binding co-operation with the ESRC to ensure adequate prudential supervision; and a strong co-ordinating role in crisis situations.
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