LCFI must be jointly supervised

The banks that belong to this group are not only very large by total assets (often far exceeding the GDP of their home country) but also operate on a global scale, beyond the jurisdiction and means of intervention of any national regulator. For them, neither the home country principle, nor the host country principle can provide efficient supervision. Agreements at a supra-national level must be sought.

There is, however, a silver lining to this cloud: given the level of bank concentration, the main source of systemic risk can be controlled by focussing macro-supervision on this group of banks. In Europe, the Financial Stability Reports of the European Central Bank have identified a cluster of 35 “large and complex banking groups”. The vice-president of the ECB reports that at the end of 2007 the 43 largest cross-border banking groups in the EU accounted for 76 percent of total EU bank assets, while in the euro area, the 30 largest cross-border banking groups accounted for 73 percent of total bank assets.11

Supervision must take account of interconnections and endogeneity of risk

The evolution of the financial system in the last twenty years has made risk more and more endogenous, thus opening a wide gap between the individual institution's perception of risk (micro level) and the actual risk incurred by that institution, taking into account its connections with other agents, which are more and more likely to react in the same way to the same stimulus, generating systemic destabilising effects (macro level).

What is needed, therefore, is a higher level of supervision that links the micro and the macro aspects. But the latter are related not only to the general conditions of the economic system, but also to the systemic effects of individual behaviours, particularly those of large complex financial institutions, that make risk more and more endogenous.

Supervision must be more discretionary at both the macro and micro level

The long list of proposals for financial reform has not been implemented because governments and regulators were too busy rescuing banks, at least until March 2009. But we now know that bank regulation must be overhauled. This does not necessarily mean that a corset of tight rules has to be stitched together. As is clearly set out in the Financial Stability Forum Report, the financial system can be fixed with a reasonable number of new rules to correct the past misjudgements as regards capital adequacy, bank liquidity, market risk, etc.

The point is that in the past, the pendulum swung too far from discretion (the traditional modus operandi of central banks) to rules and the system relied too heavily on the efficiency of automatic mechanisms, such as the Basel provisions.12 In other words, it relied too much on market discipline (the Basel Pillar 3) and not enough on the regulatory application and interpretation of the rules (Pillar 2). Regulators refrained from asking their banks to increase their level of capital, sometimes as a consequence of a form of regulatory capture, but also because they did not want (or did not dare) to correct the market.

The excess towards automatic rules was one of the determinants of the pro-cyclicality of the Basel requirements, which are now being amended. But it is almost impossible to correct flaws generated by automatic rules with other automatic rules.

In other words, future supervisory action must be based on a discretionary assessment of the riskiness of individual banks and must take a more “hands on” approach. The years of praise for the “light touch” are gone. This also means that regulators need powers and instruments to translate their judgements into action. As ECB President Jean-Claude Trichet said, “at the level of the financial system, we need to be more resolute in preventing the build-up of risks. We must strengthen financial stability assessments and develop mechanisms for translating them into concrete measures.”13

Information

The crisis has also shown that regulators lacked fundamental information on the global financial system: the formation of the shadow banking system and the opacity of the over-the-counter (OTC) markets for structured products and derivatives are significant examples. The regulators’ radar screens were blind to substantial portions of today's financial system. Therefore, an efficient database reflecting the modern global financial system must be set up, which means taking the interconnections between banks into account. Regulators have to know not only who owns what, but also who owes what to whom. They must therefore have the powers and the authority to get the necessary information from individual institutions. The next step will be to find ways and means to share the data among the supervisors, particularly for large complex financial institutions.

The macro level of prudential supervision

The Larosière Report identifies the weakness of macro-supervision as a major cause of the crisis. In particular: “regulators and supervisors focused on the micro-prudential supervision of individual financial institutions and not sufficiently on the macro-economic risks of a contagion of correlated shocks”.14 This judgement is shared by other important reports, such as the Group of Thirty's and the Financial Stability Reports issued in these years by the Bank of England and the European Central Bank, as well as by major international bodies such as the International Monetary Fund and the Bank of International Settlements, just to mention the most important. The need to strengthen the macro level of supervision in Europe and elsewhere is therefore beyond doubt. The real problem is whether the specific proposals made for the European Systemic Risk Council are adequate or not.

In several points, the Larosière Report seems to be too vague or not forceful enough to allow for a clear-cut answer to this fundamental question. These points can be seen as the seven “sins of omission”.

1. A broad vs a narrow interpretation of macro-prudential supervision

The Larosière proposal seems to reflect a narrow interpretation of macro-prudential supervision and therefore gives the ESRB a rather general and high-level role with limited powers. The European Commission has further reduced the possible actions that the ESRB can take. Therefore, the main task of the ESRB is now to assess the stability of the EU financial system in the context of macro-economic developments and general trends in financial markets. If significant stability risks are foreseen, the ESRB provides early warnings and, where appropriate, issues recommendations for remedial action.

The Commission explicitly states that

To sum up, the Larosière Report seems to assign the ESRB the role of analysing macro economic conditions and their implications for systemic risk and issuing warnings and making recommendations that the authorities in charge of micro-prudential supervision should follow.

Yet, in an important paper published in 2003, well before the crisis, Claudio Borio, a leading economist at the Bank for International Settlements, interpreted macro-prudential supervision much more broadly.16 In particular, Borio stressed two points: that systemic risk comes mainly from the common exposure of global banks to the same risk factors and that this makes financial risk more and more endogenous (exactly as happened during the crisis).

Borio clearly understood that the mainstream theory of systemic risk (embedded in the present regulation) looks primarily at the possible failure of a single financial institution as the primary cause which then spreads, through a variety of contagion mechanisms, to the financial system as a whole. In this perspective, to avoid financial instability it is enough to avoid the failure of one financial institution, that is, the first link in the chain reaction. But Borio stressed that a broader interpretation is needed because

The consequence of this broad interpretation of macro supervision should be to give the competent authority a wide mandate and very detailed powers of intervention. Moreover, the macro and micro supervisors should work together closely: from Borio's perspective the macro and micro levels of supervision are just two sides of the same coin.

Thus, macro-prudential supervision should be strictly linked to micro supervision and in a sense can be viewed as the new form of supervision required by the characteristics of the modern financial system. Borio concluded:

2. No responsibilities in matters of macro-prudential relevance

The Larosière analysis fails to identify problems that are systemic by nature. The consequence is that the Commission document wrongly assigns some of these issues to the micro-level of supervision: for instance, clearing and central arrangements, the heart of the financial system's infrastructure. From a theoretical point of view, this is unfounded. This is a typical responsibility of central banks (for the same reasons that central banks have supervisory responsibilities for the payment system); it follows that in Europe this should be a fundamental task of the European Central Bank.18 Moreover, the debate on the clearing and settlement issues of the European financial markets has clearly shown the intrinsic European and macro dimension of the problem and the need to give the ECB full responsibility.19

This point has been clearly stressed from a technical point of view in a recent ECB paper20 and officially underlined in the response to the consultation of the European Commission on possible initiatives to enhance the resilience of OTC derivative markets.21

3. The relationship between the different authorities involved

One very delicate matter on which the Larosière Report is vague is the relationship between the different regulators which in the European case involves two dimensions: the vertical, between the macro and micro European level, and the horizontal, among the various national regulators.

Looking at the first dimension, it is important to remember that there are already many examples of problems between the micro and macro levels of regulation, for example in the UK and in general in countries in which central banks do not have supervisory power at the micro level. The British experience revealed many weaknesses that deserve to be taken into account. In particular, the Turner Review pointed out that the Bank of England tended to focus on monetary policy analysis, while the Financial Services Authority focused too much on the supervision of individual institutions. Therefore, the vital activity of macro-prudential analysis and the definition and use of macro-prudential instruments “fell between two stools”.

It is likely that the most delicate matters of the Larosière proposal related to macro-prudential supervision will also “fall between two stools”. Solving this problem depends on two things. First, a very clear definition of the responsibility of the various bodies. Second, the effectiveness of the powers given to the body in charge of macro-prudential supervision (which will be dealt with in the following point). So far, neither is clear enough.

As for the problem of coordination among national authorities, an efficient outcome depends on the effective powers that will be entrusted to the ESRB (see below) and the new European Supervisory Authorities (ESA).

4. Warnings and interventions (voice vs teeth)

The Larosière Report seems to believe that warnings issued by the ESRB will be sufficient to foster action at the micro-level and therefore to correct possible threats to financial stability. So voice is the main weapon given to the ESRB.

This solution is not considered efficient even in a national environment. As Mervyn King, Governor of the Bank of England, has put it:

European proposals are extremely vague on this issue. The Larosière Report states that when a warning is issued, it must be clear who must do what and suggests different scenarios in which the ESRB could enforce supervisory instruments (countercyclical provisioning, etc) to limit systemic risks. The European Commission document says nothing on this.

Moreover, there is convincing evidence that warnings are not sufficient in the European environment either. The ECB Stability Reports issued warnings in the past, but as Lorenzo Bini Smaghi has said, “[I]t is clear that the warnings contained in these reports were not heeded by the relevant authorities”.23

In other words, the macro regulator needs not only voice, but also teeth.

5. The role of the European Central Bank

From a theoretical point of view, it is clear that the central bank should play a leading role in the macro-prudential level of supervision. But in addition to giving the ECB a fundamental position in the ESRB, it seems even more important to amend the ECB's present mandate to put monetary and financial stability on the same footing.

For the ESRB to function efficiently, a precise procedure for handling possible differences of opinion has to be established. To avoid stalemates (the more likely the more delicate the problems involved) the person or entity that has the authority to work out a solution has to be clearly identified. A solution could be to give the ECB a casting vote (that is, the vote that decides in case of a split decision).

Moreover, it is clear that the ESRB and the ECB in particular must also have a leading role vis-à-vis national regulators, should they fail to comply with the warnings and recommendations issued by the ESRB. Such a solution has now been proposed for the future British framework: the Bank of England would have the final say in case of any divergence of opinion. Instead, both the Larosière Report and the European Commission are extremely vague on these points.

6. The independence of the ESRB

A European body in charge of macro-prudential supervision must be fully independent. This is an important condition not only per se but also because the ESRB can put at risk, at least indirectly, the independence of the ECB.24 Nevertheless, the European Commission has chosen to give a Commission representative a seat (with voting power) in the Council (ESRB) and to allow the finance ministries to be represented indirectly. Both these provisions entail substantial threats to the ESRB's independence and, above all, seem unnecessary, given the provisions on the disclosure and accountability of the body's decisions.

Moreover, the effectiveness of a supervisory body is strictly determined by its endowment in terms of dedicated and high-skilled resources. The ESRB must therefore have its own budget to hire the human resources needed to build the database and conduct the research promoted by its Board, in cooperation with the ECB. The staff can be temporarily seconded by the ECB or national central banks, but in the medium term the ESRB should have a staff of its own. Instead, the European Commission document proposes a simple “advisory technical committee […] to support the ESRB, including preparing detailed technical analysis of financial stability issues”.25

7. The information necessary for macro-prudential supervision

Last but not least, information is crucial if macro-prudential supervision is to be effective. The crisis has shown that systemic analysis must be based on both macro data and a very specific knowledge of the risks inherent in the tangled web of large complex financial institutions. As seen, in a broad interpretation like Borio's, macro-prudential supervision requires adequate information on the interlinkages through which instability can spread. At the same time, for this kind of supervision to work, the authority must be protected from falling victim to the many information asymmetries typical of modern finance.

Instead, the European Commission deals with the problem of information only at the level of micro-prudential supervision, when it states:

As a result, the ESRB not only has no information power, but depends on the three future European authorities for getting it, and then only in a format that is absolutely useless from the point of view of analysing the interconnections. In other words, the radar screen of the macro-prudential supervisors could be blinded.

Jean-Claude Trichet, president of the ECB, has clearly stated: “effective macro-prudential supervision depends on access to data and its translation into concrete measures. Access to relevant data is essential for the assessment of risks and vulnerabilities in the financial system. This is why such access must be part and parcel of a well-functioning arrangement for macro-prudential supervision.” The ECB Vice-President Lucas Papademos has added that “the development of the appropriate structure and the procedures for bringing together all types of pertinent information, also in a manner that ensures strict confidentiality in the use of micro data, will represent a major challenge, which will require analytical sophistication, market knowledge and supervisory expertise”.27

The creation of a European database for macro-prudential analysis requires, first of all, close cooperation between the ESRB and national supervisors, as well as with the relevant European Supervisory Authorities. As a consequence, the ESRB should be given specific responsibility in this field as well as the power to set down the reporting requirements for the group of large and complex financial institutions.

Only if these points are solved, will a proper level of macro-prudential supervision be established – one that takes into account the lessons which must be learned from the present crisis and that follows Borio's guidelines.

The micro level of prudential supervision

In Europe, the segmentation of regulation and supervision along national lines conflicts increasingly with the common currency and the objective of fostering financial integration.

It goes without saying that supervision has to be carried out on a “federal” basis because day to day relationships with individual institutions can only be implemented, in practical terms, by authorities that are “close to the field and know the institutions well”.28 By the same token, the common monetary policy relies on a system based on national central banks and an autonomous body, the ECB, which has the main responsibility for coordinating and implementing the decisions linked to monetary policy and lending of last resort.

So, the problem is not to abolish national supervisors, but to decide what kind of body should be in charge of coordinating the decisions that are most important from the point of view of micro-prudential supervision, in particular for European LCFIs.

The Larosière Report and the European Commission discarded both the option of creating a true system of European supervisors on a federal basis, similar to the Eurosystem, and the option of giving the ECB responsibilities in this field, using Article 105(6) of the Treaty of European Union. The second not only seems much easier to implement under the present conditions, but is also more founded theoretically.

Having discarded these two extreme but theoretically robust solutions, the Larosière Report chose a compromise in an attempt to minimise the political opposition from the main European countries. It is important to remember that in the worst days of the crisis, notwithstanding the lip service paid to mutual understanding and cooperation, all major countries worked out national – not European – solutions for their banks. As a consequence, micro supervision will be assigned to three European Supervisory Authorities (ESA), resulting from an upgrading of the three committees in charge of coordinating supervision in the fields of banking, securities markets and insurance.

The ESA will issue binding interpretations of European legislation and will be the only counterpart for European banks with cross-border activity. The former provision can make an important contribution to the harmonisation of European legislation, but not to the harmonisation of supervision as such. The latter is definitely an important achievement, but effective results will depend crucially on three things: the definition of the banks to be supervised at this level; the information that will be provided by national regulators to the colleges and therefore to the ESA; and the legal powers that will be given to the ESA. These important points have not been detailed so far, particularly (and worryingly) in the European Commission document. The problem is the same as the one already discussed for the macro level of supervision: without clear rules concerning effective powers and the decision-making process, it will be very difficult for ESA to reach a decision, particularly during a crisis. The European Commission uses a very vague word to define the position of the colleges: “lynchpin of the supervisory system and [important players] in ensuring a balanced flow of information between home and host authorities”.29

Furthermore, the Larosière Report raises two important issues without providing adequate responses. First, according to the Report, the so-called Lamfalussy Procedure for fostering harmonisation of the regulatory framework has produced very dismal results and the present regulatory framework in Europe lacks cohesiveness. A very troubling example offered is that even the definition of credit institution and bank capital varies from one European country to another. Bini Smaghi shares this negative assessment of the Lamfalussy procedure and finds that “the Lamfalussy framework, which was supposed to promote the convergence of regulatory and supervisory practices, has been insufficient”.30 When the Lamfalussy Report was published, many commentators were rather sceptical about the efficacy of the proposed procedure. They were told that it was the best possible solution as only a compromise outcome would be workable, given the strong differences between European countries. The question therefore is: why should the “Larosière compromise” work any better than the “Lamfalussy compromise”? In other words, the ESA should be given very binding powers, otherwise the current lack of cohesiveness in regulation will be replicated in micro supervision.

The second problem is that the Report states that there is a disturbing “lack of frankness and cooperation between supervisors”. In particular, “as the crisis developed, in too many instances supervisors in Member States were not prepared to discuss with appropriate frankness and at an early stage the vulnerabilities of financial institutions which they supervised. Information flow among supervisors was far from optimal, especially in the build-up to the crisis.”31 On this matter, Bini-Smaghi adds that “in some countries, like Germany or Austria, where the supervisory authorities are not part of the central bank, the supervisors consider that they cannot deliver information on their own institutions to European authorities for reasons of confidentiality”.32

Neither the Report nor the Commission make any specific recommendation to remove these obstacles. This could prove to be a major flaw for the efficient working of the future European authorities. The rather byzantine structure of the micro level of supervision could make effective decision-making very difficult, particularly during a financial crisis.33