Designing Regulatory Failure

PRAGUE – At the close of last year, European Union finance ministers gave the green light to a new supervisory architecture for the EU’s financial markets. Now it is up to the European Parliament to address this hypersensitive issue, the most controversial part of which is the powers and responsibilities to be given to the three new pan-European supervisory agencies for banking, securities, and insurance.

PRAGUE – At the close of last year, European Union finance ministers gave the green light to a new supervisory architecture for the EU’s financial markets.

Now it is up to the European Parliament to address this hypersensitive issue, the most controversial part of which is the powers and responsibilities to be given to the three new pan-European supervisory agencies for banking, securities, and insurance.

The parliament’s decision will be far-reaching, and will affect European finance for many years to come. Although some complain that December’s compromise on financial regulation does not go far enough, there is a case to be made that the opposite is true.

The springboard for this fundamental policy shift was the report issued in early 2009 by former French central banker and IMF chief Jacques de Larosière. But his report ignored many vital issues that were then largely overlooked in the subsequent debate on financial reform.

As the crisis that began in 2008 has shown, there are too many, rather than too few, supervisory and regulatory institutions overseeing European financial markets – almost 70 in the EU as a whole.

De Larosière and the political debate he fostered completely gave up on first simplifying and consolidating institutions at the national level, and only then perhaps building a supranational body on that pared-down foundation. Instead, we are starting directly with what will be entirely new Europe-wide institutions.

This is a classic bureaucratic response: faced with a problem, create a new institution. What a mistake. If we merely add new institutions to EU countries’ already Byzantine arrangements, we will fail to address the effectiveness, flexibility, and smoothness of information transfer through the EU-level supervisory system.

Recall the beginnings of the crisis: the British bank Northern Rock, for example, is now seen as a notorious example of how poor communication and information sharing among just three national authorities can easily make matters worse. We need to start with national supervisors (as Germany wisely does), and then go to the European level if necessary, not the other way round.

The new regulatory model also fails to address a persistent weakness of the single European financial market: how to pay the costs (or “share the burden”) when a multinational bank fails. A systemic solution must precede, not follow, the creation of new European institutions.

We Europeans may proudly say that we have a single financial market, but it is configured for good times only. In bad times, it is national taxpayers who pay for any financial-sector trouble, because there is no pan-European taxpayer or plausible burden-sharing models.But it will be difficult to move forward without one.

Last June, it was agreed at the EU level that European institutions’ decisions should not impinge on member states’ control of fiscal policy. How this can be reconciled with pan-European regulation is hard to say.

Many of the decisions to be taken by the new European institutions may imply costs that will emerge only much later.

There is an interesting paradox here. Many day-to-day cross-border services, ranging from freight transport to hairdressing, face major barriers and restrictions.

Yet if the provider of such a service goes bankrupt or runs into difficulties, there is little likelihood that any national government would be called on to bail it out. After all, how many “systemically important” hauliers are there?

By contrast, banks and others can use European “passports” to provide financial services – which do have significant public-finance implications – throughout the EU. That is a nice idea, but it is half-baked: it fails to specify which taxpayers should be on the hook if something goes wrong and savers want their money back, as with the Icelandic banks in the United Kingdom, the Netherlands, or even Switzerland.

With these crucial issues unresolved, we are creating a Europe-wide system that violates the golden rule of any institutional design: decisions should be made by those who bear responsibility and who ultimately must pay.

With too much power at the European level, national authorities will be answerable to their citizens and be forced to foot the bill, yet they will lack power. Conversely, the European institutions will bear neither the costs nor the responsibility, but will make the decisions.

How disturbing, then, that these institutions’ powers may be increased still further. The three new agencies will not only enforce common technical standards, which may eventually become binding throughout the EU if endorsed by the European Commission, but will also be allowed to settle disputes between national supervisors.

More important, should the Council declare a state of financial emergency – such as the one we are in currently – the EU agencies might exceptionally be given a position of predominance over national supervisory authorities.

Needless to say, “disputes” and “emergencies” are exactly the future situations likely to matter most to national policymakers and taxpayers.

If decisions about systemically important national financial institutions are made at the European level in good times, while in bad times national taxpayers pick up the tab, the whole EU will lose.

In good times, we probably would not be able to tell the difference, but the grim reality is that such an arrangement would be unlikely to prevent another crisis. Why, then is the EU building the house from the roof down?

Mojmír Hampl is Vice Governor of the Czech National Bank and a member of the EU’s Economic and Financial Committee (EFC).

Copyright: Project Syndicate, 2010.

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