European disunion

The European Union’s effort to coordinate banking regulation has turned into a turf war between central bankers and Finance ministers.

The European Union’s effort to coordinate banking regulation has turned into a turf war between central bankers and Finance ministers.

By Tom Buerkle
July 2002
Institutional Investor Magazine

Central bankers are a worrying breed. The weight of the world’s monetary systems, and in turn global banking and economic stability, rests on their shoulders. Tommaso Padoa-Schioppa is more worried than most.

A member of the European Central Bank’s executive board responsible for international issues, Padoa-Schioppa frets about the state of banking supervision and especially about regulators’ ability to respond to a serious financial crisis, such as a major bank failure. He sees European markets growing increasingly integrated and interdependent, while their bank regulatory systems remain haphazardly decentralized. To close that gap, Padoa-Schioppa has proposed a solution that most European central bankers have readily endorsed: Let an ECB committee take the lead in coordinating closer cooperation among national authorities and in advising governments on banking legislation and regulation.

“Central banks have a very strong interest in the soundness of the banking system. They should, therefore, work closely with bank supervisors,” asserts Padoa-Schioppa, who enjoyed a long career as a banking and securities regulator in his native Italy before joining the Frankfurt-based ECB in 1998.

His proposal - and his reasoning - are what might be expected of a European Union official who is trying to balance the imperatives of multinational risk management with the realities of individual countries’ market structures and with the sovereign rights of member states.

But powerful forces are resisting Padoa-Schioppa and his advocacy of central coordination at the ECB. The leading opponents, U.K. Chancellor of the Exchequer Gordon Brown and German Finance Minister Hans Eichel, share Padoa-Schioppa’s concerns about the need for closer cooperation, but they suspect him of trying to usurp regulatory responsibilities that rightfully belong in their departments. In a letter to their fellow EU ministers in April, Brown and Eichel called for the formation of a new coordinating body reporting not to the ECB but directly to the Finance ministries, because they would bear the costs of any banking failure. The ECB should be excluded, they added, because not all EU central banks are involved in banking supervision.

“Those who have to set out a political framework for regulation have to have political accountability,” says Axel Nawrath, the German Finance Ministry’s director general for financial markets and monetary policy. “Central banks, for all that they do, don’t have political accountability.”

And so the battle lines are drawn for yet another tiff over the terms of European unification. Basic principles are not in dispute: Both sides generally agree that the advent of the euro and the interconnected-ness of financial markets both within and outside of the euro zone require closer cooperation among national and EU banking authorities. Yet ideological conflicts and turf fights are stalling progress toward a consistent regulatory framework.

The clash is on one level philosophical - concerning whether central bankers or independent agencies should control the regulatory reins. There is also a geopolitical element - a long-simmering controversy over transfers of power and influence from national capitals to pan-European agencies like the ECB.

The U.K. - home to Europe’s premier financial center and a holdout from the euro - is the leading proponent of the single-regulator approach, having created the Financial Services Authority in 1997 to consolidate banking, securities and insurance regulation. Germany is the most recent convert to that model, with the formation in May of the Federal Authority for Financial Services Supervision, known by its German abbreviation, BaFin. Both countries believe that a single independent regulator can best cope with the increasingly blurred distinctions between banks, insurers and securities firms.

“They want to export their model to the Continent,” says an ECB official of the British. But the ECB has its own agenda. Its president, Wim Duisenberg of the Netherlands, and former Bank of Italy official Padoa-Schioppa both come from countries whose central banks supervise commercial banks - a common arrangement in continental Europe. So it is no wonder that the two are seen as partisan.

Duisenberg has also served as president of the Basel, Switzerland,based Bank for International Settlements, which plays the regulatory role of setting minimum capital standards for private sector banks in the industrialized countries. In a recent speech in Amsterdam, Duisenberg maintained that central banks gain essential insight into the state of commercial banks through their money market operations and control of payments systems. Central banks also depend on healthy and stable banking systems to transmit their monetary policies to the wider economy through interest rate policies and open market operations. “In my opinion, banking supervision is a central bank function,” he said.

Earlier this year Duisenberg and Padoa-Schioppa began lobbying discreetly to designate the ECB’s Banking Supervision Committee, a panel of central bankers and supervisors from all 15 EU countries, as the body that would foster closer multinational cooperation. Indeed, it is the only established entity that brings supervisors together from across the EU, from both euro and noneuro countries. But the committee meets only a few times a year, spends much of its time debating procedural matters and over four years has produced only one memorandum of understanding - on cooperation and information-sharing among national payments systems.

That modest record illustrates just how difficult it is to forge closer supervisory links in Europe. Duisenberg and Padoa-Schioppa insist that they are not trying to consolidate power; they want to maintain a system of national banking supervision but say that the only way to assure its effectiveness is through closer cooperation at the ECB level. The single currency, they argue, has deepened financial linkages across the region, raising the possibility that a banking crisis, if not contained, might have a domino effect of cross-border contagion. Interbank loans in the euro countries rose from $650 billion in 1997 to about $900 billion in 2000; those claims represent nearly 50 percent of the banks’ total international exposure, up from 35 percent in 1997.

“The single currency has produced a single money market that did not exist before,” Padoa-Schioppa says. “As integration proceeds, regulation and supervision have to proceed in parallel.”

But to British eyes, any new coordinating role for the ECB is a first step down the slippery slope toward a single EU regulator and must therefore be resisted. U.K. Chancellor Brown certainly won’t want to give ground on such a vital issue ahead of a possible referendum next year on British adoption of the euro.

As long as their alliance holds, Eichel and Brown present a formidable tandem in the world of EU infighting. But might the German minister prove less resolute and accept a single EU supervisory body in the future? German officials say that is a distant prospect at best, but centralized regulation is a less remote possibility than it was when the Maastricht Treaty was drafted more than a decade ago. At that time, EU negotiators soundly rejected the idea, deciding instead to continue relying on national oversight. They also defined the ECB’s role narrowly, saying it should “contribute to the smooth conduct of policies” pursued by the supervisory authorities. Any move to increase the ECB’s supervisory powers requires the unanimous approval of all 15 member countries.

The issue has come back to the fore because of the EU’s desire to have a fully integrated, uniformly regulated financial services market by 2005. Earlier this year the European Commission proposed a directive to tighten capital requirements and supervisory cooperation on financial conglomerates active in multiple sectors, such as banking and insurance. And late next year, assuming the so-called Basel II accord on bank capital requirements stays on track, the EU will start drafting legislation to implement those rules. Both initiatives will require an advisory and coordinating body for banking supervisors similar to the Committee of European Securities Regulators, which was established last year to enhance cooperation among securities regulators and to advise the EU on new legislation. It’s that advisory and coordinating role that Duisenberg and Padoa-Schioppa want the ECB to claim for the Banking Supervision Committee.

British officials dismiss the ECB’s gambit as an attempt to find work for underemployed central bankers. Together the central banks of the 12 euro countries employ roughly 50,000 workers, but since handing control of monetary policy over to the ECB, they have lost their chief mission.

“From their point of view, banking supervision might seem the obvious thing to do,” says David Green, head of international policy coordination at the U.K.'s FSA and a member of the ECB’s Banking Supervision Committee. It’s notable that the Bundesbank, which led the fight against a supervisory role for the ECB during the Maastricht negotiations in 1991, today sides with the ECB in its campaign to coordinate supervision. Under Germany’s new single regulatory framework, Bundesbank staff will carry out many of BaFin’s banking supervisory duties.

The U.K. and German Finance ministers have drawn first blood against the ECB partisans. In May EU Finance ministers instructed the union’s Economic and Financial Committee, a group of senior Finance Ministry and central bank officials, to draw up proposals for advisory and coordinating bodies. Conforming closely to Eichel and Brown’s demands, the instructions stipulated that the proposal should ensure that any new bodies consist of national representatives with direct supervisory responsibilities and that they report directly to Finance ministers. The policy does not specifically preclude an ECB role, however.

The ECB has offered to bend to the ministers’ demands by modifying procedures at its Banking Supervision Committee. For example, Padoa-Schioppa has suggested that central bankers without direct supervisory responsibilities not participate in detailed discussion on those policies and that the committee report to Finance ministers. While most EU governments side with Eichel and Brown on the need for ministerial control, many are also keen to keep the central bankers involved in supervision. Given that ten of the 12 euro-zone central banks have supervisory responsibilities, the political jockeying is sure to intensify before the ministers take a final decision on the coordination issue this fall.

Officials in London and Berlin insist that any new regulatory and supervisory arrangements must maintain clear lines of responsibility and that only national regulators and supervisors should advise on EU regulation and work to enhance cross-border cooperation. “The bottom line is that member states are responsible for banking supervision, and the ECB is responsible for monetary policy,” says the FSA’s Green.

Green, Brown and their allies in Germany do see a role for the ECB but only as part of a broader group that would bring all regulators, Finance ministries and central bankers together to discuss the stability of the entire European financial system. “You need a forum where all the sectors are represented,” says Germany’s Nawrath. “I want the ECB to be there but not running the engine. The ECB doesn’t know anything about insurance.”

Most Continental central bankers bristle at the suggestion that they can meet their core obligation of ensuring systemic stability without a complementary specialization in prudential supervision of banks. Securities regulation has as much to do with consumer protection as anything else, notes Edgar Meister, the Bundesbank director who chairs the ECB’s Banking Supervision Committee. “It’s completely different from the aim of banking supervision,” which is all about stability, he says. He also can’t see the logic of excluding some central banks from advising on legislation to implement the new capital rules, given that the central banks are helping to draft the accord in the Basel Committee on Banking Supervision. “Central banks work on Basel II for two, three, five years, and then they can’t give advice on the interpretation of [the capital guidelines] into law? That makes absolutely no sense,” he says.

The ECB’s Padoa-Schioppa points out that the U.K.'s banking arrangements rely heavily on close cooperation between the FSA and the Bank of England. It works, he says, because of the intimate contact between the two organizations: Many of the FSA’s supervisory staff, including Green, came from the Bank of England, and the FSA’s chairman, Sir Howard Davies, is a former deputy governor of the central bank. Padoa-Schioppa notes that those kinds of relationships simply don’t exist across Europe; he sees the ECB’s supervision committee as the sole body that is working to forge such ties. “Only by developing this continuing contact in normal times can you ensure you’ll know how to react in a crisis,” he says.

As its trump argument, the ECB points to its role model - the U.S. Federal Reserve System. The U.S. central bank is not only the guarantor of financial stability and lender of last resort but also the principal regulator of bank holding companies and the one agency in a position to coordinate a crisis response, as it did when the Long-Term Capital Management hedge fund collapsed in 1998 and in the aftermath of the September 11 terrorist attacks. The only European authority that can pretend to play a comparable role is the ECB.

“We have to look across the ocean to the Fed,” says the Bundesbank’s Meister. “We have in the States the biggest capital market. The Fed has a lot of responsibility in banking supervision, and they need it in formulating their monetary policy.”

William McDonough, president of the Federal Reserve Bank of New York, makes the same argument in his role as chairman of the Basel Committee. In an April speech at De Nederlandsche Bank in Amsterdam, McDonough entered the European debate by expressing surprisingly candid support for the ECB. “It is nice to be in a central bank that is still in the supervisory business,” he said. “In the debate that is taking place around the world, the central bankers make the mistake of behaving like gentlemen.” Proponents of the single-regulator model, he added, “seem to be vying for the position enjoyed by St. Paul: the best district sales manager in the history of the world.”

The U.S. central banking and regulatory model, of course, did not emerge full-blown. The country that adopted its constitution in 1789 did not have a national currency or a federal banking regulator - the Office of the Comptroller of the Currency - until 1863. Only after a succession of financial panics was the Federal Reserve established, in 1913, and its banking oversight powers were at first limited to state-chartered banks that chose to become Fed member banks. Even now that the Fed has primary supervisory responsibilities for diversified financial companies, the U.S. retains a regulatory patchwork that includes the Comptroller’s office as well as 50 state bank and insurance agencies and the Securities and Exchange Commission.

The ECB isn’t seeking Fed-style powers. Supervision and lender-of-last-resort will remain national functions for the foreseeable future in Europe. But the Europeans do work closely with the Fed in a crisis: On September 11 the European System of Central Banks - an umbrella body for the 15 EU central banks including noneuro countries Denmark, Sweden and the U.K. - sought to calm the markets by declaring its readiness to provide liquidity. The ECB’s Banking Supervision Committee held a two-hour conference call with members on September 12 to verify that Europe’s payment systems were functioning smoothly. The following day the ECB arranged a $50 billion swap facility with the New York Fed to guarantee the dollar liquidity needs of European banks.

In fact, though the events of September 11 were horrific, as a liquidity emergency it turned out to be relatively routine. A crisis at one of Europe’s largest financial institutions might not be so easily handled. Could European supervisors detect trouble before it escalated out of control, transmit the information rapidly to the appropriate authorities and coordinate an effective response? Some observers have their doubts.

“We were lucky,” comments one senior EU central banker on the September 11 response. “Next time it may not go so well. If something really big happens, I think the mechanisms are probably not appropriate.”

The ECB’s Banking Supervision Committee wants to establish just such a crisis mechanism. Officials hope to finesse the differences between national and centralized approaches by having home-country supervisors act as lead coordinators - the FSA if there’s a problem at Barclays, for example, and BaFin for Deutsche Bank - while creating a communications nerve center at the ECB with a single telephone number, a staff of translators and other support.

Crisis management guidelines, like the broader regulatory and supervisory framework, should be agreed upon by the end of the year. To achieve that, central bank officials and regulators will have to set their political and ideological differences aside and focus on practical arrangements that work. The EU managed to do just that earlier this year when it forged an agreement on streamlined procedures for securities regulation. Banking requires nothing less.

As Padoa-Schioppa puts it: “We have a market that is increasingly integrated, while supervisory activities are very segmented. That is very unhealthy.” Even opponents of his ECB supervisory proposals can’t argue with that.