The commission’s proposal on bank supervisory powers for the ECB

Vincent O'Sullivan, Stephen Kinsella 20 September 2012

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Proposals from the European Commission (2012a) would give sweeping powers to the ECB in potentially the biggest shake-up in financial supervision since the creation of the Federal Reserve System in the US almost a century ago.

More than 6,000 banks in the EZ would be subject to prudential supervision by the ECB from 1 January 2014; the supervision of systemically large banks and those relying on government support would be phased in a year earlier. Not just banks: bank-led financial conglomerates (including bank assurers) and financial holding companies would fall within the ECB’s purview from next year.

The ECB would be responsible for all aspects of prudential supervision – from authorisation, ongoing supervision at the start and early intervention during times of crisis to the withdrawal of bank licences where appropriate. It would assume key powers from national prudential supervisors, including national supervisory discretions, such as the imposition of higher capital and liquidity buffers to address specific systemic risks at the national level. It would become both ‘home’ and ‘host’ supervisor for banks operating across borders in the EZ. It would have power to access a bank’s corporate governance and risk management processes and systems to ensure that it meets with best practice standards.

Eurozone supervisors would become ECB ‘agents’ tasked with ongoing supervision at the coalface, but subject to ECB rulings. The ECB would be able to intervene directly with any bank in the EZ. National supervisors would only retain primary responsibility for protecting consumers and preventing financial crime at the national level.

Who does what?

So at a time when the ECB is assuming more and more influence over macroprudential supervision, under this proposal it would also assume direct micro-prudential supervision for all EZ banks. It is not totally clear from the commission’s proposals how the ECB, the body providing the secretariat to the European Systemic Risk Board, and the ECB, the microprudential supervisor for the EZ, would be configured and would interact, although the proposals do stipulate the segregation of the ECB’s supervisory responsibilities from its role in conducting monetary policy. 

Conferring such powers on the ECB raises questions aboutits interaction with the European Banking Authority (EBA). According to the EC (2012b), the EBA would retain all its existing powers and tasks under this envisaged architecture, including the creation of a single rulebook and supervisory convergence in relation to the EU as a whole. With regards to supervisory convergence, the EC is now suggesting that the EBA be tasked with the development of a ‘single supervisory handbook’. However, an important issue is how EBA members vote. Currently, decisions are taken either by qualified majority or simple majority (one person, one vote) within the EBA’s Board of Supervisors. As the ECB would take over as national ‘competent authority’ in all EZ member states, this risks distorting EBA decision making.

Consequently, an amendment to the EBA Regulation (Regulation (EU) No 1093/2010) (EC 2012b) accompanying the ECB regulation looks to change, amongst other things, the voting modalities within the EBA, giving more powers to an independent panel. With supervision centralised under the ECB, the conditions for the direct use of the European Stability Mechanism in the recapitalisation of struggling EZ banks are met (with the possibility of removing the negative feedback loop between an embattled bank sector and the relevant sovereign). The expectation, therefore, is that Spanish and Irish banks may be recapitalised shortly after the new regime goes live on 1 January 2013 (assuming it is adopted as proposed). The ECB would also have an important role to play in the recapitalisation process.

A need for speed

The commission has made it clear that the proposal on centralised supervision depends on the quick adoption of legislative proposals in key areas, such as the Capital Requirements Directive IV, bank recovery and resolution and deposit guarantee schemes. Amongst other things, with these in place, the introduction of a common deposit protection and a single bank resolution mechanism within the EZ – two further pillars of the concept of ‘banking union’ – will be easier to construct. The commission has urged EU lawmakers to finalise their negotiations on these texts by the end of this year, resolving key areas of contention as quickly as possible.

Far easier said than done, particularly, as this proposal, itself, creates an additional threat to the institutional balance between the Council and the European Parliament, which the European Parliament is keen to maintain. The legal base used for the supervision proposal (Article 127(6) of the Treaty on the Functioning of the European Union) gives sole power to the council to adopt (unanimously) the proposal. The European Parliament, normally the co-legislator for EU law on the financial services sector, is consulted only in this context (which, interestingly, the ECB is too). The European Parliament that basing the new regime on this article alone risks undermining the fourth pillar in the EMU 2.0 initiative (designed to address specific issues in the initial architecture of the Economic and Monetary Union) namely increased democratic legitimacy and accountability. It is therefore suggesting that the ECB proposal and amending the EBA regulation are considered as a package.

One institution, many hats

This institutional conundrum is parallel to another concern still expressed by many observers: the questionability of combining responsibility for prudential supervision with monetary policy within the same body. Members of the ECB Board (Constâncio 2012), amongst others, have recently set out to explain that there is no conflict between a price stability objective and a financial stability objective, pointing out that any threat to financial stability jeopardises prices within the currency union, as well as the EU more widely.

Those who favour a separation argue that there is a conflict of interest between monetary and supervisory policy objectives (Goodhart and Schoenmaker 1995). For example, a reduction in interest rates would support economic stability in times of high inflation – consistent with monetary policy objectives. However, this policy would have adverse effects on financial stability in terms of the profitability and the solvency of banks (Vittas 1992). Additionally, during instances of banking failure, supervisors many want to close a failed bank or affect an orderly wind-down due to moral hazard concerns. In contrast, fearful of systemic stability and the risk of contagion, monetary policymakers will want to rescue the institution, regardless of any moral hazards this action could create. Drawing from well-established theoretical models, a recent IMF working paper found that a dual-mandate central bank is not optimal from a welfare perspective (i.e. higher output) because of a time inconsistency problem. The paper found that while it may be optimal for a central bank to pursue low inflation targets before a crisis, after a crisis it is better to let inflation rise, at odds with price stability, to repair debt-laden private balance sheets and achieve financial stability.

Many arguments were put forward during the 1990s to support a single supervisory authority. Firstly, the emergence of universal banking in the early 1990s, posed significant problems for the traditional regulatory architecture (Goodhart et al. 1998). There were concerns that the fragmented nature of financial markets might not only generate inconsistencies but also result in insufficient oversight of the newly emerging financial conglomerates. Secondly, there was increasing recognition of the growing complexity of financial operations and the requirement for specialist expertise to be developed and centralised (Norgren 1998). Finally, instances of regulatory failure, such as the collapse of Baring Bank in the UK, resulted in considerable debate about the appropriateness of regulatory systems in the mid-1990s. For example, the UK Japan, South Korea, and Iceland all integrated their regulatory structured into a unified structure during the 1990s, which were previously the responsibility of a number of specialist authorities and government departments.

However, many commentators remain unconvinced by these arguments. As the lender of last resort, the central bank already plays an important role in managing systemic stability (both macro and micro) in the financial system. Housing prudential supervisory functions within its remit is efficient as joint responsibilities make for better supervisory and monetary policy (Peek et al. 1999). Empirically, Bernanke and Friedman and Kuttner (1992) have shown that problems in the banking system can be good indicators of emerging problems in the wider economy. Additionally, numerous studies (Bernanke and Blinder 1988; Bernanke and Lown 1991; Kashyap et al. 1993), have demonstrated that the well being of the financial system may affect an economy’s response to monetary policies. Moreover, the financial crisis has shown there is irrefutable need, even in a regime designed to avoid catastrophic bank failures, for a central bank to act as ‘lender of last resort’ when all else fails. The Commission’s proposal seeks to balance these two opposing viewpoints by establishing strict segregation of activities between supervision and the conduct of monetary policy within the ECB.

Uncertainty, uncertainty, uncertainty

Time will tell whether this is the right approach: whether other measures, such as those relating to bank recovery and resolution, sufficiently reduce ‘moral hazard’. The ancient Chinese curse says ‘may you live in interesting times’. As the four-year anniversary of the Lehman Brothers collapse approaches, banks may prefer uninteresting times for a while so they can plan to rebuild their businesses and plan for the future but, clearly, this latest proposal, combined with all the other legislative proposals in the pipeline, does not herald quieter times for those operating in the EU for the foreseeable future.

References

Bernanke, B and A Blinder (1988), "Credit, money, and aggregate demand", The American Economic Review Financial Studies 78, 435-39.

Bernanke, B and C Lown (1991), "The credit crunch", Brookings Papers on Economic Activity 2:205-248.

European Commission (2012a), “Council Regulation conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions”, September.

European Commission (2012b). “Regulation of the European Parliament and of the Council amending Regulation (EU) No 1093/2010 establishing a European Supervisory Authority (European Banking Authority) as regards its interaction with Council Regulation (EU) No…/… conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions”, September.

Friedman, Benjamin, and Kenneth Kuttner (1992). "Money, income, prices, and interest rates", The American Economic Review Financial Studies, 82:472-492.

Goodhart, C, and D Schoenmaker (1995), "Should the functions of monetary policy and banking supervision be separated?", Oxford Economic Papers, 40:539-560.

Goodhart, C, P Hartmann, D Llewellyn, L Rojas-Suarez, and S Weisbrod (1998). Financial regulation. Why, how and where now?, Routledge.

Kashyap, A, J Stein, and D Wilcox (1993), "Monetary policy and credit conditions: Evidence from the composition of external finance", The American Economic Review Financial Studies, 83:78-98.

Norgren, C (1998), "A single regulator, challenges and opportunities", Financial Services Authority Conference, Financial Services Authority.

Peek, J, E Rosengren, and G Tootell (1999), "Is bank supervision central to central banking", Quarterly Journal of Economics, 114:629-653.

Vítor Constâncio (2012), “Towards a European Banking Union”, Lecture held at the start of the academic year of the Duisenberg School of Finance, Amsterdam, 7 September 2012.

Vittas, D (1992), Thrift regulation in the united kingdom and the united states: A historical perspective, World Bank.

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Topics:  EU policies Europe's nations and regions International finance

Tags:  ECB, European Commission, financial regulation

Lecturer in Economics in the Kemmy Business School, University of Limerick

Research Associate at the Department of Economics, University of Limerick