EU Proposals for Global Financial Regulation Reform

The Economist has a short article discussing EU proposals for financial regulation reform, in the July 4, 2009 issue, “Divided by a Common Market.”  The article is not persuaded that EU regulatory reforms, divided on at least two fundamental matters, will get very far, very soon:

The EU remains riven by two deep divides on the regulation of finance.

The first is an ideological one over the degree of freedom that should be afforded to markets. It pits a weakened and distracted Britain, whose appeal as a financial centre in less troubled times was enhanced by its “light-touch” regulation, against countries such as France and Germany, which feel their long-standing distrust of freewheeling markets has been vindicated. “There is a large body of people who say that the Anglo-Saxon model has failed,” says a person involved in the new regulations. “Now they see the chance to bury it.” Tougher regulations may also peg London back in its rivalry with other European centres such as Frankfurt or Paris.

The second divide is between countries that want large cross-border banks to be overseen by a single European supervisor and those that want them to stay under the control of home regulators. The question of who is in charge cuts to the heart of Europe’s problems. Its banks operate in a largely borderless market but are often closely watched only at home.

The EU has agreed to establish a systemic risk monitor – a device that has a cognate in the US Treasury’s June paper on regulatory reform.  It is, as the article says,

intended to sound the alarm over the build-up of risk, and to create new European supervisory authorities to keep an eye on big cross-border financial institutions. The promise to create new European authorities was hailed by proponents of centralised regulation as a victory over Britain. Nicolas Sarkozy, the French president, called Britain’s agreement to their establishment a “complete change in Anglo-Saxon strategy” on financial regulation.

The new structures may not live up to his expectations. The risk board, for instance, has only the power of its voice. In good times its warnings may well be ignored and during a crisis it may have to hold its tongue for fear of sparking panic. Moreover, it seems likely to duplicate work being done globally by the newly christened Financial Stability Board, an international body which held its first meeting on June 26th and 27th.

The new supervisory authorities set out for the EU internally appear to be networks.  As we’ve discussed here at OJ with reference to the Treasury White Paper’s global regulatory reform proposals, the nature of such networks, whether globally or internally to the EU, is that that they cannot

compel countries to do anything that might cost money (“burden sharing” in the jargon), such as propping up banks with more capital. Nor can they wind up cross-border banks in an orderly way to ensure that all depositors are protected, something that is needed to stop countries from simply grabbing what assets they can when big banks fail. The danger is that national supervisors in Europe could well end up ignoring the new authorities and erecting barriers to foreign banks instead. “If we stick with national supervision we will end up with national banks,” says Dirk Schoenmaker of the Duisenberg school of finance.

The Economist criticizes the EU proposals for coming down on hedge funds and private equity, noting first that these are very different industries and, second, that “alternative investment managers” played a small role in the crisis.

Finally, however, the article notes something of unavoidable importance within the EU as a common capital market. The financial markets, or at least the banking market, is fragmenting within the EU, potentially moving systematically away from an integrated EU-wide market in bank lending.  How so?  National governments, the article notes, have bailed out their banks using national taxpayers’ money in

exchange for an explicit or unspoken promise to keep up lending to small businesses in their home markets (although some have supported continued lending in troubled eastern European and Baltic countries). The European Commission’s competition watchdog, which is policing the aid, also appears to be contributing to fragmentation, albeit unwittingly. Axel Weber, the president of the Bundesbank, Germany’s central bank, recently complained that it was forcing banks to focus their lending and borrowing in their home markets, a charge the commission has hotly denied. Those most keen to reform European finance may yet find their principal sin is tardiness. For even as they write new rules, the market they want to regulate is fragmenting before their eyes.