Financial Regulation in the European Union

Rainer Kattel, Jan Kregel, Mario Tonveronachi

• Publisher: Routledge
• Year: 2015
• Print ISBN: 9781138914049
• eBook ISBN: 9781317428831
• Topic: Business
• Subtopic: Business General
• Index: Business

This collection offers a comparative overview of how financial regulations have evolved in various European countries since the introduction of the single European market in 1986. It includes a number of country studies which provides a narrative of the domestic financial regulatory structure at the beginning of the period, as well the means by which the EU Directives have been introduced into domestic legislation and the impact on the financial structure of the economy.

In particular, studies highlight how the discretion allowed by the Directives has been used to meet the then existing domestic conditions and financial structure as well as how they have modified that structure. Countries covered are France, Germany, Italy, Spain, Estonia, Hungary and Slovenia. The book also contains an overview of regulatory changes in the UK and Nordic countries, and in post-crisis USA. This comparative approach raises questions about whether past and more recent regulatory changes have in fact contributed to increase financial stability in the EU.

The comparative analysis provided in this book raises questions on whether the past and more recent changes are contributing to increase the financial stability and efficiency of individual banks and national financial systems. The crisis has demonstrated the drawbacks of formulating the regulatory framework on standards borrowed from the best industry practices from the large developed countries, originally designed exclusively for large global banks, but now applied to all financial institutions.

1
Introduction¹

Jan Kregel, Mario Tonveronachi and Rainer Kattel

1 The evolution of the general regulatory framework in the European Union

The intention of the 1986 Single European Act was to provide renewed stimulus to the process of European integration initiated in the 1957 Treaty of Rome creating the European Economic Community or European ‘common market’. By the early 1970s, the expansion in intra-EEC trade driven by the erection of a common external tariff and elimination of internal tariff barriers had slowed. It became clear that if economic integration were to progress beyond the limits set by the simple application of a common external tariff, more radical steps would have to be taken to implement full integration of internal markets. Although there were diverse proposals and expert commission reports on how this fuller financial integration would be achieved through the creation of unified money and financial markets, the decision was eventually taken to proceed via the creation of a common European currency. This path had several clear implications for the institutional structure of the EU. In particular, it required a single issuing authority for the common currency, the euro, which took the form of a European Central Bank (ECB), independent of the control of the government of any member state, but without a Federal EU governance structure.

Following the example of the post-war Bank Deutscher Länder (itself modelled on the United States Federal Reserve’s system of geographically dispersed ‘District’ banks), the European System of Central Banks was supported by a similar system comprised of the European Central Bank supported by the existing national central banks who became the operative agents of monetary policy determined by the central institution. Following the German example, and the dominant economic theory of the period, the ECB was given by statute a single objective, price stability, that was to be implemented by a single monetary policy effectuated through a uniform interest rate. For a common interest rate policy to be effective in implementing the policy objective, and have similar impact on the member states adopting the common currency, all member states would have to have similar financial performance and similar financial architecture to ensure the efficient transmission of the single monetary policy actions implemented by the central bank into national financial conditions.²

In order to ensure the required uniformity in economic performance a number of conditions of entry into the single currency were imposed in the form of a maximum rate of inflation, similarity of interest rates, compliance with the existing exchange rate mechanism (ERM), a maximum fiscal and debt position and a sustainable current account balance of payments. Because monetary policy is primarily transmitted through the impact of interest rates on the performance of the lending behaviour of the private financial system, the decision to adopt a single currency also meant the creation of a common organizational structure for the financial systems of the member states. Indeed, the divergences in the institutional financial structure and monetary policy instruments and operating procedures used in the national banks of the component member states were as large, and in some cases even larger, than the differences in inflation performance or government fiscal policy stance. Most governments of the initial member states had made extensive use of direct controls over lending or interest rates, active management of exchange rates and direct ownership of domestic financial institutions, to implement monetary policy in the 1950s and 1960s in support of post-war recovery programs. Opening such diverse, managed domestic financial systems to a uniform, open European financial market made untenable the existing apparatus of controls and subsidies. In particular, the widespread use of directed and concessionary interest rates became increasingly difficult in the face of market determination of interest rates in other countries and their defence required both capital controls, which were in contrast with the objective of a single financial market, and exchange rate management, which was in contrast with the move to a single currency unit within a unified European financial market.

As a result, after the decision to implement monetary integration via limitations on exchange rate volatility via the ‘snake’ procedures instituted after the breakdown of the Bretton Woods System in the early 1970s and the more formal Exchange Rate Mechanism of the European Monetary System as part of the move to Economic and Monetary Union at the end of the 1970s, the European Commission initiated a series of measures starting in the 1980s to widen the scope of the single market to include measures to ensure the necessary uniformity in the structure of financial markets to ensure full integration of the markets in financial services. In particular, the controls on cross-border investments that had been a major part of domestic policies of directed lending, interest rate limits and exchange rate management were eliminated. With the decision to move toward open financial borders, the adoption of common rules and homogeneous supervisory practices became an integral part of the objective of integration of the European internal markets.

While this process of convergence of financial structure was implicit in the movement to the integration into a single market via a common currency, it also took place within a global framework leading toward greater deregulation of financial institutions and the liberalization of financial markets in the major financial centres of the developed world that commenced after the US suspended the Bretton Woods gold parity of the dollar in 1971. This approach implied an increasing emphasis on the role of market forces in the global distribution of financial assets and the regulation of financial institutions. Increased market competition was seen as a more effective means than government controls to improve efficiency, the allocation of financial resources, and the freedom of cross-border operations of financial institutions. These measures were presumed to be a prerequisite for support of long-term economic growth, since markets would be more efficient in providing the innovation of financial practices, products and institutions in support of financial and economic stability. Thus, relaxation of the constraints on international financial flows and the activities of international financial service providers accompanied the reduction of controls on capital flows and institutions within the European Community. The enduring regulatory dispute between strict application of prudential rules versus discretionary interpretation of financial regulations by national supervisors was won by the latter and the new common European regulatory structure was influenced by and largely reflected this approach to place greater reliance on market self-discipline and what came to be known as ‘light touch’ regulation.

Given the particular requirements of the European integration process, the process of the creation of a common financial market as reflected in the details of its legal agenda became more far reaching than the similar movement on the international level. The single European passport for financial institutions incorporated in, and regulated by, the home regulatory authority provides one example. The extension of the Basel I regulations to all banks, rather than only to those operating at the international level, as was the clear intention of the first Basel Accord, is another.

However, given the preservation of national regulatory jurisprudence and supervisory jurisdictions, based on diverse national legal codes and practices, substantial discretion was left to individual member countries in the practical implementation of the common EU rules and principles. As a result, the implementation of the common European Union financial marketplace was effectuated via the issuance of European Directives that, in difference from EU Regulations, are not introduced directly into member country jurisprudence, but have to be adapted and adopted with the agreement of national legislative bodies. The result was a substantial amount of national differentiation in financial market regulation.

Another important source of national differentiation within the introduction of common principles is the use of subsidiarity and proportionality in the national application of EU legislation. In practice, this means that the minimum degree, rather than the maximum, of harmonization would be the standard achieved in national legislation. In addition, the failure to introduce a common EU regulatory agency, which was implicit in the Maastricht Treaty, meant that national authorities retained full discretionary powers in the interpretation and application of EU Directives once formally adopted and incorporated in national legislation.

2 The structure of the country studies

Chapters 2–9 of the book present eight country studies on the implementation of the European Directives on banking and finance in the period from the introduction of the Single European Act to the 2007/2008 global financial crisis and the additional national measures that have been taken in response to the crisis.³ Each of the country studies provides a narrative of the domestic financial regulatory structure at the beginning of the period, defined as the date of the Single European Act, as well the means by which the EU Directives have been introduced into domestic legislation and the impact on the financial structure of the economy. In particular, the studies highlight how the Directives have been modified to meet then-existing domestic conditions and financial structure as incorporated into national legislation, as well as how they have modified that structure.⁴

The topics of regulatory and supervisory activity chosen for presentation by the country studies may be divided into three notional categories: those that were fully incorporated into EU regulation; those lightly or partially regulated; and those left outside the scope of formal regulation. As stated, the recent trend appears to be towards the elevation of the elements of the latter two categories to the higher category, increasing harmonization and reducing the space for national diversity.

The liberalization of cross-border capital movements and the single European passport for banks and providers of financial services were the first relevant measures in laying the foundation for the implementation of a single financial market. In general, the implementation of capital requirements was driven by the Basel Committee on Bank Supervision process of formulating uniform global standards of good practice and corresponded to those recommendations. Common principles on consolidation in reporting and consolidated supervision were necessary appendixes to what essentially remained cross-border activities rather than EU-wide establishment and operation of financial institutions through branches or subsidiaries. Given this framework, it was necessary to avoid unfair competition due to divergent national implementation by imbedding the various regulations in the various versions of the Basel Accords and in the specific legislation that national governments applied to different market institutions via the Markets in Financial Instruments Directive. The introduction of more binding EU rules on large exposures introduced more precision into the necessarily vague Basel principles and reduced the tendency toward discretionary application.

These are the major areas in which the EU Directives concentrated attention and in which the country studies show the largest degree of regulatory convergence, although this has not necessarily been accompanied by convergence in supervisory practice. The continued presence of national regulatory and supervisory agencies, which exercised the option of incorporating national exception into national legislation and then discretion in the interpretation of these principles, meant that strong initial differences have made the de facto convergence much more limited than is exhibited by the changes in national legislation and financial structure.

In addition, the country studies cover a second range of issues in which greater national discretion allowed for increased divergence in those lightly or partially regulated financial operations, including deposit guarantee schemes, recovery and resolution procedures and accounting standards. Although the creation of deposit guarantee schemes and participation became compulsory for all banks, the differences for the funding and coverage of the various national systems have until recently remained substantially unchanged. The conditions covering bank recovery and resolution were mainly directed at specifying the responsible authority for cross-border crises, rather than imposing homogeneous procedures on the liquidation or recapitalization of insolvent institutions.

The homogenization of accounting standards towards IFRS international standards was only compulsory for listed or large banks; moreover, the determination of this standard is outside the direct control of the EU and thus leaves banks and national authorities with a wide set of options and discretion. This issue is of crucial importance in interpreting the actual application of regulations since accounting practices are central to a system of core bank regulation that relies on the balance sheet calculation of regulatory capital as a risk-weighted minimum. This second category of measures also includes topics that have taken on additional relevance due to their aleatory application and implementation in the evolution of the recent financial crisis.

The third category of regulatory issues includes topics such as rules on liquidity, bank resolution, competition policy, usury and taxes. The provision of liquidity was a topic of the Basel Core Principles that was left to the implementation of local supervisory authorities. It was only subsequently included in the second pillar of Basel II on the basis of discretionary interpretation of principles more than strict rules and, in any case, only implemented in Europe since 2007. Before the crisis, few countries had in place specific legislation for dealing with bank crises, especially dealing with the failure of large banks. There is no specific competition policy for the banking sector for the EU, leaving large variations in the degree of bank concentration. Usury laws are present in only a few European countries. Finally, tax treatments are widely different across European member countries, although being crucial under several profiles, as for the provisioning policy of impaired assets.

The regulation process promoted by the Single European Act has undoubtedly produced a convergence on rules, supervisory practices and, above all, on institutional and structural features for the countries analysed in the previous chapters. As might have been expected, the changes were more marked for the formerly centrally planned economies. Since the Directives introduced were in large part consonant with a convergence towards international standards in all developed financial systems, the general framework, if not specific national features, would have been followed in many cases even in absence of the push towards unification of the financial systems in EU member states. However, the level playing field created by the introduction of the system of a single European passport has produced a greater harmonization than might have been reached otherwise, despite the limited degree of convergence that has resulted by the acceptance of a minimum level of harmonization and the discrepancy between formal rules and supervisory practices.

The recent global financial and European Sovereign debt crisis has made evident the relevant limits inherent in the application of the three categories of regulations presented above. Remedies have been adopted to expand and augment the regulations surveyed in the first category via Basel II.5 and then with Basel III, which was designed to remedy some deficiencies of the previous versions, notably incorporating the formal treatment of liquidity.

The crisis has also led support for tighter interpretation and application of existing regulation, as well as widening its application to encompass a higher level of harmonization. The result is a reversal of the initial approach and an increased reliance on Regulations rather than on Directives, and the creation of the European Supervisory Authorities (ESAs), whose technical standards are statutorily directed at producing a single rulebook and single supervisory handbook for banks, insurance companies and markets.⁵ Similarly to the Dodd-Frank Act in the US, the ESAs are mandated to draft hundreds of technical standards to fully implement the new legislation. A Directive on minimum harmonization at the EU level of bank recovery and resolution has recently been finalized. The need for maximum harmonization for countries inside the currency union has led to the Banking Union with its two pillars, the Single Supervisory Mechanism and the Single Resolution Mechanism.⁶

The crisis has thus produced a shift of some of those items that were previously subject to weak or national discretion in coverage into the group of items to be covered by obligatory EU harmonization.

To better understand the regulatory dynamics, Chapter 10 offer a narrative on how, before the recent crisis, the interplay between financial innovations, bank crises and regulatory reforms, significantly influenced the British institutional framework, and became a reference model for light-touch regulation and supervision. Its role on weakening financial resilience only became apparent in the evolution of the recent crisis. As a result, the British regulatory reaction to the recent crisis has been more marked than in Continental Europe, partly due to being host to a leading international financial centre.

Chapter 11 shows how the prompt and efficient way in which the Nordic countries managed their early 1990s systemic crises continues to offer important indications of the appropriate response measures to deal with managing bank recovery and resolution after major insolvency in the financial system.

Finally, Chapter 12 outlines the efforts by the G20, the Financial Stability Board and international standard setters to reach a new regulatory balance for the banking industry, where a reaffirmation of the benefits of the internationalization of finance is mitigated by a recognition of particular national or regional interests. This is also due to the fact that the post-crisis deepening and widening of the regulatory and supervisory scope could not avoid allowing a much larger role for idiosyncratic features of national financial structures. As a consequence, the concept of the regulatory level playing field is de facto evolving, especially for wholesale banking, from being based on rules to the discretionary recognition of equivalent results. T...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• Notes on contributors
• 1 Introduction
• 2 Financial regulation in France
• 3 Financial regulation in Germany
• 4 Financial regulation in Italy: liberalizations, prudential rules and governance
• 5 Financial regulation in Spain
• 6 Financial regulation in Estonia – a ‘world of “dead letters”’: the interplay of Europeanization process and national idiosyncrasies
• 7 Financial regulation in Hungary
• 8 Financial regulation in Poland
• 9 Financial regulation in Slovenia: creation, adaptation and collapse
• 10 Financial regulation in the United Kingdom from the Big Bang to post-crisis reforms
• 11 Crisis management: the 1990s experience of the Nordic countries
• 12 Post-crisis international regulatory standards and their inclusion in the European framework
• Index