Banking Supervision in Europe: Impact of the financial crisis

Banking supervision in Europe deals with how public authorities control their banking systems and make decisions on individual banks. In Europe, supervision is a separate term from regulation. Supervision is currently more of a national prerogative, whereas regulation, or rule making, is mostly legislated at the EU level. Crisis management, prudential frameworks, and capital and liquidity requirements are currently issues of primary importance in European banking supervision.

Unlike the United States, Europe has adopted and implemented the Basel II Prudential framework. This has come under heavy criticism as it allocates a low risk weighting to real estate investment, and relies critically on now-discredited internal bank models and credit ratings to measure risk. The failure of these assumptions in the crisis has shown that improvements are needed in Basel II.

Many discussions in Europe revolve around whether capital requirements should be countercyclical. Dynamic provisioning is the key issue, which means that more provisions should be taken in good times in preparation for a downturn. During downturns, the provisions should be rescinded in order to smooth out negative effects. Spain is the only European country to have retained countercyclical dynamic provisioning requirements in accounting, and has gained much respect for having done so. However, how this approach could be integrated into Basel II remains far from clear.

Supervisory architecture is also under discussion. The creation of the UK Financial Services Agency in 1997-1998 was a landmark measure for supervisory architecture at the national level. Several questions remain regarding the role of central banks in banking supervision. The academic literature is inconclusive on questions like whether insurance companies and banks should be supervised by the same authority, and to which extent supervision can be independent of government interference. Until the crisis, there was a clear trend to separate supervision from central banking, but many believe now that central banking and banking supervision are closely connected. Macro-prudential supervision (or systemic supervision) and micro-prudential supervision (supervising individual banks) are seen by many as dual functions needing a strong institutional link.

The cross-border aspect of banking supervision is very important in Europe due to the unparalleled level of integration of the banking system, compared to most other regions. Over the past ten years, there have been significant steps toward the creation of an integrated continental banking market. Whether national banking supervision and a high degree of cross-border activity are compatible is a core issue made more critical by the current crisis.

Cross-border banking integration in Europe is a study of contrast. Most of the banks in Central and Eastern European countries are owned by Western European banks. Over 70% of the banking in Eastern Europe is in the hands of non-national, European banks. U.S. financial services providers GE and Citibank do have some retail banking operations in Eastern Europe, but the big players are primarily based in Western Europe.

Some of the Nordic countries are also fairly integrated, with 65% of the Finnish banking system being held abroad, primarily in Denmark and Sweden. Also, the UK has a lot of non-domestic banking activity, though the ratio drops significantly if only retail banking is considered. Wholesale financial activity in the European Union has become increasingly concentrated in the City of London in the past twenty years.

By contrast, countries like Spain, Germany and France have few important foreign-owned banks. There have been some foreign acquisitions into Italy and other countries, but most of the banking systems in Western European nations, excluding the UK, are in the hands of domestic banks.

There has also been a gradual upward trend among banks in the 27 EU countries to hold more foreign assets. From 1997 to 2007, the share of total revenue attributed to domestic assets has decreased from 62% to 46%. The situation among individual banks is very diverse, with some banks holding almost all of their assets in emerging economies while other banks have reduced by one-half their domestic holdings in the last ten years. This is the case both within and outside the Euro zone.

The banking sector, however, remains less integrated on a cross-border basis than other sectors in Europe. Among the top 100 companies in Europe between 1996 and 2006, banks continued to do much more business in their national home market than other sectors, even as the group of companies as a whole decreased the proportion of business conducted in 'headquarter zones' (as defined in Nicolas Véron, 'Farewell National Champions', Bruegel Policy Brief, July 2006, available on www.bruegel.org) over that 10-year period.

The main driver of these trends has been competition policy and the single-market policy. The single-market policy aims to create a single market and establish a competitive, level playing field across Europe. It has been the enabling factor for landmark mergers between banks.

The first landmark case in which competition policy has unlocked cross-border banking consolidation occurred when the Portuguese government attempted to block the acquisition of Champalimaud by Banco Santander, a Spanish bank, on the grounds that if a Spanish bank becomes big in Portugal, it would be detrimental to the Portuguese financial stability. The European Commission (EC) saw the case simply as attempted protection of a national champion and deemed that there would be no negative impact on stability, and therefore the Portuguese government should not prevent the merger from going forward. A variation of the proposed merger eventually went through and other landmark cases in which the EC either intervened or threatened to intervene occurred after that. This has prevented member states from prohibiting cross-border mergers on the grounds of financial stability. However, supervision has lagged behind integration.

Antonio Fazio, the governor of the Central Bank of Italy, decreed that the Italian banking system had to remain Italian. Fazio tried to prevent two takeover bids in 2005 for mid-sized Italian banks by encouraging rival bids from other Italian banks. This maneuver was criticized by the EC, but Fazio claimed that it was done for reasons of financial stability because a cross-border merger would take control of the Italian banking system out of the hands of Italian supervisors. A lawsuit led to a police inquiry that uncovered, through wiretaps, inappropriate conversations between Fazio and Italian bidders. On one occasion, he made a decision to delay a bid by a foreign bank and an Italian bidder called him at midnight to thank him profusely. Due to incidents like this, Fazio was forced to resign and the deals went through. One of the banks was acquired by a Dutch bank and the other by a French bank.

Even though Fazio's conduct was indefensible, there was a serious point at issue: supervision had lagged behind cross-border integration. The Lamfalussy architecture, put together by the EU, is a series of committees and coordination processes to deal with financial regulations. It was initially devised for securities regulation, but it was extended to banking and insurance in 2004. The Committee of European Banking Supervisors (CEBS) is made up of all European national banking supervisors and central banks, who share information and coordinate with each other. Being a consultative body, however, CEBS has no decision-making authority and few resources. Large and highly integrated pan-European banks were still being supervised by national authorities, which led to a fragmented public authority.

The recent financial crisis has brought greater scrutiny to concerns that had existed beforehand. On the positive side, the European Central Bank (ECB) has been a well-functioning lender of last resort. This is true for the entire EU and not only the Euro zone. For example, the Bank of England did not want to provide liquidity to the system in the beginning of the crisis. Most British banks thus acquired liquidity from the ECB through subsidiaries or branches in the Euro area.

There have been a number of national rescues in Europe since the beginning of the crisis. Most of them were for local banks that did not have much cross-border activity. Two exceptions are Fortis and Dexia, two banks headquartered in Belgium that had much activity in neighboring countries, primarily the Netherlands and France, respectively. Both were rescued in what ended up being a messy process where member states were initially able to come together.

In the case of Fortis, the cooperation between the Dutch and the Belgians collapsed after less than one week. The Dutch unilaterally nationalized the Dutch operations of Fortis and the Belgians tried to sell the rest of Fortis to BNP Paribas of France. This sale has been stalled in court because minority shareholders have sued the Belgian government, claiming that the Belgian government had not complied with the rights of minority shareholders. It is still unclear whether or not BNP Paribas will buy Fortis, and what will happen if it is not bought. Presumably, the Belgian government has guaranteed it. In the case of Dexia, both the Belgian and French governments have bailed it out with equity and subordinated debt, though it is too early to tell exactly what the final result will be.

In the early days when the consequences of Lehman's failure started to hit Europe, in late September / Early October 2008, it appeared that governments were able to come together to deal with the problem. But this initial optimism was misplaced, as shown in the case of Fortis. The concerns before the crisis of not having a working framework for management of cross-border banks are still very valid. The most worrisome scenarios have not yet been tested, as none of the banks with the highest level of cross-border integration has yet failed. If banks with significant activities in Central and Eastern European countries were to fail, it would put the system in uncharted territory and could lead to undesirable situations. A number of the countries in Central and Eastern Europe are emerging countries that cannot be called developed countries in spite of being a part of the EU.

The European banking system is currently in a "trilemma" because of three desired situations - an integrated EU banking market, effective supervision of all banks, and national sovereignty over banking supervision - that cannot be maintained simultaneously. In the past decade, banks were integrated and nations maintained sovereignty over banking supervision, but the banking system lacked an effective supervisory framework. With the crisis, effective supervision can no longer be neglected due to the enormity of financial stability concerns. In order to attain effective supervision, either banking integration or national supervisory sovereignty must be compromised. The inescapable decision is between a more fragmentary EU banking market or a more supranational supervisory framework.

It is a familiar choice for those well-acquainted with the EU. The process of forming the EU has been fraught with cases requiring change to a supranational way of doing things, because European countries are too small to do such things individually in an increasingly integrated world economy. Jean Monnet, the intellectual founder of the EU, said in 1954 that "our countries have become too small for today's world, given the scale of modern technological means, and the size of the United States and the Soviet Union today, and of China and India tomorrow." What he meant was that Europe was entering a world with very large economic entities and very large integrated markets, and if Europe remained fragmented it would lag behind. This concern remains at the core of EU dynamics.

This familiar choice has been exacerbated by the current crisis. There are both short- and long-term aspects to this. In the short term, the question relates to how to manage the ongoing crisis. For example, if a truly Pan-European bank were to come under problems, the solution would have to be solved in the short term. In the long term, the question is whether cross-border banking in Europe has a future. Whether the European banking system further integrates or reverts to a fragmentary makeup due to inadequate supervisory frameworks will be played out in the long term. Supervisory framework refers to supervisory institutions as well because if a bank needs to be rescued, the dispenser of bailout funds needs to be made clear. At this time, the EU does not have a federal framework for fiscal and budgetary affairs. There is almost no issuance capacity at the EU level, so essentially, the EU cannot issue bonds.

This is very topical because a high-level report soon to be released by a group chaired by Jacques de Larosiere, the former managing director of the IMF, will make recommendations on banking supervision at the request of the EC. This will be an important step in the European debate. Banking supervision is also on the agenda of the G20 meetings, put there on the insistence of the UK.

The big banks in the UK, starting with HSBC, Standard Chartered and Barclays, have much of their activity in the rest of the world, ie outside the EU. For them, cross-border integration means more integration with the rest of the world than with the EU. The vision of cross-border integration for UK banking players is very different from the perspective of those in Germany, France or Italy, where cross-border integration primarily means integration within the EU. Spain is in an intermediary position because the two large Spanish banks have a lot of activity in Latin America.

Thus, it is not only a European problem, which is why the UK insisted on putting banking on the G20 agenda. There is also the question of whether an integrated framework for supervision and regulation at the global level can be envisioned if strong global institutions are not present. The EU has no budgetary or fiscal framework, but the legal and political frameworks are quite well-suited to implementing common rules and tools at the EU level.

Q: Regarding the policy trilemma, what is the future of the European banking industry? How could the unraveling of the existing system take place, especially in Eastern European countries where there is no national banking system?

Nicolas VERON
In some ways there has been good news for the banking sector since October, though national governments have been extending extensive guarantees. While Central and Eastern European banks did the same, their fiscal and budgetary situations are weak. Ireland is in a similar position as the Irish government has taken on very big guarantees for a country its size. There are unconfirmed rumors that Ireland has engaged in discussions with the IMF.

Fragmentation would be like the Royal Bank of Scotland's situation, where it is aggressively cutting its overseas operations since the government took a 70% stake in it. This may happen if other large banks run into problems. However, this has not yet happened on a large scale, contrary to assumptions that pan-European banks would cut liquidity outside of their home country.

If cross-border integration were to collapse, local governments may have to start nationalizing local operations. Central and Eastern European countries will need the assistance of the IMF and the EU to do this and the local operations would then try to privatize through local groups or foreign banks.

Central and Eastern Europe has benefited massively from the integration of the banking system as Western European banks have acted as a channel of credit from Western to Eastern Europe that has outpaced foreign direct investment by three times in the past decade. Housing market bubbles are not as significant as the catch-up game from the low credit-to-GDP ratios in these countries, and their high current account deficits leave the future unclear.

Q: Regarding the Spanish bank that bought the Portuguese bank, does that case mean that the regulators or supervisory committee in Portugal lose all control over supervision of their citizens' assets?

Nicolas VERON
No, because there is a difference between branches and subsidiaries. A branch is supervised predominantly by the home country, while a wholly owned subsidiary is supervised predominantly by the host supervisory authority. Banco Totta is a subsidiary, so it is supervised by the Portuguese subsidiary authorities.

With the exception of the UK, where many foreign branches that are under foreign supervision are present in the City of London, almost all cross-border activity in Europe is done through subsidiaries. That is why national supervision means supervisory fragmentation. Supervisors do not entirely lose control, but how this system works in a crisis is still unknown because repatriation of assets cannot take place.

Considering the Lehman Brothers bankruptcy, Lehman Brothers transferred $8 billion in cash from the UK to the U.S. the evening before its bankruptcy filing, which caused much anger on the UK side. Many difficulties arise in supervising an integrated banking group with integrated cash operations and liquidity management. It is not easy to separate it into pieces, especially since cross-border synergies exist between many countries. For most of these cases, what will happen in the case of a default is yet unknown.

One interesting example involves LyondellBasell, a chemical group company with operations in both Europe and the U.S. that defaulted and is now going through several simultaneous bankruptcy procedures. This is developing into a test case for simultaneous, international bankruptcy procedures, and while it is not as difficult as dealing with a bank, conflicts of jurisdiction still arise. Banks cannot use normal bankruptcy procedures. Most parties want to avoid bankruptcy proceedings and try to wind up failed banks in a more orderly fashion.

Q: Would it be right to assume that you are promoting the idea of supranational supervision in Europe? What has the reaction been from governments, such as those in the UK? Have governments been opposed to the idea of supranational banking supervision?

Nicolas VERON
There is no fiscal framework at the EU level, so an EU-level supervisory framework would not look like a supervisory framework at the national level. It has to be a sort of hybrid between national and supranational frameworks, keeping in mind that the financial resources have to stay mostly at the national level.

In my opinion, the creation of a European supervisory authority is advisable. This would be an EU agency with its own budget that would be accountable to European governments and the European Parliament. This supervisory agency would have the power to conduct inspections and undertake some prompt corrective action, including the power to force undercapitalized banks to raise capital, and possibly the power to replace management if management is deemed to have failed. These would be quite significant binding powers, but the agency would not be able to recapitalize banks because the funds would be in the hands of member states. If there is a need for recapitalization, the supervisory agency would need to communicate with member states to determine the breakdown of burden sharing.

There are other views in the European policy discussion. The main alternative view, which has been echoed by some voices in the ECB, is that the ECB should have supervisory authority. However, it may not be a workable option for the same reasons supervision has been separate from central banking: if there is a failure of supervision, it is undesirable to have the central bank considered at fault.

More generally, supervision is an activity that has a much more direct link to government activity and ministries of finance than monetary policy. In order to have an independent monetary policy, supervision by a different body would be preferable. This is especially the case for the ECB. The independence of monetary policy is in relation to national governments. The independence of the ECB is more fragile than the independence of national central banks due to the lack of a supranational political framework to support it.

The other reason why this may not be a good idea is that the Euro zone does not include large parts of the EU. When looking at the patterns of cross-border integration, it can be seen that much of the integration happens in the Euro zone, but much is also happening outside the Euro zone and even this is an underestimation because it does not truly account for the importance of London as a hub for the wholesale financial operations of most of the large European banks. As long as the UK and most of Central and Eastern Europe remain outside the Euro zone, the cross-border coordination issue will not be solved with a Euro-zone only solution.

In regard to political feasibility, a European supervisor was considered necessary by many before the crisis. However, such claims were empty since there was no political consensus in support of them. National governments do not want to be deprived of this responsibility due to the issue of sovereignty. The trilemma is being felt much more acutely since the financial crisis hit. Ideas which were considered utopian two years ago are now considered less utopian.

The UK also has a problem because it has benefited hugely from European financial integration. UK banks do not have much continental activity, but much of the business conducted in the City of London is related to the EU. Should the banking landscape in the EU become fragmented, it would cause the UK and especially the City of London to lose a lot. The situation, at this point, is far from this and the crisis actually reinforces London so far, because strong financial centers are better able to weather these problems than weaker ones. The dominant view in the London financial community is that the UK is looking more toward globalization than European integration, but the numbers show that it will lose a lot if it loses some of its continental European business. At this point, though, the British government is against any solution that smacks of federalism.

However, things are changing direction. The big U.S. investment banks used to be in line with the UK position, but they are now rethinking their stances. Howard Davies, the first chairman of the FSA in the UK, recently supported a European supervisor, a previously unthinkable position. The UK may also separate further from Europe, as conservatives in the UK are skeptical of the EU. The status quo, however, is unlikely to remain the same.

Q: Please explain why your envisioned EU supervisory authority lies in the hands of member states rather than the hands of the EC.

Nicolas VERON
The EC cannot be an effective supervisor in Europe because it is not tooled for such a role. It is a general-purpose governmental organization. Another obstacle blocking the EC from supervision is the long European experience of financial regulations not being based on the ministry of finance itself. The EC has not been a policy leader in financial regulatory issues. The directorate-general in charge of financial regulation in the EC plays a very important role and prepares legislation, but it has not convinced the marketplace that it has a firm grasp of financial issues the same way that an independent regulator can have. This is not likely to change. Also, it does not seem like the EC staff have a very firm hand on accounting issues. Being a general-purpose civil service, it is difficult for directorate-general to obtain specialized skills like accounting.

Q: How do you see the separation of toxic assets from European banks' balance sheets given the Japanese experience with banking crises?

Nicolas VERON
In past banking crises outside the EU there has been such separation in the form of government agencies buying assets from the banks, but it has come quite late and in relatively small volumes compared to the extent of bad debt that existed in the marketplace. The most convincing scheme for a bad bank is when the split happens inside a bank as an operational management issue, with the separation becoming complete if the whole bank falls under full government ownership. This was what happened in the Swedish case. However, these schemes generally do not work early in a crisis because there is often a long period of denial during which the banks do not accept the fact that their assets have lost most of their value. Such is definitely the case now in both Europe and the US.