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The European Commission proposes a new architecture for the European financial system
Joe Beashel
As anticipated, the European Commission, on 27th May, adopted a Communication to overhaul financial supervision in Europe, which follows closely the recommendations made in the de Larosière Report published in February this year. The general thrust of these proposals have been welcomed by the financial markets, however, there are some contentious issues which will result in intensive debate, writes Joe Beashel.
As anticipated, the European Commission, on 27 May, adopted a Communication to overhaul financial supervision in Europe, which follows closely the recommendations made in the de Larosière Report published in February this year. The general thrust of these proposals have been broadly welcomed by the financial markets, however, there are a number of contentious issues which are likely to result in intensive debate.
Joe Beashel


The financial crisis has exposed serious failures in the European financial supervision system and has highlighted the need for significant reform of the financial system as a whole. I analysed the de Larosière Report in detail in an article which appeared in last month’s edition of Finance Magazine Online. In this article, I will examine the Commission’s proposals to strengthen Europe’s financial supervision infrastructure which are based around two new pillars, a European Systemic Risk Council and a European System of Financial Supervisors

1. European Systemic Risk Council (ESRC)

The core of the Commission’s proposal involves the establishment of a new body to be known as the European Systemic Risk Council (ESRC). The ESRC, as its name suggests, will be responsible for macro-prudential supervision to help prevent a major disruption in the EU financial markets, like that which occurred in the period following the collapse of the US sub-prime market in mid-2007.

This body will be entrusted with the following tasks:

- to provide early warnings of system-wide risks and to issue recommendations on how to deal with them;
- to monitor the follow-up to warnings and recommendations, and
- to liaise closely with the IMF, the Financial Stability Board and other international systemic-risk bodies.

Composition and functioning: The ESRC will be chaired by the president of the European Central Bank and will include all 27 governors of the central banks in Europe, chairpersons of the three European Supervisory Authorities and a member of the Commission. The proposal states that each central bank governor should be accompanied by one senior representative of the national supervisory authorities who will be present in an observatory capacity only. To address the concerns of non-euro-zone members, it is proposed that a vice-chairman should be elected from outside the euro area. Finance ministers will not be invited to the body as it is felt this could dilute its independence.

The ESRC meetings are to be scheduled at least quarterly, although during times of crisis it could meet more regularly. Significantly, it would not have legally binding powers to direct member states to take a particular course of action although an EU state would have to explain why it was refusing to take the recommended action. The Communication recommends that a steering committee should be established to "prepare and ensure efficient ESRC meetings" which would consist of the ESRC chairperson and vice-chairperson, five additional central bank members of the ESRC, the chairpersons of the new European Supervisory Authorities and a European Commission member.

Concerns: While the proposal to independently review systemic risk is broadly welcomed there are concerns regarding the lack of clarity in the proposal on what levels and types of risk should be regarded as acceptable and the vague nature of the ESRC's power to issue recommendations to deal with systemic risks. There is also some concern as to the democratic legitimacy of an unelected body making recommendations to member states on how to run their economic affairs.

2. European System of Financial Supervisors (ESFS)

The new ESFS structure is to be largely as the de Larosière Report proposed and would act at the microeconomic level, creating a network of national financial supervisors tasked with overseeing banks and other financial institutions, including credit rating agencies, which operate in several EU member states. This would consist of three new EU bodies with legal authority to supervise the banking, insurance and securities sectors. The three pan-European authorities would transform the existing EU "Lamfalussy level 3 Committees" namely the Committee of European Banking Supervisors (CEBS), Committee of the Committee of European Securities Regulators (CESR) European Insurance and Occupational Pensions Committee (CEIOPS) giving them increased responsibilities and greater authority. The Commission’s proposal in this area goes slightly further than the de Larosière Report envisaged by proposing the establishment of a new steering committee to replace the Joint Committee on Financial Conglomerates which will be tasked with ensuring mutual understanding, cooperation and consistent supervisory approaches between the European Supervisory Authorities (ESAs).

A single European regulator is not proposed rather the proposal starts from the premise that day to day supervision should remain at a national level (except for some special types of institution such as credit rating agencies and EU central counterparty clearing houses). The ESAs will be responsible for cross-border institutions and will be required to fulfil the following functions:

- to develop common supervisory approaches to the supervision of all financial firms, to protect consumers of financial services and to contribute to the development of a single set of harmonised rules;
- to perform a coordinated response during a crisis;
- to collect macro-prudential information;
- to develop a new dispute settlement mechanism, which aims to balance home and host interest and provide more effective supervision. The decisions under the new mechanism should not directly impinge on the fiscal responsibilities of Member States;
- to require a national supervisor to take a particular action where there is a manifest breach of Community law and in certain extreme cases to adopt decisions directly applicable to financial institutions;
- to refer member states to the Commission for non-compliance of Community law; and
- responsibility for authorising and supervising certain pan-European entities such as credit ratings agencies and a newly proposed EU central counterparty clearing house for certain financial products.

Composition and functioning: Each ESA would have a Board of Supervisors comprised of representatives from the appropriate national supervisory authorities. Representatives from the Commission and the ESRC would take part in the Board of Supervisors as observers. They should meet on a regular basis, with additional meetings held it times of stress. Decisions on technical rules would be taken by the ESAs, through the board structure, by qualified majority. The steering committee is to be made up of representatives from the three ESAs and the Commission.

Concerns: This system is intended to ensure national regulators make the best possible decisions for cross-border institutions rather than act nationally in the best interests of their own locally-based financial institutions. While this goal is clearly laudable the strength of the new institutions, might undermine the influence and control of smaller member states, for example the international fund industries which are important in both Ireland and Luxembourg might struggle where there is a conflict with the interests of larger member states.

Conclusion
The de Larosière Report recommends that the new regime be introduced in two phases to be completed in 2012. However, the Commission has proposed a much more ambitious timeframe as it believes that the best chance of getting agreement to the far-reaching proposals from all member states is to push them through during the current deep financial crisis.

The European Commission is hoping that the June European Council approves the proposals and then the Commission will present legislative proposals to give effect to the framework for EU supervision in the autumn. The Commission President, José Manuel Barroso, has urged the EU leaders to endorse a 2010 implementation timeframe. The release of the Communication marks a key milestone in the future of financial regulation in Europe. Whether the proposals will be implemented within that timeframe remains to be seen and whether they will be substantially amended remain to be seen but it is clear that there is a very strong momentum to significantly restructure the architecture of Europe’s financial system, it is now not a question of if but when, change will be enacted.


Joe Beashel is a partner in the Banking and Financial Services Department and head of the firm’s Regulatory Risk Management and Compliance Group at Matheson Ormsby Prentice and can be contacted on +353 1 232 2000 or by email: joe.beashel@mop.ie. Further information on Matheson Ormsby Prentice is available at www.mop.ie.