EU wise guys always centralise

Former Central Banker Alexandre Lamfalussy was yesterday holding court at a debate in Brussels, looking at EU financial regulation, and in particular the creation of the three new EU authorities for 'micro-prudential' supervision and their sister organisation, the new European Systemic Risk Board, for the macro-prudential side of things.

We've looked at this issue in detail before, but let's have another go.

Lamfalussy is an EU "wise man" - belonging to an exclusive group of men (they're almost always men and have usually seen too many winters) whose services are called upon when Europe is need of a game-changing policy that will solve all its problems overnight.

Lamfalussy certainly has an impressive CV. He was the chair of the Committee of Wise Men on the Regulation of European Securities Markets (which is a ridiculous name - why not go for the Fellowship of the Ring while they're at it?), having also served as first President of the European Monetary Institute, predecessor to the ECB, and Director General of the Bank for International Settlements.

It was also Lamfalussy's committee that proposed the so-called Lamfalussy process - the EU's method for deciding and implementing financial regulation (Zzzzz).

Speaking at the debate, Lamfalussy labelled the recent makeover of the EU's financial supervisory architecture a "quantum leap", saying he was particularly pleased with the fact that "the level 2 committees [in the Lamfalussy process] have become authorities now", which in plain English means that more powers have now been given to the EU. As Lamfalussy put it, the three supervisors - charged with overseeing banks, insurance and securities - are now equipped with proper "decision-making powers" (how that is legal under the EU treaties is open to debate, but that's for another time).

He wasn't as happy about the limited mandate of the European Systemic Risk Board, which has more of an advisory role at the moment. He said that "it should get decision-making powers as soon as possible" since "the absence of a macro-prudential supervision component [which is meant to be the ESRB's area] did play a major role in the crisis."

Warming to his subject, he then went on to argue that "the problem with the people now in charge [i.e. the three EU supervisors] is that they haven't been trained or mandated" for their task, adding that "the three should instead have direct and frequent access to the bankers." In other words, the supervisors need to get closer to the people/level that they are meant to be regulating.

Right, so let's recap. Mr Lamfalussy says that 1) financial supervisors failed to spot/address the crisis and 2) the people working for the EU's new financial supervisors aren't trained properly and 3) we need to regulate closer to the ground but 4) we need to concentrate more supervisory powers at the hands of EU regulators - micro as well as macro - at the expense of experienced national authorities which, naturally, are closer to the ground.

Hmmm, something doesn't seem to add up here. Indeed, as someone once noted, "the problem with wise men is that there aren't enough of them." They tend to have an inherent bias towards whatever option they're commissioned to write about, with no one there to take a contrary view.

Judging from Lamfalussy's comments - which of course should be seen in light of his entire speech - it's not entirely clear to us whether he's making the argument for more EU supervisory powers -or less, i.e. devolving powers to a level closer to the firms that are being regulated and where the expertise also lies.

In addition, it remains unclear to us why EU supervisors would do a better job spotting bubbles and systemic risks than their national counterparts (an issue which we look at here).

Having said that, we do see potential in the European Banking Authority (on stress tests, cross-border banking wind-downs and solving host-home country conflicts) and the ESRB (to serve as a forum for exchanging information on systemic risk and keep up with new developments, such as the rise of "shadow banking" for example.)

But surely, an EU wise man must be able to put up a stronger case than this?

How to prevent bubbles

The new year sees the launch of the EU’s new financial supervisors: the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority. If you haven't already done so, have a look at our take on the new EU supervisors here.

Green MEP Sven Giegold (Germany), who took the lead on the issue in the European Parliament, seems to be their most ardent supporter. He told German TV channel ARD that the huge structural problems in Ireland's banking sector "could have been prevented by the new European banking supervisors, thanks to their new legal possibilities".

Hmmm, a bit of a simplistic explanation, no?

Giegold doesn't have to look very far to spot the reason why his reasoning is painfully incomplete. In fact, casting his eyes to Frankfurt and the ECB would do the trick.

As often repeated nowadays, low eurozone interest rates, essentially designed for a sluggish Germany, led to an abundance of cheap credit in Ireland, in turn fuelling a property bubble that burst with the financial crisis in 2008, while the Irish government turned a blind eye. The Irish banks became insolvent, and private debt became public debt through bank bail-outs.

Inappropriate interest rates weren't the only issue, but to ignore the problems they caused Ireland is just silly. Therefore, there are several problems with Giegold's view:

1. It's heroic to assume that the EU's financial supervisors - somehow by virtue of being ran at the EU level as opposed to the national level - would spot the credit dangers looming, and act accordingly. It's also not clear why EU supervisors would be less vulnerable to commercial or political "hijack" than their national counterparts.

2. Regulators often find it difficult to spot bubbles, not matter where they sit (in the Spectator, Johan Norberg does a good job of breaking down the flawed assumptions underpinning the thuinking ahead of the 2008 crash). Ireland, for example, had been experiencing sound growth since the beginning of the nineties, thanks to some brave economic reforms. Booming house prices could be seen as 'normal' in such economic circumstances. It's not at all clear that the new EU supervisors would possess the kind of competence needed to really dig into the markets, or know where to look (American regulators quite clearly didn't pre-Lehman).

Having said that, however, in a best case scenario, the European Banking Authority, alongside the European Systemic Risk Board, could in theory serve as important facilitators of information sharing to help regulators/supervisors keep up with new developments, such as the rise of the shadow banking system, and control leverage accordingly. The EBA could also coordinate cases where cross-border banks expose taxpayers and savers in different countries to risks, ideally leading to wind downs of insolvent banks at the minimum cost, rather than more taxpayer-backed bail-outs (solving nothing).

3. But, and here's the thing, even if the EU supervisors were to spot, say, a housing bubble and stop it (through taxes at the national level and regulating the housing market, for example), the problem of excessive cheap credit, fuelled by low interest rates, would not be addressed. There are other things to spend your cash on apart from houses. If money is cheap, risk-taking is easy. And the more risks the greater the scope for bubbles.

The only effective way to stamp out excessive cheap credit in a boom is to make money more expensive, through higher interest rates. But here the familiar dilemma appears yet again: in a currency union it's impossible to tailor the interest rates like this, meaning that the EU supervisors can scream "bubble" all they want.

This is of course a difficult conclusion to reach if you have an ideological commitment to centralised decision making and a single currency for everyone...