While everyone is talking bond-buying: Here's the first proposal for an EU banking union (leaked)

That ECB, it's so hot right now.

While everyone is watching and reacting to the ECB announcement from yesterday, the Commission's highly anticipated proposal for an EU Banking Union, due to be released on 12 September, has leaked (courtesy of Italian daily Il sore 24 ore). The full document can be read here.

It's the first chance to analyse the first document in its entirety (though snippets have leaked in various media reports over the last week or so - more to come for sure, that will add to this proposal) and below we highlight some of the key points. We’re still going through the main doc and will update this blog with anything else that catches our eye, but this is what we got so far:

• As expected, the Commission proposes that the ECB should supervise all banks, as the document notes: “recent experience shows that smaller banks can also pose a threat to financial stability. Therefore, the ECB should be able to exercise supervisory tasks in relation to all banks”.

• National supervisors will continue to assist the ECB with preparation and implementation of its new role as necessary, but the ECB will have final authority in most areas (a major change).

• Paragraph 25 of the preamble notes that: “In order to ensure consistency between supervisory responsibilities conferred on the ECB and decision making within the EBA, the ECB should coordinate a common position amongst representatives of the national authorities of the participating Member States in relation to matters falling within its competence.”

• The ECB will have to power to wind down banks if necessary, as well as grant or remove banking licences within the eurozone.

• The ECB will work with the Commission and the ESM to recapitalise ailing banks (this could be a hint that the ESM could form the future resolution mechanism and financial backstop).

• Paragraph 10 of the pre-amble says that “In view of the close interlinkages and spillovers between Member States participating in the common currency, With a view to maintaining and deepening the internal market, and to the extent that this is institutionally possible, the Banking Union should also be open to the participation of other Member States.”

• Paragraph 18 highlights that the ECB has the power to increase capital buffers if deemed necessary under its macroeconomic surveillance.

• Paragraph 41 states that: “Given the globalisation of banking services and the increased importance of international standards, the ECB should carry out its tasks in respect of international standards and in dialogue and in close cooperation with supervisors outside the Union, without duplicating the international role of the EBA. It should be empowered to develop contacts and enter into administrative arrangements with the supervisory authorities and administrations of third countries and with international organisations, subject to coordination with the EBA while fully respecting the existing roles and respective competences of the Member States and the Union institutions.” 

The relationship outlined between the EBA and the ECB is vague but interesting. The ECB (eurozone countries) will be represented as a single bloc in the EBA from now on, meaning, under the voting procedure of simple majority (applicable to settlement of disagreements and breaches of EU law) , the ECB will always have a majority. Also under the new voting weights coming into force in 2014 / 2017, the eurozone will have permanent majority under QMV (applicable to technical standards and some other issues).  Even though the eurozone often voted cohesively previously, the fact that it will now be represented by a single voice and will always vote as a cohesive bloc looks worrying for the UK in future negotiations on financial supervision and regulation.

It is also concerning, from a UK/non-euro point of view, that the ECB will be able to develop international relationships on supervision. This could undercut the wider EU poisition on negotiating international standards such as the Basel III (bank capital) rules and other such issues.

The point in paragraph 10 is interesting as the Commission seems to draw a direct link between a Banking Union and the ‘deepening’ of the single market – which involves all 27 member states – which again raises huge questions over where regulation at the level of all 27 member states ends, and supervision involving 17+ begins.

This ties in with the plans to allow the ECB to increase capital buffers above EU-wide standards, which could see a blurring of supervisory and regulatory powers. It also increases the incentive for the euro countries/ECB to set the agenda in international forums, such as Basel, and in future regulations adopted at the EU level.

Update 07/09/12 16:45 - 
A key discussion – and no doubt one of the key issues that will be subject to intense negotiations once the Commission has tabled all its docs - will be whether the voting weight within the EU financial supervisory structure (ESAs) will change (if the ECB does indeed get involved in votes in, say, the EBA). Will the ECB essentially control all 17 eurozone member votes or condense it into a single vote, or will it simply be a matter of soft coordination. How will non-euro countries ensure that the Eurozone isn’t using an inbuilt majority to basically push through euro-tailored measures? Decisions in the ESAs are taken by a simple majority vote or QMV meaning that anything more than mere ECB coordination, might require rewriting the ESA voting rules and even the standard procedure for calculating weightings (based on population, GDP etc.). Presumably, there should be a safeguard for non-Eurozone countries.

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...

The new gatekeeper

For quite some time, we have tried to highlight how the EU's new financial supervisors could eventually take on too much power for comfort - not least when viewed from the City of London. The European Securities and Markets Authority, in particular, looks set to become a force to be reckoned with. As we argued in our recent report on the subject, this is a bit peculiar since most of the commentary - such as the de Larosière report or the Turner review - which precipitated the creation of the new supervisors, related to cross-border supervision of large retail banks.

Over the last couple of weeks, negotiations over the AIFM Directive seem to be moving in the direction of giving ESMA powers, possibly exclusive, to supervise hedge funds and other types of funds based outside the EU and decide whether these should be granted EU-wide market access (a so-called passport). In other words, ESMA could become the sole 'gatekeeper' deciding who has the right to enter the EU market. This is no small power.

The UK could possibly accept such far-reaching powers for ESMA in return for keeping the passport provision in the AIFM Directive - a provision which the French don't like at all but that is popular with the industry.

From the City's point of view, the problem with this arrangement is that market access for the many funds which operate in the City but are domiciled elsewhere (i.e. Cayman or the US) could be decided in a forum where the UK has the exact same voting strength as Malta or Slovakia, as most decisions within ESMA will be taken by simple majority voting, meaning one country, one vote. The lack of safeguards in this voting arrangement could lead to this issue being hijacked by narrow commercial or political interests - or protectionist forces.

A blanket solution to market access, with ESMA calling the shots, would therefore be a mistake. As a leader in today's FT argues,

"Restricting this power to ESMA alone sparks concerns about protectionism. Keeping the state-level door open would also ensure that if ESMA proves inefficient, hedge funds can go directly to national bodies."

Quite right. The negotiations are now entering the final stretch - a break-through could even come today. The UK must resist calls to give ESMA exclusive powers over market access.

Voting By Your Weight

Karl Otto Pöhl - former President of the Bundesbank - is quoted in German economic weekly Wirtschaftswoche, making an interesting observation. According to Pöhl, bigger eurozone countries (and most importantly the biggest of them all) should be given greater voting weight within the governing board of the European Central Bank.

He argues:

"It can't be the case that central banks from Malta or Cyprus have as much as a say as the Bundesbank [...] The 'one country, one vote' principle is no longer timely".

Sie sind recht, Herr Pöhl. This makes sense, especially from Germany's point of view. But then why not apply the same reasoning to the UK and the new EU financial authorities, the creation of which MEPs endorsed today in Strasbourg?

Within these supervisors, most decisions will be taken under a 'one country, one vote' arrangement, regardless of the actual size of member states' fianancial markets. As we've pointed out here and here, the UK controls 36% of the EU's wholesale finance market - but will have exactly the same voting weight within the supervisors as all other member states, such as Cyprus or Malta.

Quite irrespective of the merits or the drawbacks of the proposal, that is.

Financial supervision: a gamble or a victory?

An article in yesterday’s Telegraph celebrated the ‘victory’ of George Osborne, who, it claimed, secured an agreement at yesterday’s ECOFIN meeting that one of the new pan-European financial regulators – the European Banking Authority (EBA) – will have its seat in London. The European Parliament has demanded that all three of the new supervisors be based in Frankfurt, and working under the auspices of a 'quasi-umbrella' organisation.

But is this really a victory? There was absolutely no way that member states were going to accept the EP's proposal to make Frankfurt the sole supervisory centre - it is politically impossible and MEPs know that. Remember, Germany already has the most important financial institution of them all, the ECB, and there's at least one francophone President who has no intention of allowing another key-institution be handed over to the Germans.

That is presumably why the French press also left aside the geography of the proposal, and focussed on the vital aspect: how much power that will be transferred from member states to these new authorities. Reuters France notes that,

the UK, under the pressure of its peers and of the European Parliament, has notably accepted the principle that the new European Supervisory Authorities for banks, markets and insurances will be able to address a financial institution directly – bypassing national supervisors – in emergency situations.

This is potentially huge as it will for the first time - via the EBA, ESMA and EIOPA (the three supervisors in question) - give the EU direct supervisory powers, with their decisions taking precedence over those of national supervisors. We knew that this would be the case for Credit Rating Agencies' EU operations (which kind of makes sense), but the UK now seems to have lost the plot on extending the scope beyond CRAs.

To be fair to Osborne, he's fighting the legacy of the previous UK government and his leverage is highly limited as this will all be decided by Qualified Majority.

As a 'concession' EU finance ministers agreed that the Council (rather than the Commission, as the Commission wants, or the new EU Systemic Risk Board, which the EP insists on) will determine when an “emergency situation” occurs. But this was always the Council's position. And as was made very clear at a debate Open Europe organised on the topic on Monday - there are few safeguards in place against this mechanism being misused or hijacked by political/ideological interests in the future. Crucially, the decision on whether to call an "emergency" will be taken by simple majority, meaning that the UK has exactly the same voting strength as everyone else (despite being home to the bulk of Europe's financial sector).

The potential pitfall ought to be obvious. Only a couple of months ago EU leaders used a clause in the Treaties (Article 122), designed for natural disasters and "exceptional occurrences beyond [member states']control" to make taxpayers in one country liable for the mistakes of a government in a different country, in a decision which involved majority vote (when it should have been unanimity), and which took the EU a huge step closer to a common bond (and fiscal federalism). Using Article 122 in this way was absolutely inconceivable when the Lisbon Treaty was discussed and ratified, particularly as the Treaties clearly and unequivocally prohibit bailouts (see here and here to get a feel for just how arbitrarily EU leaders used Article 122).

Give EU leaders "emergency powers" and they could well use them to justify the most dramatic and previously unthinkable measures. The recent ban on short-selling in Germany also ought to give an indication of how such measures stand the risk of being driven by politics rather than economic reality or long-term thinking.

There could be cases where strong and decisive action at the EU-level could be beneficial, but think about this: what exactly would the new EU supervisors have prevented in the financial crisis - given that the causes of the crisis were inherently global; a credit bubble in the US, global trade imbalances and so forth.

The new EU bodies will also be in charge of drawing up a 'single rule book' in the EU's financial services market and implementing uniform technical standards across Europe, overriding national authorities. This could actually benefit the City of London by ensuring the consistent implementation of directives and standards across the bloc, i.e. uniform application of UCITS IV so that fund managers can market their funds in all member states without additional barriers.

However, here there are also possible pitfalls. All of this assumes that the UK will actually write the single rulebook - which is a heroic assumption indeed (think the AIFM Directive). And as William Underhill, Chairman of the City of London Law Society's Company Law Committee, pointed out at Open Europe's debate:

What are the boundaries of the single EU rulebook that lies behind a lot of this new architecture?...The assumption is that the single rulebook in all circumstances justifies the change, whereas I think we still need to look at each specific proposal, each technical standard that comes forward needs to be justified against more subsidiarity principles.

In other words, the risk is that the EU, incrementally and over time, resorts to more interventions, in the name of a single rulebook.

So there are possible benefits, but it could also go in the completely opposite direction. A leader in today's Wall Street Journal describes the potential consequences:

One need not be conspiracy-minded or euroskeptic to see that more harmonization of regulation and supervision means less room for the U.K. to outcompete its rivals on the Continent. The transfer of power to the EU being negotiated this week in Brussels will, of necessity even if not by design, erode the U.K.'s competitive advantages in the financial sphere.

So this amounts to a pretty serious gamble. After all, the EU needs more safeguards against arbitrary government, not fewer.