20 September 2012

VoxEU: The Commission's proposal on bank supervisory powers for the ECB

The European Commission is planning a shake-up in financial supervision in Europe. This column argues that time will tell whether or not this is a good idea – for now all we have for certain is uncertainty.

Authors Vincent O'Sullivan, Stephen Kinsella

A need for speed

The Commission has made it clear that the proposal on centralised supervision depends on the quick adoption of legislative proposals in key areas, such as the Capital Requirements Directive IV, bank recovery and resolution and deposit guarantee schemes. Amongst other things, with these in place, the introduction of a common deposit protection and a single bank resolution mechanism within the eurozone – two further pillars of the concept of ‘banking union’ – will be easier to construct. The Commission has urged EU lawmakers to finalise their negotiations on these texts by the end of this year, resolving key areas of contention as quickly as possible.

Far easier said than done, particularly, as this proposal, itself, creates an additional threat to the institutional balance between the Council and the European Parliament, which the European Parliament is keen to maintain. The legal base used for the supervision proposal (Article 127(6) of the Treaty on the Functioning of the European Union) gives sole power to the Council to adopt (unanimously) the proposal. The European Parliament, normally the co-legislator for EU law on the financial services sector, is consulted only in this context (which, interestingly, the ECB is too). The European Parliament basing the new regime on this article alone risks undermining the fourth pillar in the EMU 2.0 initiative (designed to address specific issues in the initial architecture of the Economic and Monetary Union) namely increased democratic legitimacy and accountability. It is therefore suggesting that the ECB proposal and amending the EBA regulation are considered as a package.

One institution, many hats

This institutional conundrum is parallel to another concern still expressed by many observers: the questionability of combining responsibility for prudential supervision with monetary policy within the same body. Members of the ECB Board, amongst others, have recently set out to explain that there is no conflict between a price stability objective and a financial stability objective, pointing out that any threat to financial stability jeopardises prices within the currency union, as well as the EU more widely.

Those who favour a separation argue that there is a conflict of interest between monetary and supervisory policy objectives. For example, a reduction in interest rates would support economic stability in times of high inflation – consistent with monetary policy objectives. However, this policy would have adverse effects on financial stability in terms of the profitability and the solvency of banks. Additionally, during instances of banking failure, supervisors many want to close a failed bank or affect an orderly wind-down due to moral hazard concerns. In contrast, fearful of systemic stability and the risk of contagion, monetary policymakers will want to rescue the institution, regardless of any moral hazards this action could create. Drawing from well-established theoretical models, a recent IMF working paper found that a dual-mandate central bank is not optimal from a welfare perspective (i.e. higher output) because of a time inconsistency problem. The paper found that while it may be optimal for a central bank to pursue low inflation targets before a crisis, after a crisis it is better to let inflation rise, at odds with price stability, to repair debt-laden private balance sheets and achieve financial stability.

Many arguments were put forward during the 1990s to support a single supervisory authority. Firstly, the emergence of universal banking in the early 1990s, posed significant problems for the traditional regulatory architecture. There were concerns that the fragmented nature of financial markets might not only generate inconsistencies but also result in insufficient oversight of the newly emerging financial conglomerates. Secondly, there was increasing recognition of the growing complexity of financial operations and the requirement for specialist expertise to be developed and centralised. Finally, instances of regulatory failure, such as the collapse of Baring Bank in the UK, resulted in considerable debate about the appropriateness of regulatory systems in the mid-1990s. For example, the UK Japan, South Korea, and Iceland all integrated their regulatory structured into a unified structure during the 1990s, which were previously the responsibility of a number of specialist authorities and government departments.

However, many commentators remain unconvinced by these arguments. As the lender of last resort, the central bank already plays an important role in managing systemic stability (both macro and micro) in the financial system. Housing prudential supervisory functions within its remit is efficient as joint responsibilities make for better supervisory and monetary policy. Empirically, Bernanke and Friedman and Kuttner (1992) have shown that problems in the banking system can be good indicators of emerging problems in the wider economy. Additionally, numerous studies have demonstrated that the well-being of the financial system may affect an economy’s response to monetary policies. Moreover, the financial crisis has shown there is irrefutable need, even in a regime designed to avoid catastrophic bank failures, for a central bank to act as ‘lender of last resort’ when all else fails. The Commission’s proposal seeks to balance these two opposing viewpoints by establishing strict segregation of activities between supervision and the conduct of monetary policy within the ECB.

Uncertainty, uncertainty, uncertainty

Time will tell whether this is the right approach: whether other measures, such as those relating to bank recovery and resolution, sufficiently reduce ‘moral hazard’. The ancient Chinese curse says ‘may you live in interesting times’. As the four-year anniversary of the Lehman Brothers collapse approaches, banks may prefer uninteresting times for a while so they can plan to rebuild their businesses and plan for the future but, clearly, this latest proposal, combined with all the other legislative proposals in the pipeline, does not herald quieter times for those operating in the EU for the foreseeable future.

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