Eurozone Watch

I have been asked to testify in front of the European Parliament's Committee on Economic and Monetary Affairs on the planned financial supervisory structure in the European Union and I had my hearing in Brussels last week. Here is my statement:

Dear Ms. Chairwoman Sharon Bowles, Ladies and Gentlemen,

Let me first thank you for inviting me to testify in front of your committee. I am very honored to be able to provide you with my expertise on the reform of the macro-prudential supervision of the European financial system.

I will base my comments on the EU Commission's proposal for a new supervisory structure. I have been specifically asked to talk about the macro supervision and in particular about the planned European Systemic Risk Board. However, as the question of how to set up an efficient and effective macro supervision touches upon the structure of the micro supervision, I will also testify at least in a few sentences on the overall planned structure of financial sector supervision.

Let me first start by saying that I think that the basic thrust taken both for micro and macro supervision goes clearly into the right direction. Given the increasing cross-border linkages between national financial institutions in the European Union, a strengthening of the European level in financial market supervision is overdue. Similarly, the idea to give an institution a special mandate to look at potential systemic problems in the European financial system is also very sound and clearly to be welcomed.

However, there are a few elements in the Commission proposal which might hinder the creation of a truly well-working supervisory structure in the EU.
Let me start with the overall planned structure and the possible consequences for macro supervision: The planned new European System of Financial Supervisors, consisting of a network of national financial supervisors working in tandem with the three new European Supervisory Authorities (ESAs) seems to be more fragmented than necessary. Given that the dividing lines between different types of financial institutions and the products they are offering are blurring, I cannot see any good reason to separate banking supervision which will be covered by a European Banking Authority from insurance supervision to be covered by the European Insurance and Occupational Pensions Authority (EIOPA) and from market supervision to be covered by the European Securities and Markets Authority (ESMA).

One thing that we have learned during the past crisis is that one should regulate all institutions and instruments the same way if they provide similar services, no matter what the original aim or legal nature of the institutions in question is. A division of supervision between different authorities always creates scope and incentive for regulatory arbitrage, meaning that certain activities might be shifted towards the part of the financial system which is most weakly supervised. While of course good coordination between the sectoral authorities might overcome this problem, the fragmentation clearly creates extra costs and possibilities for blind spots.

Related to this issue is the question why the three authorities are planned to be located in three different cities. Another experience from past crisis has been that geographical proximity matters for good supervision as well as for the exchange of ideas. Having the three agencies in three cities makes informal links and contacts less likely and might hence hinder the informal flow of information. Putting all three authorities into one city, preferably in one building, would enhance the exchange of ideas and information on all levels among the authorities.

All this might not matter as much for the micro supervision of individual banks or insurance corporations, but might matter for the macro supervision which has to focus on the big picture and on the linkages between the different institutions. Let me remind you that a number of the problems in the U.S. subprime crisis exactly originated from both the sectoral and geographical fragmentation of the supervisory structure. In addition, some central elements in the crisis concerned not only banks or insurances, but the linkages between the two sectors. For example, the insurance business of AIG did not cause any trouble and was sound. The derivative business of AIG, in contrast, created the liquidity problems for AIG which caused the near-bankruptcy of the company. At the same time, the fact that AIG was counterparty to a number of important banks in this market led the U.S. Fed and the U.S. treasury to define it as of systemic importance for the banking sector and hence to the bail-out.

In short, in order to get a good macro picture, you need to monitor the different parts of the financial system together and this could be done more easily if the micro supervision is done in a uniform, integrated structure as the information then are collected in a uniform way from the very beginning.

The second issue which I believe is problematic is the currently planned set-up and voting power in the European Systemic Risk Board (ESRB). The ESRB is supposed to monitor and assess potential threats to financial stability that arise from macro-economic developments and from developments within the financial sector. The general board is composed 33 members with voting power, namely the 27 heads of the national central bank, the president and the vice-president of the ECB, a member of the European commission and the chairpersons of the three ESAs. In addition, the general board has 28 members without voting power: a high level representative from each national supervisory authority and the president of the economic and financial committee.

What strikes me is the heavy bias towards central bankers here. The general board thus looks almost identical to the General Council of the ECB, plus the member of the European Commission and the chairpersons of the ESA. I believe it is very unlikely that such a body will come to fundamentally different views on any issue than the General Council of the ECB. The same holds for the other committees of the ESRB such as the Steering Committee or the Advisory Technical committee: They are all heavily dominated by central bankers.

Central bankers are often subject to a strong uniform thinking and intellectual capture. They have been educated in similar theories and models and the stern discipline demanded by them in communication to the outside world makes them strongly inclined to buy into their institutions predominant way of thinking.

This is a very serious problem for macro supervision: As we know from past experiences of financial fragility, financial booms and financial crisis, problems very seldom appear at the same place in the financial system twice in a row. In order to spot new dangers and potential systemic risks, a very important issue is to bring outside ideas and scenarios into the discussion process. My point again can be underlined by the Federal Reserve's failure to spot the dangers of the housing bubble: Most of the Fed governors just followed the chairman Alan Greenspan's notion that a nationwide crash of house prices was very unlikely and that the fall-out could be easily contained. There was very little, if any opposition to this thinking. Outside economists like Raghuram Rajan or Robert Shiller who warned of imminent dangers were actually frowned upon.

A second problem might arise from a conflict of interest between central bankers and the ESRB's task. Imagine a situation in which the very action of the ECB, i.e. an unexpected strong number of interest rates hikes, threaten financial stability. Would the ESRB heavily dominated by central bankers issue a warning on this danger? I assume that at least there would be some delays in spotting the danger.

An efficient macro supervision would thus have to find a possibility to get outsiders' views and fears into the central bankers' discourse. One option would be to appoint one or preferably more academics in the field of financial or monetary economics as board members with voting rights and give them resources to investigate specific risks. These members could be appointed by the European Parliament in a way that guarantees wide variety of views on the board.

A related question to that of central bankers' bias to conformity is why one wants to give the European System of Central Banks such a heavy weight in running the ESRB, given that the ECB's record for spotting systemic risks is not overly impressive. Of course, the ECB is in a very good position to collect data on financial sector exposure. For years, it has been monitoring financial sector risk. Since 2004, it has been publishing bi-annually the Financial Stability Review.

But to be frank: The ECB did not do well in spotting or reacting to the last crisis. Way into 2008, almost a year after the first tensions had appeared in the money market, the ECB was still significantly underestimating systemic risk, the risk of a substantial economic downturn and was overestimating inflationary pressure. In July 2008, when leading indicators clearly pointed to a substantial slowdown of the European economy and the economy in fact was already in recession, the ECB even hiked interest rates again. Even if the interest rate move was only 25 basis points, this move might well have aggravated the problems in the banking sector. Clearly the ECB was at this point not aware of the problems building in the banking sector even though it was supposedly monitoring that sector. I do not see any reason why the ECB should do much better spotting systemic risks in the future than it has been in the past.

Thank you very much for your attention.

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