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Hight Level Group on Financial Supervision in the EU Report Appunti scolastici Premium

Materiale didattico per il corso di Theories of Regulation della prof.ssa Laura Ammannati. Trattasi del rapporto dal titolo "The Hight Level Group on Financial Supervision in the EU", stilato dal gruppo presieduto da Jacques de Larosiére e avente riguardo al ruolo delle autorità di regolazione dei mercati nella prevenzione delle speculazioni e degli squilibri... Vedi di più

Esame di Theories of Regulation docente Prof. L. Ammannati




AVANT-PROPOS .................................................................................................................... 3

DISCLAIMER.......................................................................................................................... 5

INTRODUCTION.................................................................................................................... 6

CHAPTER I: CAUSES OF THE FINANCIAL CRISIS...................................................... 7

CHAPTER II: POLICY AND REGULATORY REPAIR................................................. 13

I. INTRODUCTION........................................................................................................ 13


III. CORRECTING REGULATORY WEAKNESSES..................................................... 15


V. CORPORATE GOVERNANCE.................................................................................. 29

VI. CRISIS MANAGEMENT AND RESOLUTION........................................................ 32

CHAPTER III: EU SUPERVISORY REPAIR................................................................... 38

I. INTRODUCTION........................................................................................................ 38

II. LESSONS FROM THE CRISIS: WHAT WENT WRONG? ..................................... 39


AND CRISIS MANAGEMENT.................................................................................. 42


OF FINANCIAL SUPERVISION ............................................................................... 48


SYSTEM OF FINANCIAL SUPERVISION (ESFS).................................................. 58

CHAPTER IV: GLOBAL REPAIR ..................................................................................... 59


II. REGULATORY CONSISTENCY .............................................................................. 60

III. ENHANCING COOPERATION AMONG SUPERVISORS ..................................... 61


V. CRISIS MANAGEMENT AND RESOLUTION........................................................ 66




FINANCIAL SUPERVISION IN THE EU ................................................. 69



FINANCIAL MARKET ................................................................................ 71


IN THE EU .................................................................................................... 75





I would like to thank the President of the European Commission, José Manuel

Barroso, for the very important mandate he conferred on me in October 2008 to

chair an outstanding group of people to give advice on the future of European

financial regulation and supervision. The work has been very stimulating. I am

grateful to all members of the group for their excellent contributions to the work,

and for all other views and papers submitted to us by many interested parties.

This report is published as the world faces a very serious economic and financial


The European Union is suffering.

An economic recession.

Higher unemployment.

Huge government spending to stabilize the banking system – debts that future

generations will have to pay back.

Financial regulation and supervision have been too weak or have provided the

wrong incentives. Global markets have fanned the contagion. Opacity,

complexity have made things much worse.

Repair is necessary and urgent.

Action is required at all levels – Global, European and National and in all

financial sectors.

We must work with our partners to converge towards high global standards,

through the IMF, FSF, the Basel committee and G20 processes. This is critical.

But let us recognize that the implementation and enforcement of these standards

will only be effective and lasting if the European Union, with the biggest capital

markets in the world, has a strong and integrated European system of regulation

and supervision.

In spite of some progress, too much of the European Union's framework today

remains seriously fragmented. The regulatory rule book itself. The European

Unions' supervisory structures. Its crisis mechanisms. 3

This report lays out a framework to take the European Union forward.

– to reduce risk and improve risk

Towards a new regulatory agenda

management; to improve systemic shock absorbers; to weaken pro-cyclical

amplifiers; to strengthen transparency; and to get the incentives in financial

markets right.

Towards stronger coordinated supervision – macro-prudential and micro-

prudential. Building on existing structures. Ambitiously, step by step but with a

simple objective. Much stronger, coordinated supervision for all financial actors

in the European Un ion. With equivalent standards for all, thereby preserving

fair competition throughout the internal market.

Towards effective crisis management procedures – to build confidence among

supervisors. And real trust. With agreed methods and criteria. So all Member

States can feel that their investors, their depositors, their citizens are properly

protected in the European Union.

In essence, we have two alternatives: the first "chacun pour soi" beggar-thy-

neighbour solutions; or the second - enhanced, pragmatic, sensible European

cooperation for the benefit of all to preserve an open world economy. This will

bring undoubted economic gains, and this is what we favour.

We must begin work immediately.

Jacques de Larosière

Chairman 4


The views expressed in this report are those of

the High-Level Group on supervision.

The Members of the Group support all the recommendations.

However, they do not necessarily agree on all the detailed points

made in the report. 5


1) Since July 2007, the world has faced, and continues to face, the most serious and

disruptive financial crisis since 1929. Originating primarily in the United States, the crisis

is now global, deep, even worsening. It has proven to be highly contagious and complex,

rippling rapidly through different market segments and countries. Many parts of the

financial system remain under severe strain. Some markets and institutions have stopped

functioning. This, in turn, has negatively affected the real economy. Financial markets

depend on trust. But much of this trust has evaporated.

2) Significant global economic damage is occurring, strongly impacting on the cost and

availability of credit; household budgets; mortgages; pensions; big and small company

financing; far more restricted access to wholesale funding and now spillovers to the more

fragile emerging country economies. The economies of the OECD are shrinking into

recession and unemployment is increasing rapidly. So far banks and insurance companies

have written off more than 1 trillion euros. Even now, 18 months after the beginning of

the crisis, the full scale of the losses is unknown. Since August 2007, falls in global stock

markets alone have resulted in losses in the value of the listed companies of more than

€16 trillion, equivalent to about 1.5 times the GDP of the European Union.

3) Governments and Central Banks across the world have taken many measures to try to

improve the economic situation and reduce the systemic dangers: economic stimulus

packages of various forms; huge injections of Central Bank liquidity; recapitalising

financial institutions; providing guarantees for certain types of financial activity and in

particular inter-bank lending; or through direct asset purchases, and "Bad Bank" solutions

are being contemplated by some governments. So far there has been limited success.

4) The Group believes that the world's monetary authorities and its regulatory and

supervisory financial authorities can and must do much better in the future to reduce the

chances of events like these happening again. This is not to say that all crises can be

prevented in the future. This would not be a realistic objective. But what could and should

be prevented is the kind of systemic and inter-connected vulnerabilities we have seen and

which have carried such contagious effects. To prevent the recurrence of this type of

crisis, a number of critical policy changes are called for. These concern the European

Union but also the global system at large.

5) Chapter 1 of this report begins by analysing the complex causes of this financial crisis, a

sine qua non to determine the correct regulatory and supervisory responses. 6


Macroeconomic issues

6) Ample liquidity and low interest rates have been the major underlying factor behind the

present crisis, but financial innovation amplified and accelerated the consequences of

excess liquidity and rapid credit expansion. Strong macro-economic growth since the mid-

nineties gave an illusion that permanent and sustainable high levels of growth were not

only possible, but likely. This was a period of benign macroeconomic conditions, low

rates of inflation and low interest rates. Credit volume grew rapidly and, as consumer

inflation remained low, central banks - particularly in the US - felt no need tighten

monetary policy. Rather than in the prices of goods and services, excess liquidity showed

up in rapidly rising asset prices. These monetary policies fed into growing imbalances in

global financial and commodity markets.

7) In turn, very low US interest rates helped create a widespread housing bubble. This was

fuelled by unregulated, or insufficiently regulated, mortgage lending and complex

securitization financing techniques. Insufficient oversight over US government sponsored

entities (GSEs) like Fannie Mae and Freddie Mac and strong political pressure on these

GSEs to promote home ownership for low income households aggravated the situation.

Within Europe there are different housing finance models. Whilst a number of EU

Member States witnessed unsustainable increases in house prices, in some Member States

they grew more moderately and, in general, mortgage lending was more responsible.

8) In the US, personal saving fell from 7% as a percentage of disposable income in 1990, to

below zero in 2005 and 2006. Consumer credit and mortgages expanded rapidly. In

particular, subprime mortgage lending in the US rose significantly from $180 billion in

2001 to $625 billion in 2005.

9) This was accompanied by the accumulation of huge global imbalances. The credit


expansion in the US was financed by massive capital inflows from the major emerging

countries with external surpluses, notably China. By pegging their currencies to the

dollar, China and other economies such as Saudi Arabia in practice imported loose US

monetary policy, thus allowing global imbalances to build up. Current account surpluses

in these countries were recycled into US government securities and other lower-risk

assets, depressing their yields and encouraging other investors to search for higher yields

from more risky assets…

10) In this environment of plentiful liquidity and low returns, investors actively sought higher

yields and went searching for opportunities. Risk became mis-priced. Those originating

investment products responded to this by developing more and more innovative and

complex instruments designed to offer improved yields, often combined with increased

leverage. In particular, financial institutions converted their loans into mortgage or asset

backed securities (ABS), subsequently turned into collateralised debt obligations (CDOs)

often via off-balance special purpose vehicles (SPVs) and structured investment vehicles

(SIVs), generating a dramatic expansion of leverage within the financial system as a

1 Evidenced by a current account deficit of above 5% of GDP (or $700 billion a year) over a number of years. 7

whole. The issuance of US ABS, for example, quadrupled from $337 billion in 2000 to

over $1,250 billion in 2006 and non-agency US mortgage-backed securities (MBS) rose

from roughly $100 billion in 2000 to $773 billion in 2006. Although securitisation is in

principle a desirable economic model, it was accompanied by opacity which camouflaged

the poor quality of the underlying assets. This contributed to credit expansion and the

belief that risks were spread.

11) This led to increases in leverage and even more risky financial products. In the macro

conditions preceding the crisis described above, high levels of liquidity resulted finally in

risk premia falling to historically low levels. Exceptionally low interest rates combined

with fierce competition pushed most market participants – both banks and investors – to

search for higher returns, whether through an increase in leverage or investment in more

risky financial products. Greater risks were taken, but not properly priced as shown by the

historically very low spreads. Financial institutions engaged in very high leverage (on and

off balance sheet) - with many financial institutions having a leverage ratio of beyond 30 -

sometimes as high as 60 - making them exceedingly vulnerable to even a modest fall in

asset values.

12) These problems developed dynamically. The rapid recognition of profits which

accounting rules allowed led both to a view that risks were falling and to increases in

financial results. This combination, when accompanied by constant capital ratios, resulted

in a fast expansion of balance sheets and made institutions vulnerable to changes in

valuation as economic circumstances deteriorated.

Risk management

13) There have been quite fundamental failures in the assessment of risk, both by financial

firms and by those who regulated and supervised them. There are many manifestations of

this: a misunderstanding of the interaction between credit and liquidity and a failure to

verify fully the leverage of institutions were among the most important. The cumulative

effect of these failures was an overestimation of the ability of financial firms as a whole to

manage their risks, and a corresponding underestimation of the capital they should hold.

14) The extreme complexity of structured financial products, sometimes involving several

layers of CDOs, made proper risk assessment challenging for even the most sophisticated

in the market. Moreover, model-based risk assessments underestimated the exposure to

common shocks and tail risks and thereby the overall risk exposure. Stress-testing too

often was based on mild or even wrong assumptions. Clearly, no bank expected a total

freezing of the inter-bank or commercial paper markets.

15) This was aggravated further by a lack of transparency in important segments of financial

markets – even within financial institutions – and the build up of a "shadow" banking

system. There was little knowledge of either the size or location of credit risks. While

securitised instruments were meant to spread risks more evenly across the financial

system, the nature of the system made it impossible to verify whether risk had actually

been spread or simply re-concentrated in less visible parts of the system. This contributed

to uncertainty on the credit quality of counterparties, a breakdown in confidence and, in

turn, the spreading of tensions to other parts of the financial sector. 8

16) Two aspects are important in this respect. First, the fact that the Basel 1 framework did

not cater adequately for, and in fact encouraged, pushing risk taking off balance-sheets.

This has been partly corrected by the Basel 2 framework. Second, the explosive growth of

the Over-The-Counter credit derivatives markets, which were supposed to mitigate risk,

but in fact added to it.

17) The originate-to-distribute model as it developed, created perverse incentives. Not only

did it blur the relationship between borrower and lender but also it diverted attention away

from the ability of the borrower to pay towards lending – often without recourse - against

collateral. A mortgage lender knowing beforehand that he would transfer (sell) his entire

default risks through MBS or CDOs had no incentive to ensure high lending standards.

The lack of regulation, in particular on the US mortgage market, made things far worse.

Empirical evidence suggests that there was a drastic deterioration in mortgage lending

standards in the US in the period 2005 to 2007 with default rates increasing.

18) This was compounded by financial institutions and supervisors substantially

underestimating liquidity risk. Many financial institutions did not manage the maturity

transformation process with sufficient care. What looked like an attractive business model

in the context of liquid money markets and positively sloped yield curves (borrowing

short and lending long), turned out to be a dangerous trap once liquidity in credit markets

dried up and the yield curve flattened.

The role of Credit Rating Agencies

19) Credit Rating Agencies (CRAs) lowered the perception of credit risk by giving AAA

ratings to the senior tranches of structured financial products like CDOs, the same rating

they gave to standard government and corporate bonds.

20) The major underestimation by CRAs of the credit default risks of instruments

collateralised by subprime mortgages resulted largely from flaws in their rating

methodologies. The lack of sufficient historical data relating to the US sub-prime market,

the underestimation of correlations in the defaults that would occur during a downturn and

the inability to take into account the severe weakening of underwriting standards by

certain originators have contributed to poor rating performances of structured products

between 2004 and 2007.

21) The conflicts of interests in CRAs made matters worse. The issuer-pays model, as it has

developed, has had particularly damaging effects in the area of structured finance. Since

structured products are designed to take advantage of different investor risk appetites, they

are structured for each tranche to achieve a particular rating. Conflicts of interests become

more acute as the rating implications of different structures were discussed between the

originator and the CRA. Issuers shopped around to ensure they could get an AAA rating

for their products.

22) Furthermore, the fact that regulators required certain regulated investors to only invest in

AAA-rated products also increased demand for such financial assets. 9

Corporate governance failures

23) Failures in risk assessment and risk management were aggravated by the fact that the

checks and balances of corporate governance also failed. Many boards and senior

managements of financial firms neither understood the characteristics of the new, highly

complex financial products they were dealing with, nor were they aware of the aggregate

exposure of their companies, thus seriously underestimating the risks they were running.

Many board members did not provide the necessary oversight or control of management.

Nor did the owners of these companies – the shareholders.

24) Remuneration and incentive schemes within financial institutions contributed to excessive

risk-taking by rewarding short-term expansion of the volume of (risky) trades rather than

the long-term profitability of investments. Furthermore, shareholders' pressure on

management to deliver higher share prices and dividends for investors meant that

exceeding expected quarterly earnings became the benchmark for many companies'


Regulatory, supervisory and crisis management failures

25) These pressures were not contained by regulatory or supervisory policy or practice. Some

long-standing policies such as the definition of capital requirements for banks placed too

much reliance on both the risk management capabilities of the banks themselves and on

the adequacy of ratings. In fact, it has been the regulated financial institutions that have

turned out to be the largest source of problems. For instance, capital requirements were

particularly light on proprietary trading transactions while (as events showed later) the

risks involved in these transactions proved to be much higher than the internal models had


26) One of the mistakes made was that insufficient attention was given to the liquidity of

markets. In addition, too much attention was paid to each individual firm and too little to

the impact of general developments on sectors or markets as a whole. These problems

occurred in very many markets and countries, and aggregated together contributed

substantially to the developing problems. Once problems escalated into specific crises,

there were real problems of information exchange and collective decision making

involving central banks, supervisors and finance ministries.

27) Derivatives markets rapidly expanded (especially credit derivatives markets) and off-

balance sheet vehicles were allowed to proliferate– with credit derivatives playing a

significant role triggering the crisis. While US supervisors should have been able to

identify (and prevent) the marked deterioration in mortgage lending standards and

intervene accordingly, EU supervisors had a more difficult task in assessing the extent to

which exposure to subprime risk had seeped into EU-based financial institutions.

Nevertheless, they failed to spot the degree to which a number of EU financial institutions

had accumulated – often in off balance-sheet constructions- exceptionally high exposure

to highly complex, later to become illiquid financial assets. Taken together, these

developments led over time to opacity and a lack of transparency.

28) This points to serious limitations in the existing supervisory framework globally, both in a

national and cross-border context. It suggests that financial supervisors frequently did not


have and in some cases did not insist in getting, or received too late, all the relevant

information on the global magnitude of the excess leveraging; that they did not fully

understand or evaluate the size of the risks; and that they did not seem to share their

information properly with their counterparts in other Member States or with the US. In

fact, the business model of US-type investment banks and the way they expanded was not

really challenged by supervisors and standard setters. Insufficient supervisory and

regulatory resources combined with an inadequate mix of skills as well as different

national systems of supervision made the situation worse.

29) Regulators and supervisors focused on the micro-prudential supervision of individual

financial institutions and not sufficiently on the macro-systemic risks of a contagion of

correlated horizontal shocks. Strong international competition among financial centres

also contributed to national regulators and supervisors being reluctant to take unilateral


30) Whilst the building up of imbalances and risks was widely acknowledged and commented

upon, there was little consensus among policy makers or regulators at the highest level on

the seriousness of the problem, or on the measures to be taken. There was little impact of

early warning in terms of action – and most early warnings were feeble anyway.

31) Multilateral surveillance (IMF) did not function efficiently, as it did not lead to a timely

correction of macroeconomic imbalances and exchange rate misalignments. Nor did

concerns about the stability of the international financial system lead to sufficient

coordinated action, for example through the IMF, FSF, G8 or anywhere else.

The dynamics of the crisis

32) The crisis eventually erupted when inflation pressures in the US economy required a

tightening of monetary policy from mid-2006 and it became apparent that the sub-prime

housing bubble in the US was going to burst amid rising interest rates. Starting in July

2007, accumulating losses on US sub-prime mortgages triggered widespread disruption of

credit markets, as uncertainty about the ultimate size and location of credit losses

undermined investor confidence. Exposure to these losses had been spread among

financial institutions around the world, including Europe, inter alia via credit derivative


33) The pro-cyclical nature of some aspects of the regulatory framework was then brought

into sharp relief. Financial institutions understandably tried to dispose of assets once they

realised that they had overstretched their leverage, thus lowering market prices for these

assets. Regulatory requirements (accounting rules and capital requirements) helped trigger

a negative feed-back loop amplified by major impacts in the credit markets.

34) Financial institutions, required to value their trading book according to mark-to-market

principles, (which pushed up profits and reserves during the bull-run) were required to

write down the assets in their balance sheet as markets deleveraged. Already excessively

leveraged, they were required to either sell further assets to maintain capital levels, or to

reduce their loan volume. "Fire sales" made by one financial institution in turn forced all

other financial institutions holding similar assets to mark the value of these assets down


"to market". Many hedge funds acted similarly and margin calls intensified liquidity


35) Once credit rating agencies started to revise their credit ratings for CDOs downwards,

banks were required to adjust their risk-weighted capital requirements upwards. Once

again, already highly leveraged, and faced with increasing difficulties in raising equity, a

range of financial institutions hastened to dispose of assets, putting further pressure on

asset prices. When, despite the fear of possible negative signalling effects, banks tried to

raise fresh capital, more or less at the same time, they were faced by weakening equity

markets. This obliged them to look for funding from sovereign wealth funds and, in due

course, from heavy state intervention. What was initially a liquidity problem rapidly, for a

number of institutions, turned into a solvency problem.

36) The lack of market transparency, combined with the sudden downgrade of credit ratings,

and the US Government's decision not to save Lehman Brothers led to a wide-spread

breakdown of trust and a crisis of confidence that, in autumn 2008, practically shut down

inter-bank money markets, thus creating a large-scale liquidity crisis, which still weighs

heavily on financial markets in the EU and beyond. The complexity of a number of

financial instruments and the intrinsic vulnerability of the underlying assets also explain

why problems in the relatively small US sub-prime market brought the global financial

system to the verge of a full-scale dislocation. The longer it took to reveal the true amount

of losses, the more widespread and entrenched the crisis of confidence has become. And it

remains largely unresolved to this day.

37) The regulatory response to this worsening situation was weakened by an inadequate crisis

management infrastructure in the EU, both in terms of the cooperation between national

supervisors and between public authorities. The ECB was among the first to react swiftly

by provide liquidity to the inter-bank market. In the absence of a common framework for

crisis management, Member States were faced with a very difficult situation. Especially

for the larger financial institutions they had to react quickly and pragmatically to avoid a

banking failure. These actions, given the speed of events, for obvious reasons were not

fully coordinated and led sometimes to negative spill-over effects on other Member

States. 12



The present report draws a distinction between financial regulation and supervision.

38) Regulation is the set of rules and standards that govern financial institutions; their main

objective is to foster financial stability and to protect the customers of financial services.

Regulation can take different forms, ranging from information requirements to strict

measures such as capital requirements. On the other hand, supervision is the process

designed to oversee financial institutions in order to ensure that rules and standards are

properly applied. This being said, in practice, regulation and supervision are intertwined

and will therefore, in some instances, have to be assessed together in this chapter and the

following one.

39) As underlined in the previous chapter, the present crisis results from the complex

interaction of market failures, global financial and monetary imbalances, inappropriate

regulation, weak supervision and poor macro-prudential oversight. It would be simplistic

to believe therefore that these problems can be "resolved" just by more regulation.

Nevertheless, it remains the case that good regulation is a necessary condition for the

preservation of financial stability.

40) A robust and competitive financial system should facilitate intermediation between those

with financial resources and those with investment needs. This process relies on

confidence in the integrity of institutions and the continuity of markets. "This confidence,

taken for granted in well-functioning financial systems, has been lost in the present crisis

in substantial part due to its recent complexity and opacity,…weak credit standards,

mis-judged maturity mismatches, wildly excessive use of leverage on and off-balance

sheet, gaps in regulatory oversight, accounting and risk management practices that


exaggerated cycles, a flawed system of credit ratings and weakness of governance ".

All must be addressed.

41) This chapter outlines some changes in regulation that are required to strengthen financial

stability and the protection of customers so to avoid – if not the occurrence of crises,

which are unavoidable – at least a repetition of the extraordinary type of systemic

breakdown that we are now witnessing. Most of the issues are global in nature, and not

just specific to the EU.

42) What should be the right focus when designing regulation? It should concentrate on the

major sources of weaknesses of the present set-up (e.g. dealing with financial bubbles,

strengthening regulatory oversight on institutions that have proven to be poorly regulated,

adapting regulatory and accounting practices that have aggravated pro-cyclicality,

promoting correct incentives to good governance and transparency, ensuring international

consistency in standards and rules as well as much stronger coordination between

regulators and supervisors). Over-regulation, of course, should be avoided because it

2 G30 report, Washington, January 2009. 13

slows down financial innovation and thereby undermines economic growth in the wider

economy. Furthermore, the enforcement of existing regulation, when adequate (or

improving it where necessary), and better supervision, can be as important as creating new




43) The fundamental underlying factor which made the crisis possible was the ample liquidity

and the related low interest rate conditions which prevailed globally since the mid-

nineties. These conditions fuelled risk taking by investors, banks and other financial

institutions, leading ultimately to the crisis.

44) The low level of long term interest rate over the last five years – period of sustained

growth – is an important factor that contrasts with previous expansionary periods.

45) As industrial economies recovered during this period, corporate investment did not pick

up as would have been expected. "As a result, the worldwide excess of desired savings

over actual investment … pushed its way into the main markets that were opened to

investment, housing in industrial countries, lifting house prices and rising residential


construction ". This phenomenon, which affected also financial assets, took place in the

US but also in the EU, where significant housing bubbles developed in the UK, Ireland

and Spain.

46) This explanation is not inconsistent with the one focusing on excessive liquidity fuelled

by too loose monetary policy. Actually the two lines of reasoning complement each other:

too low interest rates encouraged investment in housing and financial assets, but had

monetary policy been stricter, there would have been somewhat less expansion in the US,

more limited house prices increases and smaller current account deficits. By the same

token, if countries with big surpluses had allowed their currencies to appreciate, smaller

current account deficits and surpluses would have been the consequence. This raises the

question of what competent authorities can do in order to at least mitigate the risks of

bubbles building up, instead of simply intervening ex-post by injecting liquidity to limit

the damage from a macro-economic standpoint.

47) The lack of precise and credible information on whether a given state of asset markets is

already a bubble is not a sufficient argument against trying to prevent a serious bubble.

48) It is commonly agreed today that monetary authorities cannot avoid the creation of

bubbles by targeting asset prices and they should not try to prick bubbles. However, they

can and should adequately communicate their concerns on the sustainability of strong

increases in asset prices and contribute to a more objective assessment of systemic risks.

Equally, they can and should implement a monetary policy that looks not only at

consumer prices, but also at overall monetary and credit developments, and they should be

ready to gradually tighten monetary policy when money or credit grow in an excessive

and unsustainable manner. Other competent authorities can also use certain tools to

contain money and credit growth. These are of particular importance in the context of the

3 See "the global roots of the current financial crisis and its implications for regulation" by Kashyap, Raghuram Rajan and

Stein. 14

euro zone, where country-specific monetary policies tailored to countries' positions in the

economic cycle, and especially in the asset market cycle, cannot be implemented. The

following are examples of regulatory tools which can help meet counter-cyclical


- introducing dynamic provisioning or counter-cyclical reserves on banks in "good

times" to limit credit expansion and so alleviate pro-cyclicality effects in the "bad


- making rules on loans to value more restrictive;

- modifying tax rules that excessively stimulate the demand for assets.

49) These tools were not, or were hardly, used by monetary and regulatory authorities in the

run-up to the present crisis. This should be a lesson for the future. Overall cooperation

between monetary and regulatory authorities will have to be strengthened, with a view to

defining and implementing the policy-mix that can best maintain a stable and balanced

macro-economic framework. In this context, it will be important for the ECB to become

more involved in over-seeing the macro-prudential aspects of banking activities (see next

chapter on supervision). Banks should be subject to more and more intense scrutiny as the

bubble builds up.

50) Finally, a far more effective and symmetric "multilateral surveillance" by the IMF

covering exchange rates and underlying economic policies is called for if one wants to

avoid the continuation of unsustainable deficits (see chapter on global issues).


Reforming certain key-aspects of the present regulatory framework

51) Although the relative importance assigned to regulation (versus institutional incentives -

such as governance and risk assessment, - or monetary conditions…) can be discussed, it

is a fact that global financial services regulation did not prevent or at least contain the

crisis as well as market aberrations. A profound review of regulatory policy is therefore

needed. A consensus, both in Europe and internationally, needs to be developed on which

financial services regulatory measures are needed for the protection of customers, the

safeguarding of financial stability, and the sustainability of economic growth.

52) This should be done being mindful of the usefulness of self-regulation by the private

sector. Public and self-regulation should complement each other and supervisors should

check that where there is self-regulation it is being properly implemented. This was not

sufficiently carried out in the recent past.

The following issues must be addressed as a matter of urgency.

a) The Basel 2 framework

53) It is wrong to blame the Basel 2 rules per se for being one of the major causes of the

crisis. These rules entered into force only on 1 January 2008 in the EU and will only be


applicable in the US on 1 April 2010. Furthermore, the Basel 2 framework contains

several improvements which would have helped mitigate to some extent the emergence of

the crisis had they been fully applied in the preceding years. For example, had the capital

treatment for liquidity lines given to special purpose vehicles been in application then they

might have mitigated some of the difficulties. In this regard Basel 2 is an improvement

relative to the previous "leverage ratios" that failed to deal effectively with off-balance

sheet operations.

54) The Basel 2 framework nevertheless needs fundamental review. It underestimated some

important risks and over-estimated banks' ability to handle them. The perceived wisdom

that distribution of risks through securitisation took risk away from the banks turned out,

on a global basis, also to be incorrect. These mistakes led to too little capital being

required. This must be changed. The Basel methodology seems to have been too much

based on recent past economic data and good liquidity conditions.

55) Liquidity issues are important in the context both of individual financial firms and of the

regulatory system. The Group believes that both require greater attention than they have

hitherto been afforded. Supervisors need to pay greater attention to the specific maturity

mismatches of the firms they supervise, and those drawing up capital regulations need to

incorporate more fully the impact on capital of liquidity pressures on banks' behaviour.

56) A reflection is also needed with regard to the reliance of Basel 2 on external ratings. There

has undoubtedly been excessive reliance by many buy-side firms on ratings provided by

CRAs. If CRAs perform to a proper level of competence and of integrity, their services

will be of significant value and should form a helpful part of financial markets. These

arguments support Recommendation 3. But the use of ratings should never eliminate the

need for those making investment decisions to apply their own judgement. A particular

failing has been the acceptance by investors of ratings of structured products without

understanding the basis on which those products were provided.

57) The use by sophisticated banks of internal risk models for trading and banking book

exposures has been another fundamental problem. These models were often not properly

understood by board members (even though the Basel 2 rules increased the demands on

boards to understand the risk management of the institutions). Whilst the models may pass

the test for normal conditions, they were clearly based on too short statistical horizons and

this proved inadequate for the recent exceptional circumstances.

58) Future rules will have to be better complemented by more reliance on judgement, instead

of being exclusively based on internal risk models. Supervisors, board members and

managers should understand fully new financial products and the nature and extent of the

risks that are being taken; stress testing should be undertaken without undue constraints;

professional due diligence should be put right at the centre of their daily work.

59) Against this background, the Group is of the view that the review of the Basel 2

framework should be articulated around the following elements:

- The crisis has shown that there should be more capital, and more high quality capital,

in the banking system, over and above the present regulatory minimum levels. Banks

should hold more capital, especially in good times, not only to cover idiosyncratic

risks but also to incorporate the broader macro-prudential risks. The goal should be to


increase minimum requirements. This should be done gradually in order to avoid pro-

cyclical drawbacks and an aggravation of the present credit crunch.

- The crisis has revealed the strong pro-cyclical impact of the current regulatory

framework, stemming in particular from the interaction of risk-sensitive capital

requirements and the application of the mark-to-market principle in distressed market

conditions. Instead of having a dampening effect, the rules have amplified market

trends upwards and downwards - both in the banking and insurance sectors.

60) How to reduce the pro-cyclical effect of Basel 2? Of course, it is inevitable that a system

based on risk-sensitivity is to some extent pro-cyclical: during a recession, the quality of

credit deteriorates and capital requirements rise. The opposite happens during an upswing.

But there is a significant measure of "excessive" pro-cyclicality in the Basel framework


that must be reduced by using several methods .

- concerning the banking book, it is important that banks, as is the present rule,

effectively assess risks using "through the cycle" approaches which would reduce the

pro-cyclicality of the present measurement of probability of losses and default;

- more generally, regulation should introduce specific counter-cyclical measures. The

general principle should be to slow down the inherent tendency to build up risk-taking

and over-extension in times of high growth in demand for credit and expanding bank

profits. In this respect, the "dynamic provisioning" introduced by the Bank of Spain

appears as a practical way of dealing with this issue: building up counter-cyclical

buffers, which rise during expansions and allow them under certain circumstances to

be drawn down in recessions. This would be facilitated if fiscal authorities would treat

reserves taken against future expected losses in a sensible way. Another method would

be to move capital requirements in a similar anti-cyclical way;

- this approach makes sense from a micro-prudential point of view because it reduces

the risk of bank failures. But it is also desirable from a macro-prudential and macro-

economic perspective. Indeed, such a measure would tend to place some restraint on

over rapid credit expansion and reduce the dangers of market over-reactions during

recessionary times;

- with respect to the trading book of banks, there is a need to reduce pro-cyclicality and

to increase capital requirements. The present statistical VaR models are clearly pro-

cyclical (too often derived, as they are, from observations of too short time periods to

capture fully market prices movements and from other questionable assumptions). If

volatility goes down in a year, the models combined with the accounting rules tend to

understate the risks involved (often low volatility and credit growth are signs of

irrational low risk aversion and hence of upcoming reversals). More generally, the

level of capital required against trading books has been well too low relative to the

risks being taken in a system where banks heavily relied on liquidity through

"marketable instruments" which eventually, when liquidity evaporated, proved not to

be marketable. If banks engage in proprietary activities for a significant part of their

total activities, much higher capital requirements will be needed.

4 See Lord Turner, The Financial Crisis and the Future of Financial Regulation, Economoist's inaugural city Lecture,

21 January 2009. 17

It is important that such recommendations be quickly adopted at international level by the

Basel committee and the FSF who should define the appropriate details.

61) Measuring and limiting liquidity risk is crucial, but cannot be achieved merely through

quantitative criteria. Indeed the "originate-and-distribute" model which has developed

hand in hand with securitisation has introduced a new dimension to the liquidity issue.

That dimension has not sufficiently been taken into account by the existing framework.

The assessment by institutions and regulators of the "right" liquidity levels is difficult

because it much depends on the assumptions made on the liquidity of specific assets and

complex securities as well as secured funding. Therefore the assets of the banking system

should be examined in terms not only of their levels, but also of their quality (counterparty

risk, transparency of complex instruments…) and of their maturity transformation risk

(e.g. dependence on short term funding). These liquidity constraints should be carefully

assessed by supervisors. Indeed a "mismatch ratio" or increases in liquidity ratios must be

consistent with the nature of assets and the time horizons of their holdings by banks.

The Basel committee should in the future concentrate more on liquidity risk management.

Even though this is a very difficult task, it should come forward with a set of norms to

complement the existing qualitative criteria (these norms should cover the need to

maintain, given the nature of the risk portfolio, an appropriate mix of long term funding

and liquid assets).

62) There should be stricter rules (as has been recommended by the FSF) for off-balance sheet

vehicles. This means clarifying the scope of prudential regulation applicable to these

vehicles and determining, if needed, higher capital requirements. Better transparency

should also be ensured.

63) The EU should agree on a clear, common and comprehensive definition of own funds.

This definition should in particular clarify whether, and if so which, hybrid instruments

should be considered as Tier 1. This definition would have to be confirmed at

international level by the Basel committee and applied globally. Consideration should

also be given to the possibility of limiting Tier 1 instruments in the future to equity and


64) In order to ensure that management and banks' board members possess the necessary

competence to fully understand complex instruments and methods, the "fit and proper"

criteria should be reviewed and strengthened. Also, internationally harmonized rules

should be implemented for strengthening the mandates and resources for banks’ internal

control and audit functions. Regulators and supervisors should also be better trained to

understand risk assessment models.

65) The Group supports the work initiated by the Basel committee on the above issues. It will

however be important that the Basel committee works as expeditiously as possible. It took

8 years to revise Basel 1. This is far too long, especially given the speed at which the

banking sector evolves. It will be important for the Basel committee to find ways to agree

on the details of the above reforms far more quickly. 18

The Group sees the need for a fundamental review of the Basel 2

Recommendation 1:

rules. The Basel Committee of Banking Supervisors should therefore be invited to urgently

amend the rules with a view to:

- gradually increase minimum capital requirements;

- reduce pro-cyclicality, by e.g. encouraging dynamic provisioning or capital buffers;

- introduce stricter rules for off-balance sheet items;

- tighten norms on liquidity management; and

- strengthen the rules for bank’s internal control and risk management, notably by

reinforcing the "fit and proper" criteria for management and board members.

Furthermore, it is essential that rules are complemented by more reliance on judgement.

Recommendation 2: In the EU, a common definition of regulatory capital should be

adopted, clarifying whether, and if so which, hybrid instruments should be considered as

tier 1 capital. This definition should be confirmed by the Basel Committee.

b) Credit Rating Agencies

66) Given the pivotal and quasi-regulatory role that they play in today's financial markets,

Credit Rating Agencies must be regulated effectively to ensure that their ratings are

independent, objective and of the highest possible quality. This is all the more true given

the oligopolistic nature of this business. The stability and functioning of financial markets

should not depend on the opinions of a small number of agencies – whose opinions often

were proven wrong, and who have much too frequently substituted for rigorous due

diligence by firms.

67) The Commission has made a proposal for a Regulation on CRAs. However, the system of

licensing and oversight contained in this proposal is too cumbersome. The allocation of

work between the home and host authorities, in particular, is likely to lack effectiveness

and efficiency. The Group is of the view that it would be far more rational to entrust the

Committee of European Securities Regulators (CESR) with the task of licensing CRAs in

the EU, monitoring their performance, and in the light of this imposing changes (as is

proposed in the new supervisory framework proposed in the next chapter).

68) Beyond this proposal for a Regulation, a fundamental review of CRAs economic model

should be conducted, notably in order to eliminate the conflicts of interests that currently

exist. One drawback of the present model is that CRAs are entirely financed by the issuers

and not by the users, which is a source of conflict of interest. The modalities of a switch

from the current "issuer pays" model to a "buyer pays" model should be considered at

international level. Furthermore, and even though this may well be a difficult task in

practice, consideration should be given to the ways in which the formulation of ratings

could be completely separated from the advice given to issuers on the engineering of

complex products. 19

69) The use of ratings required by some financial regulations raises a number of problems, but

is probably unavoidable at this stage. However, it should be significantly reduced over


70) Regulators should have a close eye on the performance of CRAs with the recognition and

allowable use of their ratings made dependent on their performance. This role should be

entrusted to CESR, who should on an annual basis approve those CRAs whose ratings can

be used for regulatory purposes. Should the performance of a given CRA be insufficient,

its activities could be restricted or its licence withdrawn by CESR.

71) Finally, the rating of structured products should be transformed with a new, distinct code

alerting investors about the complexity of the instrument.

72) These recommendations will of course have to dovetail with increased due diligence from

the buy-side. Supervisors should check that financial institutions have the capacity to

complement the use of external ratings (on which they should no longer excessively rely

upon) with sound independent evaluations.

Recommendation 3: Concerning the regulation of Credit Rating Agencies (CRAs), the

Group recommends that:

- within the EU, a strengthened CESR should be in charge of registering and supervising


- a fundamental review of CRAs' business model, its financing and of the scope for

separating rating and advisory activities should be undertaken;

- the use of ratings in financial regulations should be significantly reduced over time;

- the rating for structured products should be transformed by introducing distinct codes

for such products.

It is crucial that these regulatory changes are accompanied by increased due diligence and

judgement by investors and improved supervision.

c) The mark-to-market principle

73) The crisis has brought into relief the difficulty to apply the mark-to-market principle in

certain market conditions as well as the strong pro-cyclical impact that this principle can

have. The Group considers that a wide reflection is needed on the mark-to-market

principle. Whilst in general this principle makes sense, there may be specific conditions

where this principle should not apply because it can mislead investors and distort

managers' policies.

74) It is particularly important that banks can retain the possibility to keep assets, accounted

for amortised cost at historical or original fair value (corrected, of course, for future

impairments), over a long period in the banking book - which does not mean that banks

should have the discretion to switch assets at will from the banking to the trading book.

The swift October 2008 decision by the EU to modify IAS-39, thereby introducing more

flexibility as well as convergence with US GAAP, is to be commended. It is irrelevant to


mark-to-market, on a daily basis, assets that are intended to be held and managed on a

long-term horizon provided that they are reasonably matched by financing.

75) Differences between business models must also be taken into account. For example,

intermediation of credit and liquidity requires disclosure and transparency but not

necessarily mark-to-market rules which, while being appropriate for investment banks and

trading activities, are not consistent with the traditional loan activity and the policy of

holding long term investments. Long-term economic value should be central to any

valuation method: it may be based, for instance, on an assessment of the future cash flows

deriving from the security as long as there is an explicit minimum holding period and as

long as the cash flows can be considered as sustainable over a long period.

76) Another matter to be addressed relates to situations where assets can no longer be marked-

to-market because there is no active market for the assets concerned. Financial institutions

in such circumstances have no other solution than to use internal modelling processes. The

quality and adequacy of these processes should of course be assessed by auditors. The

methodologies used should be transparent. Furthermore internal modelling processes

should also be overseen by the level 3 committees, in order to ensure consistency and

avoid competitive distortions.

77) To ensure convergence of accounting practices and a level playing-field at the global

level, it should be the role of the International Accounting Standard Board (IASB) to

foster the emergence of a consensus as to where and how the mark-to-market principle

should apply – and where it should not. The IASB must, to this end, open itself up more to

the views of the regulatory, supervisory and business communities. This should be

coupled with developing a far more responsive, open, accountable and balanced

governance structure. If such a consensus does not emerge, it should be the role of the

international community to set limits to the application of the mark-to-market principle.

78) The valuation of impaired assets is now at the centre of the political debate. It is of crucial

importance that valuation of these assets is carried-out on the basis of common

methodologies at international level. The Group encourages all parties to arrive at a

solution which will minimise competition distortions and costs for taxpayers. If there are

widely variant solutions – market uncertainty will not be improved.

79) Regarding the issue of pro-cylicality, as a matter of principle, the accounting system

should be neutral and not be allowed to change business models – which it has been doing

in the past by "incentivising" banks to act short term. The public good of financial

stability must be embedded in accounting standard setting. This would be facilitated if the

regulatory community would have a permanent seat in the IASB (see chapter on global


Recommendation 4: With respect to accounting rules the Group considers that a wider

reflection on the mark-to-market principle is needed and in particular recommends that:

- expeditious solutions should be found to the remaining accounting issues concerning

complex products;

- accounting standards should not bias business models, promote pro-cyclical behaviour

or discourage long-term investment; 21

- the IASB and other accounting standard setters should clarify and agree on a common,

transparent methodology for the valuation of assets in illiquid markets where mark-to-

market cannot be applied;

- the IASB further opens its standard-setting process to the regulatory, supervisory and

business communities;

- the oversight and governance structure of the IASB be strengthened.

d) Insurance

80) The crisis originated and developed in the banking sector. But the insurance sector has

been far from immune. The largest insurance company in the world has had to be bailed

out because of its entanglement with the entire financial sector, inter alia through credit

default swaps activities. In addition, the failure of the business models of monoline

insurers has created significant market and regulatory concern. It is therefore important,

especially at a time where Europe is in the process of overhauling its regulatory

framework for the entire insurance sector, to draw the lessons from the crisis in the US

insurance sector. Insurance companies can in particular be subject to major market and

concentration risks. Compared to banks, insurance companies tend to be more sensitive to

stock market developments (and less to liquidity and credit risks, even if the crisis has

shown that they are not immune to those risks either).

81) Solvency 2 is an important step forward in the effort to improve insurance regulation, to

foster risk assessments and to rationalise the management of large firms. Solvency 2

should therefore be adopted urgently. The directive, especially if complemented by

measures which draw the lessons from the crisis, would remedy the present fragmentation

of rules in the EU and allow for a more comprehensive, qualitative and economic

assessment of the risks mentioned above. The directive would also facilitate the

management and supervision of large insurance groups. With colleges of supervisors for

all cross-border groups the directive would strengthen and organise better supervisory

cooperation – something lacking up to now in spite of the efforts made by the Committee

of European Insurance and Occupational Pensions Supervisors (CEIOPS). The AIG case

in the US has illustrated in dramatic terms what happens when there is a lack of

supervisory cooperation.

82) Differences of views between "home" and "host" Member States on the operation of the

group support regime have so far prevented a successful conclusion of the negotiation of

the directive. This should be addressed by providing adequate safeguards for host Member

States. In addition, the Group believes that the new supervisory framework proposed in

the chapter on supervision (and in particular, the setting up of a binding mediation

mechanism between home and host supervisors) plus the development of harmonised

insurance guarantees schemes could contribute to finding a solution for the current

deadlock. All the above measures (safeguards, binding mediation, insurance guarantee

schemes) should be implemented together concurrently with Solvency 2. It would be

highly desirable to agree the above package by May 2009 when the European Parliament

breaks for its elections. 22

Recommendation 5: The Group considers that the Solvency 2 directive must be adopted and

include a balanced group support regime, coupled with sufficient safeguards for host

Member States, a binding mediation process between supervisors and the setting-up of

harmonised insurance guarantee schemes.

e) Supervisory and sanctioning powers

83) A sound prudential and conduct of business framework for the financial sector must rest

on strong supervisory and sanctioning regimes. Supervisory authorities must be equipped

with sufficient powers to act when financial institutions have inadequate risk management

and control mechanisms as well as inadequate solvency of liquidity positions. There

should also be equal, strong and deterrent sanctions regimes against all financial crimes -

sanctions which should be enforced effectively.

84) Neither of these exist for the time being in the EU. Member States sanctioning regimes are

in general weak and heterogeneous. Sanctions for insider trading range from a few

thousands of euros in one Member State to millions of euros or jail in another. This can

induce regulatory arbitrage in a single market. Sanctions should therefore be urgently

strengthened and harmonised. The huge pecuniary differences between the level of fines

that can be levied in the competition area and financial fraud penalties is striking.

Furthermore, Member States should review their capacity to adequately detect financial

crimes when they occur. Where needed, more resources and more sophisticated detection

processes should be deployed.

Recommendation 6: The Group considers that:

- Competent authorities in all Member States must have sufficient supervisory powers,

including sanctions, to ensure the compliance of financial institutions with the

applicable rules;

- Competent authorities should also be equipped with strong, equivalent and deterrent

sanction regimes to counter all types of financial crime.

Closing the gaps in regulation

a) The "parallel banking system"

85) In addition to the weaknesses identified in the present regulatory framework, and in

particular in the Basel 2 framework, it is advisable to look into the activities of the

"parallel banking system" (encompassing hedge funds, investment banks, other funds,

various off-balance sheet items, mortgage brokers in some jurisdictions). The Group

considers that appropriate regulation must be extended, in a proportionate manner, to all

firms or entities conducting financial activities which may have a systemic impact (i.e. in

the form of counterparty, maturity, interest rate risks…) even if they have no direct links

with the public at large. This is all the more important since such institutions, having no

deposit base, can be very vulnerable when liquidity evaporates – resulting in major

impacts in the real economy. 23

86) Concerning hedge funds, the Group considers they did not play a major role in the

emergence of the crisis. Their role has largely been limited to a transmission function,

notably through massive selling of shares and short-selling transactions. We should also

recognise that in the EU, unlike the US, the great bulk of hedge fund managers are

registered and subject to information requirements. This is the case in particular in the

UK, where all hedge funds managers are subject to registration and regulation, as all fund

managers are, and where the largest 30 are subject to direct information requirements

often obtained on a global basis as well as to indirect monitoring via the banks and prime


87) It would be desirable that all other Member States as well as the US adopt a comparable

set of measures. Indeed, hedge funds can add to the leverage of the system and, given the

scale at which they can operate, should a problem arise, the concentrated unwinding of

their positions could cause major dislocation.

88) There is a need for greater transparency since banks, the main lenders to hedge funds, and

their supervisors have not been able to obtain a global view of the risks they were

engaging in. At the very least, supervisors need to know which hedge funds are of

systemic importance. And they should have a clear on-going view on the strategies, risk

structure and leverage of these systemically important funds. This need for supervisory

information requires the introduction of a formal authority to register these funds, to

assess their strategies, their methods and their leverage. This is necessary for the exercise

of macro-prudential oversight and therefore essential for financial stability.

89) Appropriate regulation in the US must also be redesigned for large investment banks and

broker dealers when they are not organised as bank holding companies.

90) In this context, particular attention has to be paid to institutions which engage in

proprietary trading to create value for their shareholders, i.e. investment banks and

commercial banks who have engaged in these activities (that are not essentially different

from some hedge funds). The conventional wisdom has been that light regulatory

principles could apply to these because they were trading "at their own risk". Evidence has

shown that the investment banks were subject to very thin capital requirements, became

highly leveraged and then created severe systemic problems. Furthermore, it turned out

that these institutions were subject to only very weak supervision by the Securities and

Exchange Commission (SEC), which meant that no one had a precise view on their

involvement with hedge funds and SPVs; nor had the competent authorities a view on the

magnitude of the proprietary investments of these institutions, in particular in the US real

estate sector.

91) While these institutions should not be controlled like ordinary banks, adequate capital

requirements should be set for proprietary trading and reporting obligations should be

applied in order to assess their degree of leverage. Furthermore, the wrong incentives that

induced excessive risk taking (in particular because of the way in which bonuses are

structured) must be rectified.

92) Where a bank actually owns a hedge fund (or a private equity fund), the Group does not

believe that such ownership should be necessarily prohibited. It believes however that this

situation should induce very strict capital requirements and very close monitoring by the

supervisory authorities. 24

Recommendation 7: Concerning the "parallel banking system" the Group recommends to:

- extend appropriate regulation, in a proportionate manner, to all firms or entities

conducting financial activities of a potentially systemic nature, even if they have no

direct dealings with the public at large;

- improve transparency in all financial markets - and notably for systemically important

hedge funds - by imposing, in all EU Member States and internationally, registration

and information requirements on hedge fund managers, concerning their strategies,

methods and leverage, including their worldwide activities;

- introduce appropriate capital requirements on banks owning or operating a hedge fund

or being otherwise engaged in significant proprietary trading and to closely monitor


b) Securitised products and derivatives markets

93) The crisis has revealed that there will be a need to take a wide look at the functioning of

derivative markets. The simplification and standardisation of most over-the-counter

(OTC) derivatives and the development of appropriate risk-mitigation techniques plus

transparency measures could go a long way towards restoring trust in the functioning of

these markets. It might also be worth considering whether there are any benefits in

extending the relevant parts of the current code of conduct on clearing and settlement

from cash equities to derivatives.

94) In the short-run, an important goal should be to reduce the counterparty risks that exist in

the system. This should be done by the creation in the EU of at least one well-capitalised

central clearing house for over-the-counter credit-default swaps (CDS), which would have

to be simplified and standardized. This clearing house should be supervised by CESR and

by the relevant monetary authorities, and notably the ECB (about 80% of the CDS market


is denominated in euros ). This is vital to realize the highly needed reduction from gross

to net positions in counterparty risks, particularly in cases of default such as Lehman


95) To restore confidence in securitized markets, it is important to oblige at the international

level issuers of complex securities to retain on their books for the life of the instrument a

meaningful amount of the underlying risk (non-hedged).

Concerning securitised products and derivatives markets, the Group

Recommendation 8:

recommends to:

- simplify and standardise over-the-counter derivatives;

- introduce and require the use of at least one well-capitalised central clearing house for

credit default swaps in the EU;

- guarantee that issuers of securitised products retain on their books for the life of the

instrument a meaningful amount of the underlying risk (non-hedged).

5 Use of central bank money should be made for securities settlement, as proposed by Target 2 securities. 25

c) Investment funds

i) Money market funds issues

96) Another area which deserves attention is the regulation of the investment fund industry. A

small number of investment funds in the EU have faced temporary difficulties in meeting

investor redemption demands because of the unexpected contraction of liquidity in

previously highly liquid markets (e.g. asset backed commercial paper, short-term banking


97) This highlights in particular the need for a common EU definition of money market funds,

and a stricter codification of the assets in which they can invest in order to limit exposure

to credit, market and liquidity risks.

ii) Depository issues

98) The Madoff case has illustrated the importance of better controlling the quality of

processes and functions in the case of funds, funds of funds and delegations of

responsibilities. Several measures seem appropriate:

- delegation of investment management functions should only take place after proper

due diligence and continuous monitoring by the "delegator";

- an independent depository should be appointed, preferably a third party;

- The depository institution, as custodians, should remain responsible for safe-keeping

duties of all the funds assets at all times, in order to be able to perform effectively its

compliance-control functions. Delegation of depository functions to a third party

should therefore be forbidden. Nevertheless, the depositary institution may have to use

sub-custodians to safe-keep foreign assets. Sub-custodians must be completely

independent of the fund or the manager. The depositary must continue to perform

effective duties as is presently requested. The quality of this duties should be the

object of supervision;

- delegation practices to institutions outside of the EU should not be used to pervert EU

legislation (UCITS provides strict "Chinese walls" between asset management

functions and depositary-safe-keeping functions. This segregation should be respected

whatever the delegation model is used).

Recommendation 9: With respect to investment funds, the Group proposes to further

develop common rules for investment funds in the EU, notably concerning definitions,

codification of assets and rules for delegation. This should be accompanied by a tighter

supervisory control over the independent role of depositories and custodians. 26


99) While the above areas for regulatory repair are relevant for all major jurisdictions in the

world, and should be addressed internationally, Europe suffers from an additional

problem in comparison to all single jurisdictions: the lack of a consistent set of rules.

100) An efficient Single Market should have a harmonised set of core rules.

101) There are at least four reasons for this:

- a single financial market - which is one of the key-features of the Union - cannot

function properly if national rules and regulations are significantly different from

one country to the other;

- such a diversity is bound to lead to competitive distortions among financial

institutions and encourage regulatory arbitrage;

- for cross-border groups, regulatory diversity goes against efficiency and the normal

group approaches to risk management and capital allocation;

- in cases of institutional failures, the management of crises in case of cross-border

institutions is made all the more difficult.

102) The present regulatory framework in Europe lacks cohesiveness. The main cause of this

situation stems from the options provided to EU members in the enforcement of

common directives. These options lead to a wide diversity of national transpositions

related to local traditions, legislations and practices.

103) This problem has been well-identified since the very beginning of the single financial

market process. But the solutions have not always met the challenges. The fundamental

cause for this lack of harmonisation is that the level 1directives have too often left, as a

political choice, a range of national options. In these circumstances, it is unreasonable to

expect the level 3 committees to be able to impose a single solution. Even when a

directive does not include national options, it can lead to diverse interpretations which

cannot be eliminated at level 3 in the present legal set-up.

104) As has been pointed out above, most of these issues relate to the effectiveness of the

single financial market more than to the crisis. But three observations can be made here:

firstly, the mandate of this Group is not limited to recommendations directly related to

the issues that have arisen in the crisis; secondly, a number of important differences

between Member States (different bankruptcy laws, different reporting obligations,

different definitions of economic capital…) have compounded the problems of crisis

prevention and management; thirdly, the crisis has shown that financial policy actions in

one country can have detrimental effects on other countries. To avoid as much as

possible spill-over effects and build the necessary trust, some institutionalised and

binding arrangements are needed. 27

a) Examples of current regulatory inconsistencies

105) A few examples of excessive diversity can be stressed:

- the differences regarding the sectoral extent of EU supervision. Some EU countries

have an extended definition of credit institutions (i.e. "établissements de crédit"),

while other members have much more limited definitions. This is a source of

problematic divergences between members that can lead to laxer supervision and

regulatory arbitrage;

- reporting obligations are very diverse in the EU, some institutions -especially the

non-listed ones- have no obligation to issue accounting reports. The transparency of

the system is negatively affected by such differences;

- the definition of core capital differs from one Member State to another, with an

impact in terms of communication. Some companies do not subtract goodwill from

the definition of core capital;

- there are different accounting practices for provisions related to pensions. These

differences create serious distortions in the calculation of prudential own funds in

different nations;

- the directive on insurance mediation has led to highly divergent transpositions in the

Member States. Some Member States have transposed the directive as it is with

almost no national additions, while others have complemented the directive with

very extensive national rules. Given that the directive grants a single passport to

insurance intermediaries, these different transpositions induce competition


- there is limited harmonisation of the way in which insurance companies have to

calculate their technical provisions, which makes it difficult to compare the solvency

standing of insurance companies across the Community;

- the differences in the definition of regulatory capital regarding financial institutions

are striking within the EU (for example, the treatment of subordinated debt as core

tier 1 is the object of different adaptations). This goes at the heart of the efficiency

and the enforcement of the Basel directive on capital requirements;

- there is no single agreed methodology to validate risks assessments by financial


- there are still substantial differences in the modalities related to deposit insurance;

- there is no harmonisation whatsoever for insurance guarantee schemes.

106) This brief analysis, based on concrete examples, leads to the conclusion that keeping

intact the "present arrangements" is not the best option in the context of the Single


b) The way forward

107) How to correct such a situation?

First of all, it must be noted that harmonisation is not an end in itself and that

consistency does not need identical rules everywhere. There are national approaches that


can be beneficial to the interested countries while not falling into the drawbacks

mentioned above. National exceptions should be looked at with this in mind.

108) Furthermore, allowing a country, under appropriate circumstances, to adopt safeguards

or regulatory measures stricter than the common framework should not be rejected. As

long as agreed minimum core standards are harmonized and enforced, a country could

take more restrictive measures if it considers they are domestically appropriate to

safeguard financial stability. This should of course be done while respecting the

principles of the internal market.

109) This being said the problem of regulatory inconsistencies must be solved at two

different levels:

- the global level. The EU participates in a number of international arrangements (e.g.

Basel committee, FSF) and multilateral institutions (e.g. IMF) that cannot be

unilaterally changed by the EU. If and when some changes in those global rules

appeared necessary, Europe should "speak with one voice" as we will mention in the

global chapter;

- the European level. The European Institutions and the level 3 committees should

equip the EU financial sector with a set of consistent core rules. Future legislation

should be based, wherever possible, on regulations (which are of direct application).

When directives are used, the co-legislator should strive to achieve maximum

harmonisation of the core issues. Furthermore, a process should be launched to

remove key-differences stemming from the derogations, exceptions and vague

provisions currently contained in some directives (see chapter on supervision).

Recommendation 10: In order to tackle the current absence of a truly harmonised set of

core rules in the EU, the Group recommends that:

- Member States and the European Parliament should avoid in the future legislation that

permits inconsistent transposition and application;

- the Commission and the level 3 Committees should identify those national exceptions,

the removal of which would improve the functioning of the single financial market;

reduce distortions of competition and regulatory arbitrage; or improve the efficiency of

cross-border financial activity in the EU. Notwithstanding, a Member State should be

able to adopt more stringent national regulatory measures considered to be domestically

appropriate for safeguarding financial stability as long as the principles of the internal

market and agreed minimum core standards are respected.


110) This is one of the most important failures of the present crisis.

111) Corporate governance has never been spoken about as much as over the last decade.

Procedural progress has no doubt been achieved (establishment of board committees,

standards set by the banking supervision committee) but looking back at the causes of


the crisis, it is clear that the financial system at large did not carry out its tasks with

enough consideration for the long-term interest of its stakeholders. Most of the

incentives – many of them being the result of official action – encouraged financial

institutions to act in a short-term perspective and to make as much profit as possible to

the detriment of credit quality and prudence; interest rates were low and funding

plentiful; the new accounting rules were systematically biased towards short-term

performance (indeed these rules led to immediate mark-to-market recognition of profit

without allowing a discount for future potential losses). As a result of all this, the long-

term, "through the cycle" perspective has been neglected.

112) In such an environment, investors and shareholders became accustomed to higher and

higher revenues and returns on equity which hugely outpaced for many years real

economic growth rates. Few managers avoided the "herd instinct" – leading them to join

the competitive race even if they might have suspected (or should have known) that risk

premia were falling and that securitisation as it was applied could not shield the

financial system against bad risks.

113) This is a sombre picture and not an easy one to correct; much of this behaviour was

ingrained in the incentive structure mentioned above.

114) There should be no illusion that regulation alone can solve all these problems and

transform the mindset that presided over the functioning (and downward spiral) of the


115) However, good, well-targeted measures could help mitigate or eliminate a number of

misled incentives; the Group believes that several recommendations put forward in this

report would be useful in this respect. They are:

- reform of the accounting system;

- a building-up of buffers in the form of dynamic provisioning or higher capital

requirements in the good times;

- closing of regulatory gaps (e.g. off-balance sheet operations, oversight of hedge


116) The Group however wishes to stress two further aspects of corporate governance that

require specific attention: remuneration and risk management.

Remuneration issues

117) The crisis has launched a debate on remuneration in the financial services industry.

There are two dimensions to this problem: one is the often excessive level of

remuneration in the financial sector; the other one is the structure of this remuneration,

notably the fact that they induce too high risk-taking and encourage short-termism to the

detriment of long-term performance. Social-political dissatisfaction has tended recently

to focus, for understandable reasons, on the former. However, it is primarily the latter

issue which has had an adverse impact on risk management and has thereby contributed

to the crisis. It is therefore on the structure of remuneration that policy-makers should

concentrate reforms going forward. 30

118) It is extremely important to re-align compensation incentives with shareholder interests

and long-term, firm-wide profitability. Compensation schemes must become fully

transparent. Industry has already come up with various sets of useful principles to try

and achieve this. The principles agreed in 2008 by the Institute of International Finance,

for example, are a first step.

119) Without dealing with remuneration in financial institutions that have received public

support, nor impinging on the responsibility of financial institutions in this field, it

seems appropriate to outline a few principles that should guide compensation policies.

Such principles include:

- the assessment of bonuses should be set in a multi-year framework. This would

allow, say over five years, to spread out the actual payment of the bonus pool of

each trading unit through the cycle and to deduct any potential losses occurring

during the period. This would be a more realistic and less short-term incentivised

method than present practice;

- these standards should apply not only to proprietary trading but also to asset


- bonuses should reflect actual performance and therefore should not be "guaranteed"

in advance.

120) Supervisors should oversee the adequacy of financial institutions' compensation

policies. And if they consider that these policies conflict with sound underwriting

practice, adequate risk management or are systematically encouraging short-term risk-

taking, they should require the institutions concerned to reassess their remuneration

policies. If supervisors are not satisfied by the measures taken they should use the

possibility opened by pillar 2 of the Basel framework to require the financial institutions

concerned to provide additional capital.

121) Of course the same guidelines should apply in relation to other financial institutions in

order to avoid competitive distortions and loopholes. As suggested in the "global repair"

chapter of this report, consistent enforcement of these measures at global level should be

ensured to avoid excessive risk-taking.

Recommendation 11: In view of the corporate governance failures revealed by the current

financial crisis, the Group considers that compensation incentives must be better aligned

with shareholder interests and long-term firm-wide profitability by basing the structure of

financial sector compensation schemes on the following principles:

- the assessment of bonuses should be set in a multi-year framework, spreading bonus

payments over the cycle;

- the same principles should apply to proprietary traders and asset managers;

- bonuses should reflect actual performance and not be guaranteed in advance.

Supervisors should oversee the suitability of financial institutions' compensation policies,

require changes where compensation policies encourage excessive risk-taking and, where

necessary, impose additional capital requirements under pillar 2 of Basel 2 in case no

adequate remedial action is being taken. 31

Internal risk management

122) In many cases, risk monitoring and management practices within financial institutions

have dramatically failed in the crisis.

123) In the future, the risk management function must be fully independent within the firms

and it should carry out effective and not arbitrarily constrained stress testing exercises.

Firms should organise themselves internally so that incentives are not too much tilted

towards risk taking – neglecting risk control. To contribute to this, the Senior Risk

Officer in an institution should hold a very high rank in the hierarchy (at senior

management level with direct access to the board). Changes to remuneration structures

will also be needed: effective checks and balances are indeed unlikely to work if those

who are supposed to control risk remain under-paid compared to those whose job it is to

take risks.

124) But all this must not be construed as exonerating issuers and investors from their duties.

For issuers, transparency and clarity in the description of assets put on the market is of

the essence as this report has often stressed; but investors and in particular asset

managers must not rely (as has too often been the case) on credit rating agencies

assessments; they must exercise informed judgement; penalties should be enforced by

supervisors when this is not applied. Supervisory control of firms' risk management

should be considerably reinforced through rigorous and frequent inspection regimes.

Recommendation 12: With respect to internal risk management, the Group recommends


- the risk management function within financial institutions must be made independent

and responsible for effective, independent stress testing;

- senior risk officers should hold a very high rank in the company hierarchy, and

- internal risk assessment and proper due diligence must not be neglected by over-

reliance on external ratings.

Supervisors are called upon to frequently inspect financial institutions' internal risk

management systems.


125) As a general observation, it has been clearly demonstrated that the stakes in a banking

crisis are high for Governments and society at large because such a situation has the

potential to jeopardise financial stability and the real economy. The crisis has also

shown that crisis prevention, crisis management and crisis resolution tools should all be

handled in a consistent regulatory framework.

126) Of course, crisis prevention should be the first preoccupation of national and EU

authorities (see chapter on supervision). Supervisors should act as early as possible in

order to address the vulnerabilities identified in a given institution, and use all means

available to them to this effect (e.g. calling on contributions from shareholders, fostering


the acquisition of the institution concerned by a stronger one). In this respect, the role of

central banks which are by essence well placed to observe the first signs of vulnerability

of a bank is of crucial importance. Therefore in countries where supervision is not in the

hands of the central bank, a close collaboration must be ensured between supervisors

and central banks. But crises will always occur and recent experiences in managing

crises have shown that many improvements to the present system are called for.

a) Dealing with the moral hazard issue

127) “Constructive ambiguity” regarding decisions whether or not public sector support will

be made available can be useful to contain moral hazard. However, the cure for moral

hazard is not to be ambiguous on the issue of public sector involvement as such in crisis

management. Two aspects need to be distinguished and require different treatment. On

the one hand, a clear and consistent framework for crisis management is required with

full transparency and certainty that the authorities have developed concrete crisis

management plans to be used in cases where absence of such public sector support is

likely to create uncertainty and threaten financial stability. On the other hand,

constructive ambiguity and uncertainty is appropriate in the application of these


arrangements in future individual cases of distressed banks .

b) Framework for dealing with distressed banks

128) In the management of a crisis, priority should always be given to private-sector

solutions (e.g. restructuring). When these solutions appear insufficient, then public

authorities have to play a more prominent role and the injection of public money

becomes often inevitable.

129) As far as domestic national banks are concerned, crisis management should be kept at

the national level. National supervisors know the banks well, the political authorities

have at their disposal a consistent legal framework and taxpayers' concerns can be dealt

with in the democratic framework of an elected government. For cross-border

institutions at EU level, because of different supervisory, crisis management and

resolution tools as well as different company and insolvency laws, the situation is much

more complex to handle. There are inconsistencies between national legislation

preventing an orderly and efficient handling of an institution in difficulty.

130) For example, company law provisions in some countries prevent in times of crisis the

transfer of assets from one legal entity to another within the same group. This makes it

impossible to transfer assets where they are needed, even though this may be crucial to

safeguard the viability of the group as a whole. Another problem is that some countries

place, in their national laws, emphasis on the protection of the institution while other

countries attach a greater priority to the protection of creditors. In the crisis resolution

phase, other problems appear: for example, the ranks of creditors are different from one

Member State to the other.

6 This approach is recommended by Charles Goodhart and Dirk Schoenmaker, “Fiscal Burden Sharing in Cross Border

Banking Crises”, in International Journal of Central Banking, to be published early 2009. 33

131) The lack of consistent crisis management and resolution tools across the Single Market

places Europe at a disadvantage vis-à-vis the US and these issues should be addressed

by the adoption at EU level of adequate measures.

c) Deposit Guarantee Schemes (DGS)

132) The crisis has demonstrated that the current organisation of DGSs in the Member States


was a major weakness in the EU banking regulatory framework . The Commission

recent proposal is an important step to improve the current regime, as it will improve the

protection of depositors.

133) A critical element of this proposal is the requirement that all Member States apply the

same amount of DGS protection for each depositor. The EU cannot indeed continue to

rely on the principle of a minimum coverage level, which can be topped-up at national

level. This principle presents two major flaws: first, in a situation where a national

banking sector is perceived as becoming fragile, there is the risk that deposits would be

moved to the countries with the most protective regime (thus weakening banks in the

first country even further); second, it would mean that in the same Member State the

customers of a local bank and those using the services of a third country branch could

enjoy different coverage levels. As the crisis has shown, this cannot be reconciled with

the notion of a well-functioning Single Market.

134) Another important element to be taken into account is the way in which the DGSs are

funded. In this respect, the Group is of the view that preference should be given to

schemes which are pre-funded by the financial sector. Such schemes are better to foster

confidence and help avoiding pro-cyclical effects resulting from banks having to pay

into the schemes at a time where they are already in difficulty.

135) Normally, pre-funded DGSs should take care in the future of losses incurred by

depositors. Nonetheless, it is probable that for very large and cross border institutions,

pre-funded mechanisms might not be sufficient to cover these guarantees. In order to

preserve trust in the system, it should be made clear that in those cases pre-funded

schemes would have to be topped-up by the State.

7 The Commission's recent proposal is an important step to improve the current DGS-regime, as it strengthens harmonisation

and improves the protection of depositors. However, the directive still leaves a large degree of discretion to member states,

particularly in relation to funding arrangements, administrative responsibility and the role of DGS in the overall crisis

management framework. Leaving these issues unresolved at EU-level implies that significant weaknesses remain in the DGS-

framework, including inter alia:

− Unsustainable funding – the current lack of sophisticated and risk sensitive funding arrangements involves a significant

risk that governments will have to carry the financial burden indented for the banks, or worse, that the DGS fails on their

commitments (both of which illustrated by the Icelandic case). In particular, in relation to the any of the 43 European

LFCIs identified earlier in the chapter, no current scheme can be expected to have the capacity to make reimbursements

without involving public funds.

− Limited use in crisis management – Even if DGS’ had that capacity, the pay box nature of most schemes makes it

unlikely that they ever will be utilised for LFCIs, because of the large externalities associated with letting such

institutions fail.

− Negative effects on financial stability – reliance on ex-post funding and lack of risk sensitive premiums weakens market

discipline (moral hazard), distort the efficient allocation of deposits, as well as it may be a source of pro-cyclicality.

Obstacle to efficient crisis management – due to incompatible schemes (trigger points, early intervention powers etc.) and

diverging incentives among member. 34

136) The idea of a pooled EU fund, composed of the national deposit guarantee funds, has

been discussed by the Group, but has not been supported. The setting-up and

management of such a fund would raise numerous political and practical problems.

Furthermore, one fails to see the added-value that such a fund would have in comparison

to national funds operating under well-harmonised rules (notably for coverage levels

and the triggering of the scheme).

EU harmonization should not go as far either as laying down rules on the possible use of

DGSs in the management of a crisis. It should not prohibit additional roles beyond the

base task for a DGS to act ex post, in the crisis resolution phase, as a pay box by

reimbursing the guaranteed amount to depositors in a defaulted bank. Most member

countries limit their national DGS to this pay box function. Some countries, however,

extend the activities by giving their DGS also a rescue function. The Group did not see

any need for EU harmonization in this respect.

137) There is a specific case (of the Icelandic type) when a supervisory authority allows some

of its banks to mushroom large branches in other EU countries, whilst the home

Member State is not able to honour the deposit guarantee schemes which are inadequate

for such exposures. The guarantee responsibilities then de facto fall into the jurisdiction

of the host country. This is not acceptable and should at least be addressed, for example,

in the following way: the host Member State should have the right to inquire whether

the funds available in the DGS of the home Member State are indeed sufficient to

protect fully the depositors in the host Member State. Should the host Member State not

have sufficient guarantees that this is indeed the case, the only way to address this kind

of problem is to give sufficient powers to the host supervisory authorities to take

measures that would at the very beginning curtail the expansive trends observed.

138) The Group has not entered into the specifics of the protection of policy-holders and

investors. It nevertheless considers that the above general principles, and in particular

the equal protection of all customers in the Single Market, should also be implemented

in the insurance and investment sectors.

d) Burden sharing

139) The issue of burden sharing in cases of crisis resolution is extremely complicated for

two reasons. First, cases where financial support from both public sector and private

sector is needed to reach an acceptable solution are more complex than rescues where

either private or public money is involved. Second, agreement on burden sharing on an

ex post basis, at the moment of the rescue operation, is more difficult to reach than when

one can rely on predetermined, ex ante arrangements.

140) As noted above, the current lack of pan-EU mechanism to resolve a crisis affecting a

cross-border group implies that there is no choice but to resolve this crisis at national

entity-level or to agree on improvised, ad hoc cross-border solutions. The lack of a

financing mechanism to support the resolution of a cross-border group further

complicates the situation.

141) On the basis of the experiences learnt from the crisis, the Group believes that the

Member States should become able to manage a crisis in a more adequate way than is

feasible today. There would be merit, in order to achieve this, in developing more


detailed criteria on burden sharing than the principles established in the current

Memorandum of Understanding (MoU), which limits the sharing of a fiscal burden to

two main principles: the economic impact of the crisis on the Member States concerned

(equity principle) and the allocation of home/host supervisory powers (accountability


142) Burden sharing arrangements could, in addition, include one of the following criteria, or

a combination thereof:

- the deposits of the institution;

- the assets (either in terms of accounting values, market values or risk-weighted

values) of the institution;

- the revenue flows of the institution;

- the share of payment system flows of the institution;

- the division of supervisory responsibility; the party responsible for supervisory

work, analysis and decision being also responsible for an appropriately larger share

of the costs.

143) These criteria would preferably be implemented by amending the 2008 MoU. Where

needed, additional criteria could be agreed.

Recommendation 13: The Group calls for a coherent and workable regulatory framework

for crisis management in the EU:

- without pre-judging the intervention in future individual cases of distressed financial

institutions, a transparent and clear framework for managing crises should be


- all relevant authorities in the EU should be equipped with appropriate and equivalent

crisis prevention and crisis intervention tools;

- legal obstacles which stand in the way of using these tools in a cross-border context

should be removed, with adequate measures to be adopted at EU level.

Deposit Guarantee Schemes (DGS) in the EU should be harmonised

Recommendation 14:

and preferably be pre-funded by the private sector (in exceptional cases topped up by the

State) and provide high, equal protection to all bank customers throughout the EU.

The principle of high, equal protection of all customers should also be implemented in the

insurance and investment sectors.

The Group recognises that the present arrangements for safeguarding the interests of

depositors in host countries have not proved robust in all cases, and recommends that the

existing powers of host countries in respect of branches be reviewed to deal with the

problems which have occurred in this context. 36

Recommendation 15: In view of the absence of an EU-level mechanisms for financing

cross-border crisis resolution efforts, Member States should agree on more detailed criteria

for burden sharing than those contained in the existing Memorandum of Understanding

(MoU) and amend the MoU accordingly. 37



144) The previous chapter proposed changes to the European regulation of financial services.

This chapter examines the policies and practices of supervision of financial services

within the EU and proposes both short and longer term changes. Regulation and

supervision are interdependent: competent supervision cannot make good failures in

financial regulatory policy; but without competent and well designed supervision good

regulatory policies will be ineffective. High standards in both are therefore required.

Macro and Micro prudential supervision

145) The experience of the past few years has brought to the fore the important distinction

between micro-prudential and macro-prudential supervision. Both are clearly

intertwined, in substance as well as in operational terms. Both are necessary and will be

covered in this chapter.

146) Micro-prudential supervision has traditionally been the centre of the attention of

supervisors around the world. The main objective of micro-prudential supervision is to

supervise and limit the distress of individual financial institutions, thus protecting the

customers of the institution in question. The fact that the financial system as a whole

may be exposed to common risks is not always fully taken into account. However, by

preventing the failure of individual financial institutions, micro-prudential supervision

attempts to prevent (or at least mitigate) the risk of contagion and the subsequent

negative externalities in terms of confidence in the overall financial system.

147) The objective of macro-prudential supervision is to limit the distress of the financial

system as a whole in order to protect the overall economy from significant losses in real

output. While risks to the financial system can in principle arise from the failure of one

financial institution alone if it is large enough in relation to the country concerned

and/or with multiple branches/subsidiaries in other countries, the much more important

global systemic risk arises from a common exposure of many financial institutions to the

same risk factors. Macro-prudential analysis therefore must pay particular attention to

common or correlated shocks and to shocks to those parts of the financial system that

trigger contagious knock-on or feedback effects.

148) Macro-prudential supervision cannot be meaningful unless it can somehow impact on

supervision at the micro-level; whilst micro-prudential supervision cannot effectively

safeguard financial stability without adequately taking account of macro-level


The objective of supervision

149) The prime objective of supervision is to ensure that the rules applicable to the financial

sector are adequately implemented, in order to preserve financial stability and thereby to

ensure confidence in the financial system as a whole and sufficient protection for the


customers of financial services. One function of supervisors is to detect problems at an

early stage to prevent crises from occurring. However, it is inevitable that there will be

failures from time to time, and the arrangements for supervision have to be seen with

this in mind. But once a crisis has broken out, supervisors have a critical role to play

(together with central banks and finance ministries) to manage the crisis as effectively as

possible to limit the damage to the wider economy and society as a whole.

150) Supervision must ensure that all supervised entities are subject to a high minimum set of

core standards. When carrying-out their duties, supervisors should not favour a

particular institution, or type of institution, to the detriment of others. Competition

distortions and regulatory arbitrage stemming from different supervisory practices must

be avoided, because they have the potential of undermining financial stability – inter

alia by encouraging a shift of financial activity to countries with lax supervision. The

supervisory system has to be perceived as fair and balanced. Furthermore, a level

playing field is vital for the credibility of supervisory arrangements, their acceptance by

market operators big and small and for generating optimal cooperation between

supervisors and financial institutions. This is of particular importance in the context of

the Single Market, built as it is, inter alia, on the principles of undistorted competition,

freedom of establishment and the free flow of capital. Confidence will be gained in the

European Union from common approaches by all Member States.

151) The supervisory objective of maintaining financial stability must take into account an

important constraint which is to allow the financial industry to perform its allocative

economic function with the greatest possible efficiency, and thereby contribute to

sustainable economic growth. Supervision should aim to encourage the smooth

functioning of markets and the development of a competitive industry. Poor supervisory

organisation or unduly intrusive supervisory rules and practices will translate into costs

for the financial sector and, in turn, for customers, taxpayers and the wider economy.

Therefore supervision should be carried-out as effectively as possible and at the lowest

possible cost. This, again, is crucial if the Single Market is to deliver all its benefits to

customers and companies.


152) Chapter 1 examined in detail the causes of the crisis. These were many; often with a

global dimension. Although the way in which the financial sector has been supervised

in the EU has not been one of the primary causes behind the crisis, there have been real

and important supervisory failures, from both a macro and micro-prudential standpoint.

The following significant problems have come to light:

a) Lack of adequate macro-prudential supervision

153) The present EU supervisory arrangements place too much emphasis on the supervision

of individual firms, and too little on the macro-prudential side. The fact that this failing

is duplicated elsewhere in the world makes it a greater, not a lesser, issue. The Group

believes that to be effective macro-prudential supervision must encompass all sectors of

finance and not be confined to banks, as well as the wider macro-economic context.

This oversight also should take account of global issues. Macro-prudential supervision

requires, in addition to the judgements made by individual Member States, a judgement





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Materiale didattico per il corso di Theories of Regulation della prof.ssa Laura Ammannati. Trattasi del rapporto dal titolo "The Hight Level Group on Financial Supervision in the EU", stilato dal gruppo presieduto da Jacques de Larosiére e avente riguardo al ruolo delle autorità di regolazione dei mercati nella prevenzione delle speculazioni e degli squilibri economici generatori di crisi.

Corso di laurea: Corso di laurea magistrale in economics and political science
Università: Milano - Unimi
A.A.: 2011-2012

I contenuti di questa pagina costituiscono rielaborazioni personali del Publisher Atreyu di informazioni apprese con la frequenza delle lezioni di Theories of Regulation e studio autonomo di eventuali libri di riferimento in preparazione dell'esame finale o della tesi. Non devono intendersi come materiale ufficiale dell'università Milano - Unimi o del prof Ammannati Laura.

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