The Challenge of European Integration for Prudential Policy

The economic unification of Europe is taking a long time. It has become more challenging with the advent of financial integration and the single currency. Under the pressures of globalisation and, as a necessary by-product, of increased competition, the risk profile of financial systems has dramatically changed for the worse. In Europe, soft compromises, which the principle of subsidiarity entails, have impeded the necessary reform of financial safety nets. This report will study the forces of competition which reshape financial systems and the changing pattern of risk. It will also review the theoretical foundations of prudential policy, which inspired the institutional design of the financial safety net. Finally, it will point to the shortcomings of current prudential policy, which result from a tension between the highly decentralized prudential framework and the ongoing progress in financial integration. Despite substantial progress, financial integration is still incomplete. With regard to debt markets, the integration project has admittedly moved faster and forced intermediaries to strengthen their domestic position. Banks have remained under national supervision while their risks are increasingly cross-border. As a consequence, endogenous risks, which stem from market inter-dependencies, have raised the vulnerability of markets to systemic risks. There has been a mixed response to this challenge. The aftermath of the terrorist attack has shown that when confronted with obvious systemic risks the European Central Bank is ready to fulfil its lender-of-last-resort responsibility. But when confronted with a covertly unfolding systemic episode which is generated by fast-growing indebtedness, the ECB lacks the information and the resources to diagnose the problem and intervene in a timely and effective manner. The cause is an overly decentralized supervisory structure: Market exposures are left undetected because bank supervision is conducted at the national level and a mechanism for multilateral cooperation is lacking. There is much scope for improving the financial safety net, without resorting to full centralisation. The final section of the report sets out proposals combining cooperation among national supervisors and minimum centralisation. The ECB should be capable of performing this task efficiently, because a single currency calls for a lender of last resort with overall responsibility for liquidity. Thus we propose the creation of a European observatory of systemic risk. We also propose the establishment of a European agency for transparency to coordinate information flows among national supervisors and enhance disclosure requirements. We suggest that prudential rules could be further harmonised with regard to deposit insurance schemes; that capital standards for banks should be sensitive to the credit cycle; that the creation of European rating agencies should be encouraged and those agencies should be accredited by a committee of bank supervisors. Finally, the report stresses that the most acute problem lies in the resolution of bank crises insofar as crisis management involves the use of public funds. In failing to bestow the ECB with responsibility over this major question, fiscal subsidiarity collides directly with monetary sovereignty.