INTERNATIONAL POLICY ANALYSIS

EU Financial Market Reform

Status and Prospects, Spring 2010

SEBASTIAN DULLIEN AND HANSJÖRG HERR

May 2010

쮿 The financial and economic crisis has made it clear that the financial markets are in
need of far-reaching reform and more effective regulation. Since the most pressing
dangers have been averted and the economy in most industrialised countries is clear
of recession, however, the topic of financial market regulation has largely disap-
peared from the public gaze.

쮿 Having said that, a great deal is happening in the background with regard to finan-
cial market regulation, including at the EU level. Against this background, econo-
mists Sebastian Dullien and Hansjörg Herr present the current state of the debate in
some of the most important areas of EU financial market regulation and ongoing
legislative processes and evaluate the most important plans.

쮿 The authors come to the conclusion that, although the current deliberations on re-
form are going in the right direction, they are insufficient to ensure the long-term
stability of the EU financial system. For example, the European Commission’s initia-
tives and even more so the ideas of the Council amount to an unacceptable dilution
of the demands of the De Larosière expert group. Dullien and Herr demonstrate
these defects and develop alternative proposals by means of which the European
Parliament could implement substantial EU financial market reforms.
 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

Content

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 Requirements of Well-Functioning Financial Market Regulation at the EU Level . 3

2.1 Comprehensive, Uniform Oversight of All Products and Institutions . . . . . . . . . . . . . 3
2.2 Capital Adequacy Requirements and Rating Agencies . . . . . . . . . . . . . . . . . . . . . . . 4
2.3 New Rules for Derivatives Trading and Securitisation . . . . . . . . . . . . . . . . . . . . . . . . 6

3 Current Reform Progress at the EU Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

3.1 Financial Supervision Package . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.2 Changes in Capital Adequacy Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.3 Stricter Regulation of Rating Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.4 Initiatives on Derivatives Trading and Securitisation . . . . . . . . . . . . . . . . . . . . . . . . . 12

4 What Next? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

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1 Introduction the banks’ capital requirements; and third, the regulation

of derivatives markets in the EU, including the rating
Since the outbreak of the current financial and economic agencies.2
crisis in 2007 and its intensification after the collapse of
US investment bank Lehman Brothers in September 2008
there has been no shortage of grandiloquent words as 2 Requirements of Well-Functioning Financial
politicians have sought to describe what is to be done Market Regulation at the EU Level
differently in the financial sector in future. »Making
banking boring« was suddenly the phrase on everyone’s Before attempting to assess current developments in
lips. As late as September 2009, at the G20 summit in financial market regulation it is worth taking one more
Pittsburgh, the Leaders’ Statement declared: »Today we look at where problems emerged in the latest crisis and
agreed: … To make sure our regulatory system for banks what is required for a better system of financial market
and other financial firms reins in the excesses that led to supervision.
the crisis. Where reckless behavior and a lack of respon-
sibility led to crisis, we will not allow a return to banking
as usual«. However, since for the time being critical 2.1 Comprehensive, Uniform Oversight of All Products
threats have been averted and the economies of most and Institutions
industrialised countries have come out of recession, fi-
nancial market regulation has faded from public view. A fundamental problem not only with the latest, but also
This applies in particular to Europe where, traditionally, previous financial and banking crises was often not so
legislation at the European level – where decisions on much that the banks were not regulated at home, but
financial market regulation are made, as a result of the that other financial institutions or other jurisdictions were
Single Market – has figured far less prominently in the less strictly regulated than the native banks and that the
predominantly national media than the reporting of commercial banks took advantage of this by transferring
national legislation. particularly risky transactions to less regulated parts of
the financial system (regulatory arbitrage). Before the lat-
In fact, however, a great deal is happening in the back- est crisis, for example, many banks externalised their
ground with regard to financial market regulation. The transactions involving US subprime securities in the form
European Commission has already presented a number of so-called special purpose vehicles, often located in less
of draft directives which are now slowly making their way regulated financial centres, making it possible, among
through the European decision-making bodies. other things, to circumvent capital requirements. The risk
remained for the commercial banks through their credit
The aim of this paper is to present and evaluate the cur- and ownership links with the so-called »shadow banks«
rent status of the debates and legislative procedures with (Brunnermeier et al. 2009). In the event, this behaviour,
regard to some of the most important areas of financial together with the regulatory differences in different parts
market regulation. We shall limit ourselves to financial of the financial sector, led not only to a more risky, but
market supervision and financial market regulation in the also to a more opaque financial system.
narrow sense. Although the authors are convinced that
macroeconomic imbalances played a significant role in The development of the US subprime crisis cannot be
the origins and outbreak of the global financial and eco- understood without taking a look at the still extremely
nomic crisis of 2008–2009, for reasons of space they fragmented state of financial supervision in the USA. For
must largely be left to one side.1 example, most subprime mortgages were issued not by
banks, but by mortgage companies which were subject
In what follows, we shall scrutinise three areas of finan- only to state-level regulation (Gramlich 2007). Many
cial market regulation which have particular significance
for the EU. First, financial market supervision at the EU
2. The matters that will not be dealt with explicitly include the control
level – that is, banking, securities and insurance; second, of hedge funds and other high-risk funds, a European deposit guarantee,
a European bankruptcy law and unregulated – or only lightly – offshore
centres in Europe itself, the purpose of which is to take advantage of
1. Those interested might consult Dullien et al. (2009). regulatory arbitrage and tax evasion.

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states exercised their regulatory powers so loosely that in which implement these decisions. This would mean su-
fact there was no regulation at all. The securities of in- pervisory authorities with large staffs on the ground in
vestment banks were securitised and in any case such the respective countries which, among other things,
banks were not subject to the same strict rules as normal would undertake the on-site supervision of financial in-
commercial banks. stitutions – just as, at present, the national central banks
in their day-to-day dealings with the commercial banks
Most authors are therefore in agreement that a central implement the European Central Bank’s (ECB) monetary
requirement of a well-functioning and powerful financial policy.
supervision is that it is as complete and comprehensive as
possible. It is crucial that all financial institutions – regard-
less of their legal nature – and all financial products are 2.2 Capital Adequacy Requirements and
included. Regulation should be directed towards what a Rating Agencies
product’s function is and what kind of transactions an
institution is involved in, not the legal character of the Another problem responsible for the current crisis was the
product or institution. Only in this way can regulatory ar- banks’ gluttonous appetite for risk. In all major industri-
bitrage be effectively prevented (Dullien et al. 2009: alised countries, in recent years, the banks’ capital buffer
154ff). has been systematically reduced, causing the debt-equity
ratio – so-called gearing or leverage – to rise rapidly. For
At the European level, there are further arguments for example, equity at institutions such as Deutsche Bank or
the harmonisation and – at least partial – centralisation the Swiss bank UBS was reduced from almost ten per cent
of regulation and oversight in the financial system. On at the beginning of the 1990s to two to three per cent
the one hand, the shifting of transactions to countries before the outbreak of the latest financial market crisis
with lower regulatory standards is particularly easy due (Hellwig 2008: 44).
to the Single Market. On the other hand, there is a sig-
nificant danger that the consequences of inadequate fi- One reason for this development may well have been the
nancial market regulation will spill over to the other reform of the rules on capital adequacy (the so-called
countries. First of all, the financial institutions in Europe Basel II standards). The earlier, relatively simple equity
are very closely intertwined and second, the current crisis capital guidelines were replaced by new, more complex
and the debate on financial assistance for the heavily in- guidelines, under which each investment by a bank had
debted Greece have shown that there is an implicit obli- to be backed by equity capital in accordance with its spe-
gation of liability among the partners for the debts of an cific risk. The risk of an investment in each instance was
individual country.3 This implies an enormous moral determined by an internal or external rating.
hazard problem in the absence of a uniform financial
supervision: individual countries always have the incen- There were three problems with this. First, using internal
tive to regulate financial institutions more loosely than risk models, the dangers arising from certain investments
other countries do in order to attract them. Potential were likely to be assessed as low as a matter of course.
costs in the event of a crisis are at least partially exter- Although individual risk models had to be approved by
nalised. Even basically uniform rules at the EU level are of the banking supervision, there was an incentive to adopt
no help against this problem unless there is a uniform models which evaluated the risks as low and entailed low
supervision, because national authorities have an incen- capital adequacy. Second, a strong pro-cyclical element
tive to interpret the rules as loosely as possible. was introduced into the banks’ lending. Ratings tend to
improve systematically in an upswing and to be down-
The most sensible option would be a supervisory system graded in a downturn. In connection with Basel II, the
whose structure resembled the European system of cen- problem arose that, in good times, the banks did not
tral banks, with a centralised authority which takes im- have to hold so much capital and thus could expand their
portant decisions and subordinate national authorities credit portfolio. This is likely to have further fuelled the
boom, for example, in mortgage allocation. In the down-
turn, in contrast, more equity capital was abruptly re-
3. The explicit no-bail-out clause has thus in the meantime become an
implicit bail-out guarantee (cf. Dullien / Schwarzer 2009). quired, so that the banks, in the very period in which the

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economy needed more expansive lending, were forced to nancial institutions, such as investment banks, hedge
curtail it. Third, the close links between financial institu- funds and private equity funds, whose business models
tions and rating agencies became problematic: because, are, as a rule, highly risk oriented and speculative. As a
in particular, the evaluation of structured financial prod- result, a direct channel emerged between the creation of
ucts was very profitable for the rating agencies and, at money by central banks, the commercial banks’ credit
the same time, such evaluations were commissioned and expansion and the credit financed speculation of risk-
paid for by the issuing financial institutions, there was an taking financial market actors. The central banks had no
incentive to provide even dubious products with good instrument at their disposal to promote credit expansion
ratings. Furthermore, for smaller financial institutions, in productive branches or to impede the financing of
which do not use their own risk models, rating agencies speculative activities, which led to asset market bubbles.
took over risk evaluation. For risk capital – for example, in the form of venture
capital – more than enough funds are still available, be-
Commercial banks traditionally pursued a business model cause non-commercial banks can attract investments, for
which concentrated, first and foremost, on lending to example, from risk-seeking private households.
non-financial institutions, that is, to companies, private
households and public authorities. In addition, banks The revision of equity capital rules is therefore key to
traded on capital markets, currency markets and other effective reform of financial market regulations. The fol-
speculative markets on behalf of others. In particular, lowing points are of particular importance in this regard:
banks operating internationally in recent years have dra-
matically increased the volume of proprietary trading. 1. Capital requirements should, by and large, be higher
This means that they carried out speculative bond, for- than they are now.
eign currency, precious metals and, not least, derivatives
transactions on their own account. 2. Banks should be compelled to back transactions
externalised in special purpose vehicles or similar institu-
These risky transactions on the part of the commercial tions with equity capital.
banks should be strictly limited in order to prevent them
from using their privileged access to central banks (to re- 3. The hitherto pro-cyclical effects of equity capital rules
finance their lending) to engage in highly speculative ac- should be eliminated, for example, by introducing obliga-
tivities. One option would be to impose particularly high tions on banks, in good times, to build up capital reserves
capital requirements – up to 100 per cent – on proprie- or by means of capital requirements which vary counter-
tary trading. Alternatively, a far-reaching ban on specula- cyclically over the economic cycle.
tive transactions in the proprietary trading of commercial
banks should be contemplated. US President Barack 4. The rating agencies’ role in the process should be
Obama, based on the recommendations of former Chair- reduced; furthermore, rating agencies’ payment model
man of the Federal Reserve Paul Volcker, has proposed should be changed so that they no longer have an incen-
reforms along these lines.4 Both options would also lead tive to evaluate securities in the interests of their issuers.
to a limitation or even reduction of the size of financial The establishment of a European rating agency could
institutions, which in any case is desirable on regulatory break the monopoly of the private rating agencies, which
grounds. To be sure, in both instances it must be ensured have failed.
that commercial bank loans to other highly speculative
actors in the financial sector – hedge funds, private equity 5. Commercial banks’ proprietary trading must be sub-
funds and so on – are limited. Likewise, in this case par- ject to very high capital requirements. The same applies
ticularly high capital requirements and an outright ban to commercial banks’ lending to non-banks in the finan-
are equally worthy of consideration. cial sector. Alternatively, proprietary trading could be
banned and strict limits considered on commercial banks’
The commercial banks not only engaged in risky trans- loans to non-bank financial institutions.
actions in proprietary trading, but also financed other fi-

4. Cf. Financial Times Deutschland, 21 January 2010.

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2.3 New Rules for Derivatives Trading and clearing house would have a number of advantages.
Securitisation First, regulators would be provided with summary infor-
mation on current risks, as all transactions would go
Another problem which has attracted renewed attention through it. Regulators could see at a glance who had
in the current crisis is the growing significance of unregu- taken what positions and counterpositions, so that the
lated bilateral trading – over the counter or OTC – of fi- net risk of a bank failure could be more easily assessed.
nancial derivatives. A particular focus is the market for Second, a central clearing house would provide some
credit default swaps (CDS) which, according to current sort of protection in the selection of counterparties in de-
estimates, is now worth more than 60 trillion US dollars. rivatives trading: depending on the development of lia-
Many have predicted that problems on the CDS market bilities from derivatives contracts counterparties would
could usher in a new round of bank failures.5 This funda- have to deposit a certain proportion of these liabilities at
mental problem of the CDS market also applies to many the clearing house in the form of bank deposits or highly
other derivatives and financial innovations. liquid government bonds. Although it would not be ab-
solutely guaranteed that the counterparties could even-
One of the main difficulties of the derivatives market is tually fulfil their commitments, the accumulation of ex-
that, because of its bilateral nature, it is unclear which tremely risky positions almost without the use of own
market participants hold what positions and whether funds would be prevented. Third, the obligation to de-
there is a concentration of risk or not. In the event of posit liquid securities automatically limits the amount of
more dramatic price movements or the insolvency of a derivatives that individual financial institutions can issue.
firm the purchaser of a derivative – for example, a CDS – In this way, in turn, the risk and volume of the derivatives
can find itself in financial difficulties. Furthermore, if an market, if desired, can be reduced relatively simply by in-
OTC counterparty goes bankrupt, the other also comes creasing the deposit obligation and ensuring that deriva-
under threat. In the past, market participants just blindly tives trades involve a higher proportion of investors’ own
assumed that OTC counterparties could always step into funds. A higher deposit obligation functions like a fee
the breach. In this way, business strategies were classed, which makes hedging transactions moderately more ex-
from a microeconomic perspective, as safeguarded, al- pensive and counteracts an excessively high inclination
though from a macroeconomic perspective it ought to towards risk on the markets.
have been clear that this was not the case. As a result,
financial institutions signalled solvency and liquidity posi- With the securitisation of credit instruments the original
tions from the microeconomic level which rapidly proved lender sells his claims arising from lending to a third party.
to be illusory in the crisis. A large number of loans can, as frequently happened be-
fore the subprime crisis, be pooled and divided into
Precisely these dangers manifested themselves in the tranches, allowing the process to be repeated a number
course of the nationalisation of US insurance group AIG of times. The distance between the original lender and
and the bankruptcy of Lehman Brothers. AIG had enor- the final holder of the loan, who bears the default risk,
mous sums outstanding in CDSs, so that the US govern- thereby becomes greater. The risk of moral hazard also
ment feared a domino effect of bank failures if the com- emerges because the original lender, in granting credit,
pany went bankrupt. There was a similar fear in the case no longer applies strict standards, since he can sell the
of the investment bank Lehman Brothers, which ulti- risks and de facto operates as a credit broker. Rating
mately led to the state more or less doing whatever it agencies, as the subprime crisis has shown, were not in a
took to rescue the situation after its collapse. The fact position to evaluate sometimes very complex securitisa-
was, however, that the supervisory authorities simply tions adequately. In order to solve this problem we pro-
could not foresee the consequences of insolvencies. pose that the original lender should be obliged to hold
an appropriate portion of the granted credit until the
One solution to the problem of risky OTC derivatives term of the loan is reached.6 It must be taken into ac-
markets would be to transfer all such transactions to cen- count that the original lender holds a large portion of the
tral clearing houses on a compulsory basis. A central
6. The SPD party executive’s project group »More Transparency and
Stability on the Financial Markets« in October 2008 called for the reten-
5. See, for example, Münchau (2009). tion of 20 per cent. This seems appropriate to us.

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»first loss« part, that is, the tranche which suffers first in 3.1 Financial Supervision Package
the event of default.
A key element of the Commission proposals is the cre-
The question arises, in the face of the seemingly relent- ation of a European System for Financial Supervision
less emergence of financial innovations – which overall (ESFS). Basically, the idea of a unified supervisory struc-
make financial markets increasingly opaque, even for ex- ture goes back to the outline presented by the De
perts and supervisory authorities – of how to deal with Larosière Group (De Larosière Report 2009: p. 48ff), the
new financial products. A large number of these prod- proposed structure of which was adopted virtually unal-
ucts are not financial innovations at all, but rather the tered in the draft directive presented by the European
result of regulatory arbitrage. In Dullien et al. (2009), the Commission in September 2009 (European Commission
introduction of a financial »MOT« (in German: TÜV or 2009).
Technischer Überwachungs-Verein [Technical Inspection
Association]) is proposed as a solution. In contrast to This system is intended to form a network of European
what is usually put forward when this matter is raised in financial supervisory authorities (see Figure 1). The three
the public debate, it would not, in the first instance, be previously existing so-called »Level 3 committees« for the
the task of a financial MOT to bar access to certain risky regulation of banks, insurance companies and securities
forms of investment to small investors. The point would supervision – the Committee of European Banking Super-
rather be to subject all products – that is, also those in visors (CEBS), the Committee of European Insurance and
use only in inter-bank trading – to strict examination be- Occupational Pensions (CEIOPS) and the Committee of
fore they are introduced on the market. European Securities Regulators (CESR) – are to be up-
graded to authorities with offices in Frankfurt, Paris and
The approach taken to the licensing of drugs should London. At the same time, national supervisory authori-
serve as the model here: a financial institution which ties would continue to be concerned mainly with the su-
wants to introduce a new product or a new type of con- pervision of financial institutions and markets, while the
tract must first prove that the individual or national eco- newly established European Supervisory Authorities (ESA)
nomic use of the new product is proportionate to the risk are to adopt a coordination function and, among other
and to any increase in market opacity on account of the things, »coordinate the application of common high level
product. Products which represent no discernible im- supervisory standards«, as well as directly monitoring in-
provement over existing contracts should be rejected in dividual cross-border institutions.
this process, as should innovations with excessive risk.
Good innovations, in contrast, may continue to be devel- A European Systemic Risk Board (ESRB) is to be set up
oped and find their way into the market. alongside these Supervisory Authorities, to assess macro-
economic risks and make recommendations when things
take a wrong turn. The plan is that the ESRB’s Taxation
3 Current Reform Progress at the EU Level Committee should have 33 voting members, namely the
27 national central bank heads, the ECB President and
Many of the elements proposed above are reflected in vice-president, a representative of the European Commis-
the proposals being discussed at the EU level. Of central sion and the heads of the three ESAs. The main task of
importance for the EU debate is the report by the so- this committee would be to issue warnings and recom-
called De Larosière Group, which was ordered by the mendations. The ESRB’s secretariat is to be located at the
European Commission and presented in February 2009, ECB in Frankfurt.
which more or less serves as the basis for the proposals
for a Directive which the Commission got under way in Apart from the basic structure, the powers envisaged for
the course of 2009. the Authorities in the legislative process represent a
marked dilution in comparison to the De Larosière pro-
posal. In the De Larosière Report, ESA experts were
granted relatively substantial »break-through rights« in
the form of mandatory instructions to national supervi-
sory authorities. For example, it had been recommended

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Figure 1 A new European framework for safeguarding financial market stability

Macro-prudential supervision

»European Systemic Risk Council« (ESRC)

Main tasks of the European Systemic Risk Council:
[Chaired by President ECB] decide on macro-prudential policy, provide early risk
warning to EU supervisors, compare observations on
macro-economic and prudential developments and
Members of ECB/ESCB give direction on these issues.
General Council Chairs of European
(with alternates where
+ EBA, EIA&ESA
+ Commission
necessary)

Information on
micro-prudential Early risk warning
developments

Main tasks of the Authorities: in addition to the

»European System of Financial Supervision« (ESFS) competences of the existing level 3 committees, the
Authorities would have the following key-competenc-
es: (i) legally binding mediation between national su-
Micro-prudential supervision

pervisors, (ii) adoption of binding supervisory standards,

»European Banking »European Insurance »European Securities
(iii) adoption of binding technical decisions applicable
Authority« (EBA) Authority« (EIA) Authority« (ESA) to individual institutions, (iv) oversight and coordination
of colleges of supervisors, (v) licensing and supervi-
sion of specific EU-wide institutions (e.g., Credit Rating
Agencies and posttrading infrastructures), (vi) binding
cooperation with the ESRC to ensure adequate macro-
prudential supervision, and (vii) strong coordinating role
in crisis situations.

Main tasks of national supervisors: continue to be

National Banking National Insurance National Securities fully responsible for day-to-day supervision of firms.
Supervisors Supervisors Supervisors

Source: De Larosière Report (2009), p. 65.

that the new authorities could challenge »the perfor- policies. Furthermore, the direct practical powers of the
mance by any national supervisor of its supervisory re- new European authorities in relation to financial institu-
sponsibilities … and to issue rulings aimed at ensuring tions such as rating agencies, central counterparties, in-
that national supervisors correct the weaknesses that cluding clearing houses, and similar European institutions
have been identified. In the event of the national supervi- were limited. This means that break-through rights with
sor failing to respond to this ruling, a series of graduated regard to »normal« financial institutions which operate
sanctions could be applied …« (De Larosière Report predominantly at the cross-border level were dropped.
2009: 60f).
In comparison to the Commission’s draft, the draft dis-
In the draft presented by the European Commission cussed in the Council of Ministers in December 2009
(2009a; 2009b; 2009c) in September this idea no longer (Council of the European Union 2009) represented even
had the clarity of the first draft. It is true that the Euro- thinner gruel. For example, the direct »breakthrough
pean Commission was given the right, when weaknesses rights« of the planned European authorities with regard
in the implementation of EU financial market regulations to financial institutions were further restricted and explic-
by national financial supervisions came to the notice of itly limited to rating agencies. What is more important,
the new EU authorities, to force them to change their however, is that in this draft the European Commission’s

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authority to issue instructions to national supervisory au- group AIG was not forced onto the ropes on account of
thorities is deleted and downgraded to a mere recom- its insurance business, but because it gambled in the
mendation. Furthermore, the European authorities’ deci- credit derivatives market, more precisely with credit de-
sion-making competence in an emergency is withdrawn. fault swaps (CDS). The US government took the view
Finally, the draft envisages the possibility of member that it had no choice but to stage a rescue because AIG
states exercising a veto against decisions of the European had engaged in such transactions with a multitude of
financial market supervision if they threaten their bud- banks and its bankruptcy would also have dragged these
getary sovereignty. A critical feature of this provision is institutions under. The danger is that a fragmented su-
that, according to the Council draft, no justification is re- pervision, like the one planned by the EU, would fail to
quired with regard to why an individual member state see such connections.
considers its budgetary sovereignty to have been jeop-
ardised and that such a veto automatically has a suspen- The same applies to the geographical division of supervi-
sive effect on the European authority’s decision. sory competence and the location of the authorities in
three different cities and countries. Recognising the risks
The package is currently being debated in the European emerging at the interfaces between individual financial
Parliament and its first reading is due in May or June 2010. institutions requires the active exchange of views by su-
The question is, whether the Parliament will go along pervisory personnel at all levels. The danger of geograph-
with the Council’s desired changes or risk a conciliation ical separation is that, although there will be regular
procedure. The problem with such a conciliation proce- meetings at the top level, those working at the coalface
dure may be that the supervision directives are unlikely to will be too isolated from one another to identify every
be adopted in 2010. threat in time.

The current state of reform with regard to financial mar- Turning to the ESRB, its close linkage to the European
ket supervision represents an improvement in relation to Central Bank is a matter of concern. Although central
the status quo, but it has grave defects which may hinder banks have privileged access to information on financial
the emergence of a truly powerful and efficient EU finan- stability, and the ECB has regularly published its Financial
cial market supervision through the planned directive.7 Stability Review since 2004, central banks tend to think
and act by strict consensus. Most European central bank-
It is generally to be welcomed that further competences ers are trained on the basis of similar models and modes
are being transferred to the financial supervision at the of thinking, while many years of cooperation lead to fur-
European level. This is a step which can prevent geo- ther convergence of worldviews. As the US subprime cri-
graphical regulatory arbitrage. Also generally positive is sis illustrated, it is often outsiders who identify risks. For
the fact that a special committee will be devoted at the example, the US Federal Reserve long ignored the risks
European level to the topic of systemic risk and macro- attendant on the house price bubble, while economists
economic risks. such as Raghuram Rajan and Robert Shiller sounded the
alarm. Experience of earlier financial crises shows that
It is difficult to understand the planned structure of the they generally do not arise where financial crises arose
supervisory authority, however. The division into three before, and that the dominant economic interpretation
authorities, separated both geographically and in terms often underestimates developing threats. It would there-
of subject-matter, is problematic. It is becoming increas- fore be important to integrate maverick opinions in the
ingly difficult to assign modern financial institutions to a evaluation of macroeconomic and systemic risks. This is
certain segment of the financial sector. The division of ruled out by the overwhelming majority of 29 out of 33
supervisory competence to three authorities brings with votes for central bankers in the ESRB.
it the danger of divergent application of regulations and
of transitions which lead to regulatory gaps. The recent A further problem is the question of how central bankers
crisis furnishes a vivid illustration of this: the US insurance in the committee react when ECB policy becomes a sys-
temic risk. The question is whether, for example, the cen-
tral bankers in the ESRB would agree to issue a warning
7. This section is based on Sebastian Dullien’s testimony before the Eu-
ropean Parliament’s ECON Committee in January 2010 (Dullien 2010). about an over-hasty series of interest rate hikes by the

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 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

ECB, if they jeopardised macroeconomic stability in Eu- tem to be subject to appropriate regulation. Particularly
rope. in the case of systemically important hedge funds a
worldwide obligation to register and to provide informa-
Finally, it has to be said that, so far, the ECB has not ex- tion on strategies, methods and leverage, also in global
actly covered itself with glory in its crisis assessments. For transactions, is called for. For banks which conduct pro-
example, in July 2008 – that is, almost one year after the prietary trading, an appropriate capital requirement
first appearance of turbulence on the money markets should be set. This also applies to banks which are own-
(and when Europe’s economy, as we now know, was al- ers or operators of hedge funds (De Larosière Report
ready in recession) – the ECB raised interest rates once 2009: 28f).
more. This, albeit small, interest rate increase is likely to
have further aggravated the situation in the European Although the proposals of the De Larosière Report do not
banking sector. The ECB’s decision can be explained only include quantitative stipulations, their overall thrust is
by the fact that it failed to perceive the seriousness of the relatively far-reaching. The sole relevant difference with
situation at that time. There is no reason to believe that regard to our approach concerns whether proprietary
the ECB will do better in the future than it has so far. trading should be permitted for commercial banks and
how commercial bank lending to hedge funds and other
To sum up, a better solution to the problems of financial non-bank financial intermediaries should be dealt with.
sector supervision would be to create a single supervisory On this the Group proposes that, in the case of banks
authority for the whole financial sector in one city (and which conduct proprietary trading and are owners or op-
best of all, in one building), which is responsible for the erators of hedge funds, an appropriate capital require-
banks, insurance companies and the securities markets ment should be enforced. In our view, such a proposal is
alike. certainly a step in the right direction. However, clear pro-
posals are lacking on how commercial banks’ lending
relationships to the shadow banking system can be pre-
3.2 Changes in Capital Adequacy Requirements vented or at least so strictly limited that the spread of
problems from the shadow banking system to the normal
The De Larosière Report regards the reduction of the eq- banking system can be avoided.
uity capital of financial institutions as one of the reasons
for the subprime crisis, and proposes a »fundamental re- On 6 May 2009, the European Parliament approved a
view« of the Basel II framework (De Larosière Report tightening up of banks’ capitalisation, which is supposed
2009: 22). In detail, it is proposed to gradually increase to be adopted in the member states by 31 October 2010
the minimum capital requirements, to reduce the procy- and come into force by the end of the year (European
clical effect of Basel II, to introduce stricter rules for off- Parliament 2009; Stichele 2009). More specifically, it was
balance sheet positions, to tighten up liquidity manage- laid down that banks may allocate no more than 25 per
ment and to reinforce the provisions on internal control cent of their capital to one client or group of clients.8 It
and risk management of banks. The Basel Committee of was also agreed that, in the case of securitisations, a re-
Banking Supervisors is called on to make the appropriate tention of at least 5 per cent should apply. Criteria were
changes speedily. The Report also proposes the establish- also more clearly defined for the »duty of care« in the
ment of a common definition of regulatory capital, which valuation of securitisations.
should be confirmed by the Basel Committee. With refer-
ence to the mechanical application of banks’ internal risk In July 2009, the European Commission presented pro-
models there is also an explicit demand for management posals for the further tightening up of financial institu-
personnel and board members to make greater use of tions’ capital holdings (Europa Press Releases 2009a). A
their own judgement and to possess high personal integ- consultation process then commenced on the proposals,
rity and technical knowledge (De Larosière Report 2009: which was concluded in September 2009. The key ele-
22). ments of the Commission proposals are as follows:

Concerning the shadow banking system, the Report calls

8. In future, balance sheet capitalisation can only include up to a max-
for all firms of potential significance for the financial sys- imum of 35 per cent of capital subject to withdrawal.

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 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

1. In the case of re-securitisations, banks should be sub- ion on a Basel III in April 2010. The European Commission
ject to higher capital requirements. will then make its own comments.

2. The new provisions are to tighten up disclosure re- There can be no objection to disclosure obligations with
quirements with regard to securitisation risks. Accord- regard to securitisation risks and the supervision of banks’
ingly, banks must clearly identify and publish risks related remuneration policy and practice, but these are »soft«
to securitisations. areas of regulation which, although important, are not
sufficient.
3. Capital requirements for the trading book are to be
modified in such a way that the banks take full account
of potential losses which could occur as a result of un- 3.3 Stricter Regulation of Rating Agencies
favourable market developments in stress situations,
such as those encountered in 2008 and 2009. The trad- With regard to rating agencies, the De Larosière Report
ing book includes all financial instruments held by a bank demands that their licensing and supervision be trans-
in order to resell them in the short term or in order to ferred to a reinforced European supervisory institution,
cover other instruments in the trading book, that is, es- the Committee of European Securities Regulators (CESR).
sentially the bank’s proprietary trading. Rating agencies’ business models and financing, as well
as their combination of valuation and consultation ac-
4. Banks’ remuneration policy and practice are to be de- tivities are to be subjected to fundamental examination.
signed in such a way that an excessive willingness to take Specific provisions must be introduced for the rating of
risks is neither encouraged nor rewarded. Banking super- structured products. Finally, the use of ratings in financial
visors can sanction banks which do not comply with the provisions should be severely restricted (De Larosière Re-
new provisions. port 2009: 23).

The European Commission’s proposals are disappointing With regard to the regulation of rating agencies, reform
with regard to bank capitalisation. Although higher cap- measures were instigated at the EU level. In November
italisation is implicitly proposed in the case of banks’ pro- 2009, a Regulation on the subject was issued (Official
prietary trading, including re-securitisations, it is not suf- Journal of the European Union 2009; European Parlia-
ficient. It would be much better to tightly restrict banks’ ment 2009a). The key points of the Regulation are that
proprietary trading. The banks’ banking book, which rating agencies headquartered in the Community will
should include longer-term planned investments, such as have to register with the European supervisory authority,
receivables from loans or securities and thus the banks’ the CESR. The rating agencies are regulated by the com-
core business, is not even discussed with regard to capital petent authority of the respective member state of origin,
adequacy. No general increase in bank capitalisation is in cooperation with other member states. It is under con-
provided for, nor the introduction of countercyclical ele- sideration to include the CESR in this system. Further-
ments with regard to capitalisation, in particular includ- more, under the new Regulation, rating agencies are for-
ing banks’ banking book. Commercial relationships with bidden to issue ratings for a given company or involved
non-bank financial intermediaries, such as hedge funds third parties if they are also providing it with consulting
and commercial banks, are not addressed and play no services. The rating of financial instruments may only
role with regard to capital adequacy obligations. The take place on the basis of well-founded information.
European Commission’s proposals with regard to capi- There must be annual transparency reports on the rating
talisation fall far short of the ideas contained in the De agencies’ fundamental assumptions, models and meth-
Larosière Report. As things stand at the moment, no far- ods. Structured products must be specifically designated
reaching reform measures are to be expected from the by rating agencies. With regard to the internal control of
European Commission with regard to bank capitalisation. rating agencies, there must be at least two independent
Having said that, it can be seen that the subprime crisis members on the administrative or supervisory board of
and its consequences have kick-started a Basel III. The agencies, who are remunerated independently, serve a
defects of Basel II are so deep that even its developers are one-off maximum term of five years and may be dis-
discussing reform. The Basel Committee will give its opin- missed only on the grounds of professional impropriety.

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 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

At least one member must be an expert on securitisation 1. Risk of default is to be prevented. For that purpose,
and structured financial instruments. legal provisions should be put forward to establish com-
mon safety, regulatory and operating standards for cen-
The EU Regulation falls short of the De Larosière Report tral clearing houses (central counterparties). The collater-
on one important point. In the latter, the supervision of alisation of OTC transactions is to be improved. Capital
rating agencies by a reinforced European supervisory in- requirements with regard to OTC transactions are to be
stitution was envisaged. In the Regulation, supervision significantly increased in comparison to transactions car-
remains a matter of national regulation. The financing of ried out through a central clearing house. For stan-
rating agencies by the company issuing the securities to dardised contracts, clearing through a central counter-
be rated was not changed, either. As a result, a key ele- party is to be made mandatory.
ment of the dependency of rating agencies remains,
which is a clear instance of moral hazard, affecting their 2. Operational risk is to be reduced. For that purpose,
rating activities. the standardisation of contract conditions and contract
management is to be actively pursued.

3.4 Initiatives on Derivatives Trading and Securitisation 3. Transparency is to be increased. Market participants
are to be obliged to enter positions and transactions
The De Larosière Report proposes with regard to deriva- which are not carried out through central clearing houses
tives markets that OTC derivatives be simplified and stan- in transaction registers, which are to be regulated and
dardised (De Larosière Report 2009: 29). It remains an supervised. Transparency will also be enhanced by the
open question, however, how this is to be done. For fact that standardised derivatives transactions may only
CDSs, which are regarded as particularly dangerous, the be carried out via organised trading centres. All deriva-
Report proposes a well-capitalised central clearing house tives markets are to be covered, including commodity
for the whole EU. The clearing house should be super- derivatives.
vised by the European supervisory authorities, including
the ECB. With regard to securitisation, it is proposed that 4. Market integrity and supervision are to be improved.
all issuers of securitised products must retain a significant Existing regulations against market manipulation and so
portion of the underlying risk, which is not insured by on are to be extended to derivatives. Regulatory authori-
hedging, for the entire lifetime of the instrument (De ties are to be given the possibility to set position limits.
Larosière Report 2009: 29). As in the case of capital ad-
equacy, the proposals of the De Larosière Report are fairly The intentions of the Commission, which were character-
far-reaching. It would have been more consistent, how- ised by Charlie McCreevy as »a paradigm shift away from
ever, if the Report had called for a state-supervised clear- the traditional view that derivatives are financial instru-
ing house for all derivatives transactions. One defect of ments for professional use and thus require only light-
the Report is that it did not propose the introduction of handed regulation« (Europa Press Releases 2009), are
a financial MOT. largely identical to the proposals of the De Larosière Re-
port.
After the first draft in July 2009 and consultations
(Stichele 2009), in October 2009 the European Commis- However, it would have been better if the Commission
sion presented proposals on the regulation of derivatives had proposed that all derivatives transactions be carried
markets based on the De Larosière Report and consulta- out through organised clearing houses. The idea of a fi-
tions with interest groups (Europa Press Releases 2009). nancial MOT was also left out, as it was from the De
The proposals are in line with the G20 declaration in Pitts- Larosière Report. However, only a financial MOT can end
burgh. In order to rule out regulatory arbitrage and to the pursuit of a succession of new structured products
ensure globally coherent policy approaches the Commis- which in many areas are intransparent and of no benefit
sion is willing to cooperate with authorities from all over for economic development.
the world, before finalising its legislative proposals. Draft
bills should be presented in the course of 2010. The key
points of the Commission proposals are as follows:

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 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

4 What Next? However, strongly integrated financial systems are only

ever as stable as their weakest systemically important
Taking the De Larosière Group’s Report as a starting element. Different degrees of regulatory stringency
point, it is fair to say that, while the proposals with regard within the single European market in effect encourage
to a European financial market supervision, the capitali- regulatory arbitrage. Sustainable stabilisation of the
sation of banks and the regulation of derivatives markets European financial system by means of nation-states
are a step in the right direction, they fall far short of en- going it alone simply will not work.
suring the long-lasting stability of the financial system. In
particular, the segmentation of financial market super- The question for the European Parliament is whether it
vision in the EU and the design of the committee that is accepts the proposals now on the table or insists on
to supervise macroeconomic financial market stability are stricter rules and a more coherent supervisory structure.
unsatisfactory. As far as the banks are concerned, one When this translation of this study was being completed
would have wished for tighter restrictions on banks’ pro- (beginning of May), it became apparent that the Parlia-
prietary trading, the business relations of commercial ment’s ECON Committee would suggest a large number
banks with the shadow banking system and a commit- of changes to the present draft legislation. Since the re-
ment to a financial MOT. sults of the voting in the Committee are not yet available
and the concluding readings and votes have not yet hap-
Previous Regulations at the EU level and the European pened in Parliament, there is no analysis in this study of
Commission initiatives mentioned in this article represent the Parliament’s proposals. It is clear, however, that a
a marked and unacceptable dilution of the demands of large number of proposed changes, or changes that are
the De Larosière Report. Furthermore, the Council’s particularly far-reaching, could delay the whole legisla-
stance again falls short of the Commission’s proposals. tion on a European supervisory architecture and stricter
Proposals which were a lot closer to those of the De regulations because, besides a second reading, a concili-
Larosière Report would have been much better, notwith- ation procedure could also be necessary. This would
standing the fact that the latter is hardly a radical docu- make it difficult to get the regulations finally adopted by
ment itself (see overview in Table 1). the end of 2010. The danger here is that such a delay
might be a tough sell to the voters. Weighing up the pros
What next? First, it should be emphasised that even the and cons of the various strategies, the best option would
Commission proposals watered down by the Council rep- probably be for the Parliament to take a tough line. First
resent an improvement of the status quo. There is not a of all, there is no need for undue haste, at present. A new
single area in which existing provisions are relaxed. The financial crisis is unlikely to unfold over the months or
planned new authorities have the sole purpose of pre- year which would be needed to establish the new super-
venting the inadequate application of European regula- visory structure. Second, there is the danger that the
tions at the national level. Further, stricter rules at the adoption of new laws would result in the creation of per-
national level, such as the »dynamic provisioning« – a manent unsatisfactory structures which, not least on ac-
countercyclical loan provisioning measure – stipulated for count of the particular interests of the new supervisory
commercial banks in Spain before the crisis, remain pos- personnel, will be almost impossible to change at a later
sible. It is also conceivable in principle that the single- date. It is therefore important to design these structures
currency states agree among themselves on separate, and regulations rationally from the outset and simply to
stricter rules for their financial institutions. accept a certain delay in their implementation.

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 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

Table 1: Overview of the state of financial market reform in the EU

Regulatory area De Larosière Group proposal State of the debate with regard Comment / assessment
to EU legislation*
Microprudential – Three EU supervisory authori- Commission proposal: – An integrated supervisory
Supervision ties: for banks, insurance authority for all parts of the
Like the De Larosière-Group, but:
companies and securities financial sector would be
– limited breakthrough rights for preferable
– Network of EU and national
the EU authorities
authorities – Dilution of breakthrough
– direct supervision only of clear- rights by the Commission and
– »Breakthrough rights« at the
ing houses, rating agencies, etc. Council proposals is unac-
EU level with regard to na-
ceptable
tional authorities Council proposal:
– Supervision of pan-European Like the Commission, but:
financial institutions by EU
– no authority to issue directives
authorities
for the European Commission in
relation to national authorities
– direct supervision only of Euro-
pean rating agencies
– implicit veto of member states
with regard to decisions of the
EU authorities
Macroprudential – Introduction of a European Like the De Larosière Group – Weighting of central bankers
Supervision Systemic Risk Board (ESRB) to in the ESRB should be ur-
monitor macroeconomic sta- gently reduced
bility
– Outsiders (academics etc.)
– Strong weighting of central should be included in the
banks in the ESRB process
Capital require- – Increase in capital require- – Equity capital requirements for Improvements necessary:
ments ments re-securitisations are increased
– Capital requirements for pro-
– More equity capital for securi- – Equity capital requirements for prietary trading insufficient
tisations proprietary trading increased
– No adequate capital require-
– More equity capital for off- ments for loans to the
balance sheet obligations shadow banking system
– Uniform definition of equity – So far, no solution for the
capital problem of procyclicality
– More equity capital for pro-
prietary trading
– Prevention of procyclical ef-
fects of equity capital provi-
sions
Derivatives – OTC derivatives are to be sim- – Promotion of the standardisa- Improvements necessary:
trading plified and standardised tion of contract conditions and
– Central clearing house should
contract management
– There is to be a well-capital- be made binding
ised central clearing house – Promotion of a central clearing
– Derivatives should be stan-
for CDSs house for standardised con-
dardised via a financial MOT
tracts
– Transaction register for OTC
transactions

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 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

Regulatory area De Larosière Group proposal State of the debate with regard Comment / assessment
to EU legislation*
Rating agencies – Supervision at the EU level – New transparency provisions Improvements necessary:
– Supervision of business and – Prohibition of simultaneous con- Adoption of the proposals of the
financing models sultation and ratings for the De Larosière Group
same client
– Prohibition of simultaneous
consultation and ratings for – Registration obligation with re-
the same client gard to EU supervisory authori-
ties
– Binding provisions for the rat-
ing of structured products
– Restriction of the use of rat-
ings in financial provisions
Financial MOT Not envisaged Like the De Larosière Group Introduction urgently recom-
mended; for guidance, refer to
the procedure for drug approval

* Unless noted otherwise, Commission proposal.

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 SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM

Literature

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Regulation. Geneva Reports on the World Economy 11: Geneva.
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Dullien, S. and D. Schwarzer (2009): Gerettet wird immer. Financial Times Deutschland, 13 February 2009, p. 26.
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About the authors Imprint

Prof. Dr. Sebastian Dullien teaches at the Hochschule für Friedrich-Ebert-Stiftung

Technik und Wirtschaft / University of Applied Sciences in Berlin. International Policy Analysis
Hiroshimastraße 28 | 10785 Berlin | Germany
Prof. Dr. Hansjörg Herr teaches at the Hochschule für
Wirtschaft und Recht in Berlin / Berlin School of Economics and Responsible:
Law. Dr. Gero Maaß, Head, International Policy Analysis

Tel.: ++49-30-269-35-7745 | Fax: ++49-30-269-35-9248

www.fes.de/ipa

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The views expressed in this publication are not necessarily ISBN 978-3-86872-341-0
those of the Friedrich-Ebert-Stiftung or of the organization for
which the author works.

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