Rules and Supervision

1. Rules and Supervision Sergio Lugaresi, Public Affairs Milan, 6 December, 2012

2. AGENDA • What is supervision • Supervisory failures • Rules and supervision • The EU reform • Supervision and discretion • Supervision and crisis management 2

3. Supervision • According to the “representation hypothesis” of Dewatripont-Tirole (1994), prudential regulation aims at replicating the corporate governance of nonfinancial firms, that is, at acting as representative of the “socially relevant” debtholders of banks (depositors) • There are two reasons for this: • there are many more stakeholders in banks than in non-financial firms; • the business of bank is opaque, complex and can shift rather quickly (Mehran-Morrison-Shapiro 2012). 3

4. Supervisory failures • In this respect as far as the crisis has been a bank corporate governance failure leading to excessive risk taking (Dewatripont-Freixas 2012), it has been also a supervisory failure. • Three major failures, • the lack of independence (capture and lack of skills). • the lack of macro-prudential or systemic supervision; • the lack of international (and sometimes even infra-national) coordination; 4

5. Supervisory governance failures The supervisory authorities is the agent of depositors and bank customers represented by politicians. As in many Principal-Agent relationships there is an information asymmetry. • Political capture • Different policy choices: • regional or global financial centre” (read USA and UK); • ‘national champions’ in the financial sector” (read France, Italy and Spain); • Political and cultural pressure on supervisors • A “race to the bottom” among supervisors to create institution-friendly regimes (e.g. innovative Tier 1 capital). • Industry capture • An inadequate understanding of financial institutions and markets. Two factors contributed to this: little or no direct financials sector experience and under-resourcing. • Absence of real, on-site supervision. • Political and industry capture • The “madness crowd”; • Self capture • Weak supervisory cultures: some supervisors…] are more reactive and passive, waiting until evidence of problems accumulates to the point of certainty before contemplating action”. 5

6. International supervisory coordination • International cooperation in supervision is based on colleges of supervisors for cross border banks where the home supervisor is supposed to carry out supervision at the consolidated level. • The colleges are set up on the basis of Memoranda of Understanding (MoU), which are non-binding, between relevant authorities. • Only in the European Union colleges of supervisors were given a legal status in the Capital Requirement Directive which also introduced the concept of “joint decision” and “task delegation” between different national authorities. 6

7. Lack of coordination… • There are two broad forces working against effective cross border consolidated supervision: • national governance failures (political, industry and self capture) are amplified in a cross-border context leading to competition and distrust among national agencies; • supervisors do not take into account the externalities in the other jurisdiction. Host supervisors may be inclined to inflate their risk assessment and require a higher capital buffer with the objective of encouraging the parent company to provide additional capital or resources. • On top of these two broad forces confidentiality concerns, legal constraints, lack of common metrics and terminology, the geographical risk profile of the cross-border banking group exacerbate the obstacles to effective cross-border cooperation. 7

8. …particularly in crisis times • The lack of an effective mechanism to resolve failing financial institutions that are active in multiple jurisdictions, including ex ante burden sharing mechanism, and the absence of a mediation or conflict resolution mechanism make cross-border supervisory cooperation even more difficult in crisis times. • When problems occur in the parent company, home and host incentives conflict: the consolidating supervisor gives priority to its local stakeholders and the national interest, delaying, denying and minimising the relevance of concerns and potential remedial actions as to avoid ring-fencing. The host supervisor has incentives to ring fence. • When problems occur in a systemically important subsidiary, the host supervisor has an incentive to overstate concerns to the home supervisor, so as to attract attention, capital and liquidity. At the same time, the host supervisor still keeps an incentive to ring-fence the assets he can save. 8

9. Rules and supervision • Financial regulation includes • prudential rules and • financial supervision. • Complementary: supervision need rules to implement, rules needs supervision to be implemented • Trade-off. Tarullo (2008), for example, argues for removing detailed rules in favour of national agencies’ supervision of complex, internationally active financial institutions. 9

10. Short-termism • Rules, with emphasis on transparency and market discipline, tend to favour investors and subordinated debt holders, • Supervision, which can interfere directly with corporate governance, tends to favour the interests of depositors. • Investors pursue short term objectives • Depositors are more interested in the long term sustainability, • Financial regulations based on rules (US and UK) eventually led to short-termism (a firm behaviour aimed at maximising short-term objectives), • Financial regulations based on supervision (e.g. France and Italy) were more effective in pursuing business sustainability so avoiding short-termism and procyclicality. 10

11. Supervision: EU Reform (1) • In September 2009, following a public consultation, the Commission issued its proposals: to establish a macro-prudential European Systemic Risk Board (ESRB); and replace the existing consultative (Lamfalussy) Committees with new European Supervisory Authorities (ESAs) for the • banking (European Banking Authority – EBA), • insurance (European Insurance and Occupational Pensions Authority - EIOPA) and • securities sectors (European Securities and Markets Authority - ESMA). 11

12. Supervision: EU Reform (2) • The political agreement reached by the three EU negotiators – Commission, Parliament and Council - was approved by the ECOFIN Council on 7 September 2010 and by the EU Parliament on 22 September. The reform came into effect on 01/01/2011. • The ESA’s powers are substantial. They will generally decide according to the majority rule and take binding decisions. • Specifically for the banking sector, the EBA will establish • A single rulebook and interpretations and • have the power to directly address a bank in cases when the national authorities fail to implement the rulebook. • It will be a full participant in colleges of supervisors with • the power to settle differences between national supervisors. • Furthermore, EBA will have a key role in crisis management and in the development of cross-border banks’ Recovery and Resolution Plans. • The reform was clearly a compromise. However, it is a good compromise, in part due to the role of the European Parliament. It was the EP’s first test, under the Lisbon Treaty, and with a new Commissioner for the Internal Market, Michel Barnier. 12

13. Strong Supervision • There is a now consensus on the fact that supervision needs to be more intrusive, proactive, comprehensive, adaptive, risk-based, and result oriented (Viñals-Fiechter 2010), • The industry add also the need for proportionality and predictability and for avoiding excessive regulatory reporting (IIF 2011).

14. Supervision and discretion • However, predictability cannot prevent judgemental discretion: “…the blunt truth is that limiting the supervisor’s ability to react against and excessive build-up of risk in one institution or across the financial system to the application of mathematical formulae will undermine the very objective that the rules are designed to achieve…regulators will need the flexibility to react to the unexpected both at the systemic and the institutional levels”. (Palmer-Cerruti 2009)

15. Supervision and crisis management • To be effective in preventing banking crisis, supervisors should have the power to take charge of troubled banks before they endanger their deposits and/or the stability of the financial system and of the real economy. • Effective supervision is best able to assess the emergence or occurrence of a crisis. The Authority should be credible and be able to act quickly to avoid panic spreading in the market. It faces the crucial dilemma of either supporting the bank in difficulty by arranging for medium term financing or leading the orderly resolution process in the public interest. The decision-making process is crucial and should be rapid in order to restore confidence.

16. The Gap Between The Financial Market Reality and EU Regulation and Supervision • The presence of cross-border financial groups had increased substantially in the EU: • ‘The current supervisory framework may limit the incentives to work toward a common EU-wide stability framework: a “scramble” for assets in a crisis, involving a large and complex financial institution, is likely to occur.’ • ‘The current legal framework does not ensure that national authorities take into account the effect of their decisions on the financial stability of another member state. The lack of incentives to cooperate might be detrimental not only to creditors, but also to shareholders and employees of cross-border banks (and ultimately to tax payers in the instance of failure).’ (IMF) 16

17. Crisis management: the European Commission proposal • A parent institution and its subsidiaries may enter into financial support agreements for the case that one of the parties of this agreement experiences financial difficulties (Article 16(1)). The agreements are drawn up on a voluntary basis and can provide for financial support in the form of a loan, the provision of guarantees, or the provision of assets for use as collateral in transaction between the beneficiary of the support and a third party (Article 16(1) and (2)). • Where there is a significant deterioration in the financial situation of an institution or where there are serious violations of law, regulations or bylaws and other measures taken in accordance with early intervention are no sufficient, competent authorities may appoint a special manager to replace the management of the institution (Article 24)

18. References • Palmer, John – Cerruti, Caroline, “Is There a Need to Rethink the Supervisory Process?”, paper presented at the International Conference on Reforming Financial regulation and Supervision: Going Back to Basics, Madrid, June 2009. • D’Hulster, Katia, “Cross Border Banking Supervision. Incentive Conflicts in Information Sharing between Home and Host Supervisors”, The World bank, Policy Research Working Paper 5871, November 2011. 18

19. Next • Th. 11 Oct. h 10.30-12.15, aula 3 1. Introduction. Cross-border banking and regulation • Wed. 17 Oct. dalle 14.30 alle 16.15, aula seminari 2. Prudential Regulation: Lessons from the Crisis • Fri. 26 Oct. h 10.30-12.15 aula 3 3. From Basel 2 to Basel 3 • Thu. 8 Nov. h 10.30-12.15 aula 3 4. Moral hazard • Thu. 15 Nov. h 10.30-12.15 aula 3 5. Crisis Management and Resolution • Thu. 22 Nov. h 10.30-12.15 aula 3 6. Shadow Banking • Thu. 29 Nov. h 10.30-12.15 aula 3 7. • Thu. 6 Dec. h 10.30-12.15 aula 3 8. Rules and supervision • Thu.13 Dec. h 14.30-16.30 aula 20 9. Overall assessment of the regulatory reform • Mon.17 Dec. 10.30-12.15 aula seminari 10. The Euro debt crisis and the Banking Union 19