Regulation and Supervision in the financial system

1. Regulation and Supervision in the financial system Luigi Donato

2. Learning Objectives • The structural and contingent causes that led to the financial crisis, thus giving impetus to the construction of the Banking Union. • Two specific regulatory failures of the past: the separation of micro-prudential supervision from macro-prudential supervision and the belief that corporate law was sufficient to ensure sound and prudent management. • The start-up of the Single Supervisory Mechanism. • The principles followed by the basic rules of the mechanism: separation of supervisory activities from the monetary policy functions; strict integration between the European Central Bank and the National Competent Authorities (NCAs); and responsibility of the SSM for prudential banking supervision, but not for resolution. In a different perspective, there was the decision to entrust the management of the supervision to the ECB but to separate, in any case, the prudential regulation from the supervisory function. 2

3. The genesis of the Banking Union 3

4. The genesis of the Banking Union 2007: the credit crisis in US real estate 2009: the spread of the crisis to the real economy 2010: the contagion to the sovereign debt market The weaknesses of the financial system can be summarized in the excess of the size of financial markets with respect to the real economy, in over-sized banks (too big to fail), and in the over-leverage of individual banks, reducing capital requirements. 4

5. The genesis of the Banking Union The reaction of governments and European institutions has been effective but very expensive, having to cope with the widespread liquidity crisis, to implement a monetary policy of easing, and to carry out very costly bank bailouts with public funds. Then, the reconstruction phase of a stricter supervisionbegan. Among the many flaws of the regulations there were two that certainly weakened the supervisory activities and thus contributed to the spread of instability: The separation of micro-prudential supervision on individual banksfrom macro-prudential supervision, which is responsible for financial market stability. The most dangerous risk factor of this approach was the belief that through micro-prudential supervision, in the end, financial stability could also be obtained, thanks to the steady growth in the size of the markets. The governance of banks. The basic idea was that governance is a matter of general corporate law rather than regulatory supervision. In other words, the belief was that corporate mechanisms (such as control by shareholders and internal controls) were sufficient to ensure sound and prudent management without the need for public regulation and supervisory measures. 5

6. The genesis of the Banking Union The new regulations govern the creation of banks, their lifespan and their eventual liquidation. So the post-crisis reform deserves the global brand ”Banking Union” (BU). Banking Union SSM Single Supervisory Mechanism SRM Single Resolution Mechanism DGS Deposit Guarantee Scheme 6

7. The genesis of the Banking Union The targets are: to break the bank risk-sovereign risk cycle; to counter the tendency towards fragmentation of markets on a national basis (ring fencing); to ensure the same level playing field within the euro area; to create conditions for direct re-funding from EU funds to banks in crisis; to protect taxpayers from the cost of bank bailouts. 7

8. The genesis of the Banking Union • The start of the SSM was driven by the introduction of a new toolbox for the European supervisory activities through the so-called CRD IV package, which is composed of: • Directive 2013/36 of the European Parliament and of the Council, June 26th 2013; • Regulation 575/2013 of the European Parliament and of the Council, June 26th 2013. • The CRD IV package of tools concerns both governance and capital requirements. 26 June 2012: Joint statement • 26 June 2013: • Directive 2013/36 EC; • Regulation 575/2013. 15 October 2013: Council Regulation EU N. 1024/2013 4 November 2014: The ECB started to use its supervisory powers CRD IV package 8

9. The genesis of the Banking Union Differences in the development of the Economic and Monetary Union and of the Banking Union: Economic and Monetary Union • 1992: Maastricht Treaty; • 1994: Establishment of the European Monetary Institute; • 1998: European Central Bank arising; • 1999: Irrevocable fixing of conversion rates; • 01/01/2002: Introduction of the euro. Banking Union • 2012: joint statement (European Council, European Commission, Euro group and ECB); • 2013: Council Regulation EU N. 1024/13; • 4/11/2014: The ECB started to use its supervisory powers. There was a time range of about ten years The ratification of a Treaty, conveying its whole legal binding within a European set of rules. • There was a time range of a little more than two years • Consequences: • Legal weaknesses; • Pressure to forge ahead; • Statement, equipped with a strong political meaning, accompanied by a secondary regulation. Now, wewillanalysethesethreepoints. 9

10. The genesis of the Banking Union A PREMISE A closer look at the SSM, brings to light three principles that have underpinned many important choices in designing the system: • Separation: institutional separation of supervisory activities from the traditional monetary policy functions; • Integration: strict integration between the ECB and the National Competent Authorities (NCAs); • Specialization: The SSM is exclusively responsible for banking prudential supervision, but not for the resolution of banks in crisis. This requires establishing a close collaboration framework between the SSM and the Single Resolution Mechanism, responsible for facing banking crises, realized in 2016. 10

11. The building of the Single Supervisory Mechanism 11

12. The genesis of the Banking Union The development: the time factor The restricted time factor caused a preference for the more rapid process of using cooperation among the preexisting authorities within the ECB legal framework, instead of embarking on the complex alternative way of gradually building a new unitary entity. The need arose for a careful balancing of tasks and functions of the Authorities, necessarily based on a mix of separation and integration of roles. The design that we can identify is a web of Authorities, tasks and activities, but also this image must be interpreted not with a static approach but as a work in progress. The web is inevitably destined to evolve towards further simplification of functions and rationalization of supervisory procedures. The high speed characterizing the genesis of the SSM can be seen both in the assessment activities of the banks appointed to undergo the direct ECB supervision and in the handover phase from the NCAs to the ECB. 12

13. Theory and project: a synthesis Gaps in the Regulatory framework Uniformity of supervisory procedures Inefficiency of the supervisory practices Risk-reduction instruments Ring fencing by National Authorities Tools preventing regulatory manipulations Fragmentation of the Single Market 13

14. The revision of the general architecture for the financialstability EIOPA European Insurance and Occupational Pensions Authority ESMA European Securities and Markets Authority EBA European Banking Authority European Systemic Risk Board European Supervisory Agencies 14

15. Theory and project Lacking more effective instruments, the Authorities used the tools of soft law and stress tests for measuring the resilience of the significant UE banks in case of a negative scenario. In the end, the European Baking Authority (EBA) made a recommendation for recapitalization of those banks with capital determined insufficient. However, this mechanism showed itself to be inappropriate as a real jump in quality, considering the extreme danger posed by the financial crisis, by then diffused in the real economy and strongly increased by the contagion to the sovereign debt market. 15

16. Rationale and targets The solutionwas SSM Strategies • Stability; • Integrated financial system; • Coordination of national policies; • Integration of European markets; • Convergence of national supervisory regulations; • Best practises. Contingentcauses • Contagionbetween banking sector and sovereigndebt; • Excessivefinancing by localbanks; • Lack of assurance on proper management; • Deterioration of the banks’ balance sheets. 16

17. Rationale and targets In the first phase. • The only way of intervention suitable to avoid default was bailing the banks out with public support. • In many countries, those interventions, sometimes with a wide financial impact, negatively struck the public finances. • The worsening of the crisis generated doubts in the financial markets about the sustainability of the high level of spending and the possible fragmentation of the euro zone. • Countries with an imbalance in public finances might not have sufficient resources to support the banks. 17

18. Rationale and targets • The situation reflected negatively on the banks of those States perceived by the markets as potentially riskier with respect to the banks operating in countries with larger resources available for support. • The result was a competitive disadvantage for banks located in euro zone countries with fiscal problems and, second, the perception of increased risk, in terms of access to capital markets and liquidity. • With specific reference to liquidity, the deterioration of public finances also determined the decline of sovereign debt value for certain countries and, consequently, greater difficulty in using it as collateral for financing operations. 18

19. Rationale and targets Legal weaknesses: the specifictasks. The Treaty on the Functioning of the Union provides the possibility to confer upon the ECB “specific tasks” in prudential supervision acting by: • Council unanimity; • European Parliament act of consulting; • ECB act of consulting; 19

20. Rationale and targets The consequences. The NCAs continue to monitor the less significant banks (LSIs), according to guidelines laid down by the ECB and in accordance with the principle of allocation set out in Article 5 TFEU, and remain holders of those powers not conferred on the ECB. The result has been a complex system of functions, responsibilities and powers, resulting from the double effect of the short time available in relation to the evolution of the crisis and the limited legislative base which allowed transferring to the ECB specific tasks and nothing more. 20

21. The basicrules of the SSM The secondlevel of regulation. • SSM Regulation (EU/2013/1024) regards: • allocation of powers; • division of functions; • general principles of operations. • Framework Regulation (ECB/2014/17) regards: • practical operations; • duties of each entity; • relationships between the components. It is important to note that the SSM does not have its own legal personality. The entity responsible for the European supervision is the ECB. 21

22. The basicrules of the SSM The ECB specifictasks are: • Supervision on access to the banking market; • Prudential supervisory tasks, which are: • ensure compliance with prudential requirements quantitatively and qualitatively; • carry out prudential assessments (stress tests); • exercise supervision on a consolidated basis; • participate in the supplementary supervision; • apply measures for early intervention; • use powers regarding structural changes required by the relevant NCAs under EU law. 22

23. The basicrules of the SSM The ECB may require the banks to: • hold additional capital resources; • strengthen their internal processes and review of business strategies; • present a plan to meet minimum prudential standards; • apply the specific policy provisions; • limit operations or arrange to dispose of particular activities; • reduce its overall risk exposure; • limit variable remuneration of the managers; • limit the distribution of resources in order to strengthen its capital base; • meet the specific requirements of liquidity; • comply with more frequent prudential reporting requirements. 23

24. The basicrules of the SSM The ECB has been given all the new powers and new tools needed to achieve the new responsibilities that the European legal system has introduced to strengthen supervision. But there are some exceptions, mainly: • not to supervise bodies under national law which are not covered by the definition of credit institutions under Union law; • not to supervise credit institutions from third countries establishing a branch or providing cross-border services; • not to carry out the function of competent authorities over payment services and credit institutions in relation to markets in financial instruments; • not to prevent the use of the financial system for the purpose of money laundering and terrorist financing and not to promote consumer protection. The powers entrusted to the ECB cover the full range of oversight, from the birth of the banks to the most important phases of their ongoing business (but not resolution). 24

25. The basicrules of the SSM ECB: Ensure the safetyand soundness of the European banking system. • NCA: • Receive notifications from credit institutions • Support banks' assesmenton a daily basis Customerprotection and Anti-moneylaundering are overlappingbetween the ECB and the NCA? In any case, they are relevant for the control of the ECB over sound and prudent banking management. 25

26. The basicrules of the SSM • A bank is considered significant (SIs) if any one of the following conditions is met: • the total value of its assets exceeds 30 billion euros or 20% of the national GDP; • it is one of the three most significant credit institutions established in a Member State; • it is a recipient of direct assistance from the European Stability Mechanism; • the total value of its assets exceeds 5 billion euros and the ratio of its cross-border assets/liabilities (in more than one other participating Member State) to its total assets/liabilities is above 20%. 26

27. The basicrules of SSM The main objectives of the general oversight of the ECB are: • to ensure a consistent overall supervision; • to harmonize the supervisory actions among all banks; • to protect its independence from the Member States. The balancing of the powers between the ECB and the NCAs will depend on how the ECBwill interpret its oversight role and the extent to which the activities of the NCAs with regards to the Less Significant Banks will be determined by the ECB guidelines and standards. • The ECB has the power to issue instructions to the NCAs on how to conduct supervision and has addressed the need for a constant flow of information on less significant banks. • The NCAs have to report to the ECB on a regular basis on the performance of their activities. 27

28. The basicrules of SSM The criteria that guide the distinction between significant and less significant banks are also followed for the allocation of powers to impose sanctions by the ECB or by the NCAs. • sanctions on significant banks are applied by the ECB; • sanctions on less significant banks are imposed by the NCAs. With regard to Significant Institutions, the ECB may not impose sanctions on individuals and for violations of national law. SSM Framework Regulation, art. 122:The ECB power to impose administrative penalties is generally assigned to significant supervised entities or to the less significant entities only where the relevant ECB regulation or decision imposed obligations on those entities vis-à-vis the ECB. SSM Regulation, art. 18: The criteria of application of sanctions are: • the nature of the rule breached (directly applicable Union law or national law); • the recipient of the penalty (legal person or natural person). 28

29. The basicrules of SSM • Collaboration models are different, with different levels of the NCAs’ involvement. It goes from co-management of certain procedures, to simple consultation, to mere communication, down to forms of pooling of national supervisory structures by the ECB. • The SSM is a highly integrated, meshed network in which the ECB alone is only responsible for the effective and consistent functioning of the Mechanism, having the means to play this role. Conclusions: 29

30. The balance between the principles of separation and integration in the SSM regulation 30

31. Overview Central banking functions are: • source of liquidity; • last resort lender; • preventing and managing systemic banking crises; • responsible for financial stability (with government agencies). So, the approach is similar to the macro-supervision. Central banking and macro-supervision are strictly connected. Thus, there remains the problem of the involvement of central banks in the activities of micro-supervision. On this issue there is no convergent answer either in theory or from empirical experience. 31

32. Overview CENTRAL BANKING vs SUPERVISION The main points for sepatarion are: • Stand-alone tradition • Own objectives • Financial liberalization The effective segregation of those two public functions has raised the critical question as to whether the combination in one institution might generate a dangerous conflict of interest. This issue has to be addressed distinguishing between macro-supervision and micro-supervision. 32

33. Overview European regulations which established the SSM opted for the principle of separation between central banking and supervisory functions. However, the SSM Regulation has implemented in reality a system that centralizes both the traditional ECB functions and the new supervision. Council Regulation (EU) N° 1024/2013, Recital 65: • The Governing Council (GC) operates on monetary and supervisory functions in a differentiated manner; • Tasks should be carried out in full separation; • Meetings and agendas of the GC should be strictly separated for the two matters. 33

34. The decisionmaking procedure: separation CR (EU) 1024/13, Art. 25: • Clarifies the principle of separation. • Sets the operating rules. • Creates: • a board dedicated to supervision; • a set of procedural rules; • a Mediation Panel. ECB INTERNAL ORGANIZATION: Keeps separate: • The staff involved in supervision; • Operationalareas. ECB INTERNAL RULES: • Professional secrecy; • Information exchanges. 34

35. The decisionmakingprocedure: separation Decision-making is based on two cornerstones: • The Supervisory Board (SB) • The non-objection procedure by the Governing Council (GC) CR (EU) 1024/13, Art. 26: The Supervisory Board: • Performs preliminary activities of supervisory tasks entrusted to the ECB; • Proposes draft decisions to the Governing Council; • Forwards draft decisions to the National Competent Authority of the Member State concerned. A draft decision shall be deemed adopted unless the GC objects within a period to be defined in the procedure (in any case, not over ten working days). 35

36. The decisionmakingprocedure: separation Supervisory Board (SB) • The Steering Committee is: • established by the SB; • in charge of preparatory activities; • without decision-making powers. Steering Committee (SC) Secretariat The sensitivity of the SB and the GC to the internal decision-making process has led to Art. 25 SSM Regulation which hypothesizes a difference of opinion between a National Competent Authority and the Governing Council if the latter objects to a draft decision of the Supervisory Board. In that case, the Mediation Panel resolves the differences of views, in order to preserve Union interests. 36

37. The decisionmaking procedure MEDIATION PANEL • The Mediation Panel (MP) is composed of one member from each participating Member State, with reference to a specific procedure by a Case Committee. • The use of the MP is only possible when the GC has moved an objection to a draft decision where the NCA had participated, and only by the single NCA concerned. • The MP must pursue the interest of the Union and not of a specific Member State. • The MP considers the draft opinion prepared by the Case Committee and submits their opinion to the SB and the GC. • The SB has the obligation to take into consideration the MP's opinion, but the SB can choose whether to submit a new draft decision to the GC within 10 working days. The presence of the MP is necessary in the SSM. However, in reality its work should seldom be needed. 37

38. The decisionmakingprocess of the SSM Non-objection procedure 38

39. Achievement of integration: targets SSM Regulation: • fixes the separation rules between central banking and supervision activities; • explains the reasons that led to the two functions’integration in the ECB. Relevant sections of SSM Regulation: • Recital 1: the crisis and the resulting fragmentation of the financial sector have threatened the integrity of the single currency and also of the internal market; • Recital 5: the context of the single currency has shown that, during a crisis, the mere coordination between supervisors is not enough; • Recital13: the ECB is the most appropriate institution to carry out supervisory tasks; • Recital 15: it is appropriate to entrust to the ECB specific supervisory tasks to ensure a coherent and effective implementation of prudential supervision; • Recital 2: the relation between the ECB and the NCAs intensifies the banking supervision’sintegration in order to bolster the Union, restore financial stability and lay the basis for the economic recovery. 39

40. Achievementof integration: rules • The legal regime of the ECB’s supervision is based on the integration of different levels of legislation, European and the national. • The ECB should carry out its tasks subject to and in compliance with Union law. • The ECB must follow the decisions of the Commission on: • State aid; • Competition rules; • Merger control; • Single rule book on supervision applying to all Member States. The SSM Regulation points out that the ECB should not replace the European Banking Authority in developing draft technical standards, guidelines, and recommendations within the Union. 40

41. Achievementof integration: rules • The Regulations are directly applicable throughout the Union (for instance, the CRR can be implemented directly by the ECB). All the relevant powers provided for in the Regulations go directly into the toolbox of the ECB. • Directives can only be applicable through the national laws. If provisions are set down in a Directive, the ECB can apply the national legislation transposing the concerned Directive. • There is a third case, when the relevant Union law explicitly grants options for Member States. In this case, the ECB can also apply the national legislation exercising such options. Whenever a national law confers on an NCA certain early intervention and precautionary powers, not required by Union law, the ECB is entitled to require the NCA to make use of those powers in order to ensure the performance of full and effective supervision within the SSM. 41

42. Achievementof integration: rules The ECB will apply many different national regulations in order to have a complete uniformity of national regulationstowards a European law on banking supervision. Banking legislation may converge with other regulatory areasfollowing the entry into force of EU directives relating to banking. It will not be a short path, because the national specificities are the effect not only of local supervisory traditions or particular attention to categories of banks but also of different corporate and bankruptcy laws. So, the risk of conflict in terms of jurisdiction will always be on the prowl! Recital 11 clarifies that the BU must be underpinned by a comprehensive and detailed single rule book for financial services within the internal market. 42

43. Achievementof integration: Organization and Human Resources The ECB provides services for human resources, information systems, communications, budget and organization, premises and internal audit, legal and statistical services, etc. The path chosen is based on the establishment of the Joint Supervisory Teams (JSTs) which conduct the day-to-day supervision of significant banks. There is a JST for each significant bank composed of staff from both the ECB and the NCAs. 43

44. The separationbetweenregulation and supervision The Bank of Italy has traditionally played both regulatory and supervisory functions. In the system of supervision of the Italian Banking Law of 1993, Italian regulation and supervision are closely interlinked and mutually reinforcing. The European Banking Authority, born before the SSM, has the task of promoting among Member States uniformity of regulatory supervision and supervisory standards. The distribution of functions between the EBA and ECB is usually justified by their different scopes of action (all Member States for the EBA, only the Euro Area for the ECB). It also responds to the broad objective of balancing the powers, the EBA dealing with regulation and the ECB dealing with supervision. The question is whether this division is as straightforward in application as it is in theory. The EBA, performing stress tests, invades the area of supervision. The ECB also has a role in driving and comparing regulatory processes at the EBA. The ECB is supposed to contribute, in a participating role, to the development of draft regulatory technical standards and the implementation of technical standards by the EBA. 44

45. The separationbetweenregulation and supervision • According to the SSM Regulation (Article 4), the ECB adopts regulations to the extent necessary to organize or specify the arrangements for the carrying out of the tasks conferred on it by the Regulation. • According to Article 5, the ECB issues regulations, guidelines or general instructions to the NCAs. They are regulatory powers turned to operating the overall mechanism but which can also be directed to a single NCA with regard to an individual bank. In this second perspective, the border between prudential regulation and the interpretation of this in the application phase (supervision) tends to fade out. 45

46. The due process for adopting decisions and the Administrative Board of Review The measures of the ECB against the banks can be very severe. It was necessary to establish a due process for enacting supervisory decisions. Recital 54 provides procedural guarantees to the parties affected by decisions taken by ECB. As an institution of the Union, the ECB is bound by Union rules and general principles on due process and transparency. The right to be heard and the right to request a review of the decision are fundamental for the subjects of the ECB measures. 46

47. The due process for adopting decisions • The guarantees are set out in Article 22 SSM Regulation. • The ECB gives to the subjects of the proceedings the opportunity to be heard and ensures its decisions will be within the limit of the complaints made. • In case of urgency, the ECB may adopt a provisional decision, but as soon as possible, the subjects concerned must have the opportunity to be heard. • The decisions of the ECB must state the reasons (legal and factual) on which they are based. • The measures of the ECB may also result from the reporting of breaches by the same banks, other companies, and authorities. Article 23 SSM Regulation requires appropriate protection for both the person who reported the breaches and for the accused parties. Warranty rules are rather poor. For example, there is no rule expressed about the timing of the specific procedures by the ECB. This is a gap to be filled by ECB self-regulation or from judgments of the Court of Justice (CJUE). 47

48. The Administrative Board of Review Article 24 SSM Regulation has established an Administrative Board of Review (ABOR) in order to minimize the number of proceedings submitted to the CJEU. Even if the five members are appointed by the Governing Council, the composition of the ABOR should guarantee a certain level of autonomy and independence from the supervisory functions. The members have to act independently and in the public interest. 48

49. The Administrative Board of Review This does not apply to the Secretary of the ABOR, that is the same as the Secretary of the Supervisory Board. There is an evident risk of conflict of interest, because it is the same office which has prepared the adoption of the measure and the subject of the complaint. The Secretary is responsible for: • preparing the efficient examination of reviews, • organizing the Administrative Board’s pre-hearings and hearings, • drafting the respective proceedings. 49

50. The Administrative Board of Review Recital 64 SSM Regulation: “The ECB should provide natural and legal persons with the possibility to request a review of decisions taken under the powers conferred on it by this Regulation and addressed to them, or which are of direct and individual concern to them. The scope of the review should pertain to the procedural and substantive conformity with this regulation of such decisions while respecting the margin of discretion left to the ECB to decide on the opportunity to take those decisions”. The ABOR expresses a mere opinion and the Supervisory Board has to take it into account for the preparation of a new decision to be submitted to the Governing Council. Neither the SB nor the GC are bound by the ABOR opinion. The new draft decision can replace the previous one with an identical content, or with an amended one. The decision is deemed adopted unless the Governing Council objects within a maximum period of ten working days. In any case, the request of review is without prejudice to the right to bring proceedings before the CJEU. 50