Ten legal gaps Europe’s regulators must close

René Smits identifies ten key issues that European financial legislators must consider when constructing the post-crisis regulatory framework

The credit crisis has shown the inadequacy of current regulatory and supervisory arrangements. That is the consensus among most commentators and contributors to the debate who, otherwise, often strongly disagree.

As the supervisory landscape shifts, I have here outlined ten such inadequacies that warrant the attention of European Union (EU) officials.

1. The lack of a single rule book
A single rule book has been proposed by Jacques De Larosière, abolishing exemptions and exceptions that are now still permitted under EU directives would lead to such singleness of the norms. Enshrining them in regulations instead of directives would make them directly effective across Europe, as would be no need anymore for national transportation.

2. Divergent definitions of "credit institutions"
Although the EU has adopted a single definition of the term credit institution, EU rules permit national legislators to use divergent concepts as long as they cover the entities that conform to the European definition. Thus, overlap is permitted. The divergence of national definitions of what is in normal usage called a bank means that the scope of prudential supervision may be different from one member state to the next.

3. Jurisdictional delimitation
Another area of attention for the legislator should be the limited applicability of national rules. As an inevitable result of the reliance on national law as the immediate source of rules pertaining to the finance industry, even where these rules translate EU or Basel agreements, measures adopted under national law will largely have effect only within each State's territory

This problem of jurisdictional limitations to rules issued by multiple agencies in the same market affects other areas than the example given of an emergency measure such as the prohibitions on naked short-selling adopted during the crisis. This calls for federal legislation replacing dispersed State law: harmonising the ground rules will not do if the application in practice does not ensure effective regulation of market behaviour, especially in times of crisis. As a first step, emergency regulations may be adopted which would give the newly formed European Supervisory Authority over the securities industry the competence to enact prohibitions, such as the one on cold calling imposed by national authorities in the autumn of 2008, on an EU-wide basis, after appropriate consulting of other regulatory agencies, including the ECB.

4. Divergent supervisory regimes
Close to the subject just discussed is the issue of divergent national supervisory regimes: the tool box given by national law to the supervisory authorities may vary from state to state, reflecting own preferences, national traditions and local peculiarities. This may lead to situations in which one supervisor can adopt certain corrective measures, but another involved in the supervision of a cross-border banking group, cannot.

Europe should move away from merely recognising national measures applied to other parts of a financial institution operating across borders and organise EU rules and mechanisms for resolution and winding-up. The issues of harmonisation of supervisory powers and a possible EU-wide resolution regime for banks are the subject of a consultation by the Commission.

5. Differing resolution regimes
Another issue concerns an EU-wide resolution and insolvency regime for banks. That banks operate internationally but come home to die has been much cited during the crisis. This cannot endure in a single market. EU rules and mechanisms for resolution and winding up must be in place. Here, the time for action is now.

6. Duplicative reporting regimes
Both preceding issues are connected to the absence of a single European rule book and the many divergent and duplicative reporting requirements to which financial institutions are subject. Divergent rules form a hindrance for a truly common market. Tax, language and cultural differences are sufficient blockages for a real retail financial market at EU level. There is no need for unnecessary supervisory differences to add to this.

7. Information collection
The adoption of proposed provisions to provide a European Banking Authority, to be established, "with all the necessary information to carry out the duties assigned to it" would be a great step forward. Such clauses would not, however, change the lack of uniformity in exchange of information provision among supervisors at state level (see point 9. below).

8. Cooperation between home and host supervisors
The material rules on cooperation among supervisors merit serious attention. Cooperation among the supervisors of the authorising home state and the member state in which a financial institution operates through a branch or cross-border provision of services without a physical presence in the recipient jurisdiction has not been extensively regulated in EU directives.

This potentially undermines the level playing field of the internal market. In so far as the current, low-key level of establishing working arrangements among supervisors prevails under the new rules to be adopted in the wake of the De Larosière Report, attention should be focused by supervisors and those to whom they report, as well as by academia, on these arrangements.

9. Confidentiality and exchange of information
Financial institutions are supervised in respect of their soundness of the basis of prudential supervision, the rules for which are largely harmonised EU-wide and worldwide but which is exercised at the national level by agencies that may, or may not, coincide with the national central banks. Financial institutions are also supervised in respect of their conduct on the market by supervisory agencies that perform oversight of the securities markets and which have the protection of the consumer as their remit. Finally, financial institutions are subject to systemic overview by central banks that takes into account the safety and soundness of the financial system as a whole.

The challenge of ensuring that the various financial supervisors and central banks provide ample information to one another, becomes harder to meet because of the lack of uniformity in EU directives and, hence, in national law when it comes to the regulation of professional secrecy and exchange of information. Thus there is a need to align, and clarify, the rules applicable to exchange of information among supervisors and between them and central banks. A single set of rules, clear to all and common to all, would be highly preferable to the current patchwork of provisions.

10. Interaction between private law and supervisory law
Another issue which may have to be further tackled is that of the interplay between contract clauses and the use of supervisory instruments.

A financial institution that has entered into such provisions may hold the supervisory authorities hostage. The supervisor is damned if it intervenes because it risks exacerbating the problem through the effect of cross-default clauses leading the imperilled bank's counterparties to stop funding it, and it is damned if it doesn't because it will later be charged with trepidation and shying away from effective action when the bank could still have been rescued. Legislative action is needed to remedy the effect of such clauses. The financial institutions themselves should consider whether entering into such clauses doesn't undermine the viability of the company and may thus be against corporate interests.

René Smits is professor of the law of the economic and monetary union, University of Amsterdam; and visiting professorial fellow, Queen Mary, University of London.

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