Eva Srejber: The divorce between macro financial stability and micro
supervisory responsibility - are we now in for a more stable life?
Speech by Ms Eva Srejber, First Deputy Governor of the Sveriges Riksbank, at the 33rd Economics
Conference of the Oesterreichische Nationalbank (Austrian National Bank), Vienna, 13 May 2005.
* * *
Introduction
I hope I won't disappoint our kind hosts who asked me to deliver this address but I have a confession
to make - in Sweden, macro financial stability and supervision are not divorced. They have never
been married. Indeed, it is only quite recently that the Riksbank and the FSA (Financial Supervisory
Authority) have started to acknowledge - operationally in their respective policy frameworks - the link
between macro financial stability and micro supervisory issues.
Whether we just got divorced or are soon to get married, the relationship between financial stability
and supervision is highly relevant. I will structure this address in the following way. First, I will give a
brief description of how the relationship between supervision and financial stability has developed in
Sweden. Then, I will move on to the financial sector developments that now challenge the ways
supervisors and central banks have been working. The process of internationalisation, in general, and
cross-border integration, in the EU, will force both supervisors and national central banks to focus on
their core tasks and to a certain degree invent new ways to perform those tasks. Finally, I will
comment more specifically on some of these challenges, and in connection to that also discuss some
of the proposed alternative ways of responding to these challenges.
The Swedish case
Before the banking crisis in the early 1990s, the cooperation between the Riksbank and the Swedish
FSA (then the Banking Inspection) was limited to high-level contacts. In their day-to-day activities,
however, the two authorities worked in different silos - the Riksbank with monetary and exchange rate
policy and the FSA with regulating and supervising financial institutions. The crisis made it very clear
to the Swedish authorities that there is a strong link between soundness of financial institutions and
macro financial stability, and hence a need for close cooperation between the FSA and the central
bank.
This economic link is mirrored by a parallel link spanning at least three aspects of regulatory
involvement in the financial sector - crisis prevention, crisis management and crisis resolution. In
Sweden, these aspects of regulatory involvement are shared between the supervisor, the central bank
and the Ministry of Finance.
In crisis prevention, the supervisor has the tools for regulating and supervising the institutions, while
the central bank might play a supporting role through monitoring the stability of the system and the
links to the real economy. In crisis management, the supervisor lacks the financial resources to back
any intervention, while the central bank has the power to act as a lender of last resort. In other words,
the likelihood that the central bank will have to provide liquidity support to a financial institution is partly
determined by the quality of supervision. At the same time, the central bank may very well need the
supervisor's analytical or informational support to be able to decide on whether or not and how to
intervene. Finally, in crisis resolution, even if the Ministry of Finance takes the lead, it is likely to rely
extensively on the supervisor and the central bank for advice and execution.
If we agree that there is a link between the soundness of institutions and financial stability, then
supervisors must be interested in crisis management and resolution and central banks must be
interested in certain aspects of supervision.
In the last decade, at least in Sweden, the macro and micro perspective have grown gradually closer.
Indeed, the Swedish FSA now has an explicit interest in the stability of the system, while the Riksbank
has taken a greater interest in the stability of single institutions, if they are judged as systemically
relevant. We have regular contacts to share information and assessments and coordinate policy. If
before, the relationship between the two authorities might have been described as polite but
uninterested, it is now a mix of curiosity, some competition and frequent flirting.
The times they are a-changin'
This could have been the happy end of our story but recently there have appeared challenges to this
set-up. All over the globe, the financial markets are becoming more integrated and financial institutions
as well as financial infrastructure companies are consolidating domestically as well as cross-border.
The challenge touches all the aspects of regulatory involvement - crisis prevention, crisis
management and crisis resolution.
Cross-border integration of financial markets...
In the EU, the process of cross-border integration has been actively promoted by the creation of the
euro and the ongoing harmonisation of regulation and supervision - in the last years epitomised by the
Financial Services Action Plan (FSAP). Admittedly, financial markets integration in the EU has so far
been a mixed picture.
Until now, integration has mostly taken place in wholesale markets, such as the money market and the
bond markets. Many investment banking segments such as capital raising and mergers and
acquisitions (M&A) for large corporates are also dominated by global giants. In contrast, retail financial
services are still to a very large extent controlled by domestic players, at least in the old member
states.
... and institutions...
My guess is that we still have only seen the beginning of cross-border integration. Banking integration
will probably not primarily take place through direct cross-border provision of services but through
cross-border bank M&A. Integration of ownership will result in integration of lending/funding,
organisation, products and services.
According to a study by the ECB, 43 banks and banking groups are active in more than three EU
countries.1 Only some years ago, cross-border banking M&A in the EU was only taking place between
small countries or vis-à-vis the new member states - Austrian banks' expansion into some Central
European countries is a good example of this phenomenon. Now this is changing. Today French,
Spanish, German and UK banks are all trying to build European platforms. For instance, as you all
know, Spanish Grupo Santander now owns the fifth biggest UK bank, and Barclays of UK owns the
sixth largest private sector bank in Spain. And this spring, we are all witnessing the takeover battles,
started by foreign bids, for two Italian banks.
...is good news for the economy but raises challenges to supervisors and central banks
At the Riksbank, we welcome this development. We believe financial market integration is strongly
positive for economic efficiency and hence for growth and welfare in the EU. But we admit that
integration presents some complex and multifaceted challenges to us as authorities.
At the outset, integration is obviously hindered by differences in language, business culture and
national laws and regulations. But once it happens, integration tends to follow the logic of business,
not the "logic" of country border or national law. For instance, for financial groups which are expanding
cross-border a part of the synergies is derived from centralising functions. Hence, the group's credit
risk model might be developed in the parent bank, while the group's liquidity is managed through a
foreign subsidiary, and the group's derivatives trading is done in yet another subsidiary. That is why
integration gives rise to a structure that often seems to be in conflict with the present regulatory
structure. But the problem is not integration - the problem is that our regulatory framework is not
designed for a single market for financial services.
Let me give you a concrete example of this. In the Nordic and Baltic countries - excluding Iceland -
there are six banking groups with significant cross-border activities. Each one of these cross-border
groups has regulatory contacts with seven supervisors and eight central banks.2 It is commonplace to
note that Western Europe is over-banked. It would not be outrageous to say that it is also
over-crowded with regulatory authorities.
Our conclusion is that we, as national authorities in the EU, must solve the issues that integration
gives rise to, rather than stopping integration. This might sound very obvious, but some of us
authorities still only pay lip service to the idea of the single market. Or we love the idea of the single
market as long as it means that our own banks survive as national champions and are able to expand
abroad.
The question of how the relationship between financial stability and supervisory responsibility might
evolve is a big and difficult one. Still, it is dwarfed by and will be determined by the question of which
will be the shape of the relationship between authorities - central banks and supervisors - in different
countries in the EU. It goes without saying that since laws and regulations and the division of
responsibilities between authorities are ultimately decided by the governments of the member states,
the challenge of integration inevitably also concerns finance ministries. I will now try to give some
thoughts on the alternatives before us.
Back to basics
What will be the roles of national supervisors and central banks in an integrated EU financial market?
If central banks and supervisors haven't done it before, cross-border integration will force them to think
hard about their responsibilities, mandates and tools.
In order to do this, they will have to go back to the beginning and find their "raison d'être". What is
special about the financial system and why are we regulating, supervising and monitoring financial
markets and institutions? Who or what are we protecting and which tools do we need?
Whether authorities want to defend the status quo or reform the regulatory framework, they will need
to prove their case to politicians as well as to each other. By itself, this might very well improve the
way supervisors and central banks work. You may call this a positive external effect of integration.
Regulation and home-host issues
There are many issues at the table, but in the context of this presentation I would like to divide them
into two categories.
The first category includes the issues of what regulations should be imposed on institutions and
markets in the EU. How can we design laws and regulations that are flexible enough to fit all countries
reasonably well, while strict and "harmonised" enough to support a single market?
The second category is essentially about the relationship between supervisors and central banks in
different countries - the division of labour, power and responsibilities. This category of issues has
come to be broadly referred to as the home-host issues. I will just give a short comment on the
regulatory issues, while devoting the rest of my time to the home-host issues.
Regulation
Regulation on the EU-level first of all faces the same basic trade-off as on the country level. The
Riksbank's view is that since almost all regulation involves costs - in terms of lower efficiency and
growth - it should be the last resort and used only when there is a clear case of market failure. Some
regulation is surely needed to ensure a stable and sound financial system and necessary consumer
protection. But too much or too strict regulation will give rise to new costs that are higher than the
original costs that regulation initially aimed to address.
Regulation on the EU-level also faces another trade-off that is not present on the national level - that
between the value of a level playing field and the cost of an overly detailed or inadequate regulation. A
completely level playing field presupposes detailed rules that are applied in the same way in every
market. But too detailed rules on the EU level risk being inadequate on the national level since
national markets often differ widely. This could give rise to costly overregulation hampering financial
development or driving financial institutions to settle elsewhere. Hence, it might be wise to leave some
degree of freedom to the member countries. Historically, institutional competition has proved to be
very positive for development in the long run.
At the same time, EU directives (as most international rules) tend to leave plenty of room for national
discretions, effectively reducing the value of the convergence/harmonisation that probably was the
motivation for the directive in the first place. We risk ending up with the worst of two worlds - very
detailed rules on the EU level and loads of discretions on the national level. This makes the rules
opaque and their implementation difficult to predict for the private sector. The starting point for EU
rules should be the least common denominator. Today instead, it often seems like the starting point is
the sum of all member states' national rules.
As national authorities we are all convinced that our national discretions are worth fighting for and we
take pride when they are included in the final drafts. Perhaps we should ask ourselves more often
whether our discretions are motivated by a fundamental need or just deep-rooted tradition or, even
worse, our unconscious caving in to special interest groups. I realise this might be naïve but why not
take this opportunity of change and think new instead of designing EU regulation on the basis of
existing, often imperfect, national regulation.
The need for a common rule book for big cross-border banking groups is often raised by the industry.
In principle, we are sympathetic to this wish. If a common rule book means "just" common rules we are
certainly moving in that direction. One of the main objectives of the Committee of European Banking
Supervisors (CEBS) is to promote convergence of supervisory rules and practices. However, in the
sense of common or centralised decision making by authorities, I think it is still far away from coming
true. As long as the implementation and interpretation of directives and rules is done on a national
level it will take time before we have a common rule book.
Still, the aim should be to eliminate or reduce as much as possible these differences. Remaining
differences in supervisory practices between countries should be clearly disclosed in order to improve
the predictability of the EU regulatory system - which is another area where the CEBS is doing
important work. Another practical example on how to reduce the regulatory burden would be for
countries to agree on a common and centralised reporting standard for large cross-border groups.
The home-host relationship...
The home-host relationship is the underlying theme running through a number of issues in the
regulatory debate. Broadly speaking, the home-host relationship is about how we should divide tasks,
powers and responsibility between different countries when it comes to supervising, monitoring and, in
the worst case, sorting out financial institutions in distress.
Formally, the home-host relationship only refers to the division of responsibility between supervisors,
which currently is based on the principle of home country control. The home country is the country
where the bank is licensed. For a bank, this means that the home country is responsible for
supervising the bank and its foreign branches. The home country's deposit insurance also covers its
banks' foreign branches. In the case of a group, it means that the home country is also responsible for
supervising the entire group on a consolidated basis, while the host countries are responsible for their
respective subsidiary banks and deposits. At this very moment, the CEBS is drafting the so-called
home-host paper giving guidance on how the home-host supervisory relationship should be arranged
given existing EU legislation.
Even if there are no legally binding rules regarding the relationship between countries in crisis
management or crisis resolution, these aspects of regulatory involvement have borrowed the
terminology of the supervisory home-host concept. For example, when discussing lender of last resort
in crisis management and burden sharing in crisis resolution we now talk about home and host central
banks and finance ministries, respectively. This is natural, since legally the financial liabilities for a
group are ultimately carried by the parent bank. Of course, a parent can choose to default a
subsidiary, but it will then have to bear the capital loss. Subsequently, in practice, the ultimate public
responsibility over a group rests with the home country.
... comes under strain...
At first glance, the home country principle seems very neat. But take a closer look and you will see
signs that this set-up was not designed for a fully integrated market. Essentially, there is a gap
between, on the one hand, legal powers and mandates and, on the other hand, de facto abilities and
responsibilities. Home countries are given powers over branches and subsidiaries but might be unable
or unwilling to use them, while host countries are losing powers that they have been willing to use.
This gap becomes a problem once you have a banking group or bank that is systemically relevant in a
host country (see table 1). Even if there are not so many of these cases yet, I am convinced that the
number will increase. The potential conflicts of interest and coordination problems are of many kinds.
Let me give you some examples:
Table 1: The home-host relationship (both bank and group)
Systemic relevance in Systemic relevance in
HOST country HOST country
Systemic relevance Significant Non-significant
in HOME country
Significant Potential conflict of interest Not a big problem
and coordination problems
Non-significant Potential conflict of interest Not a big problem
and coordination problems
... when branches and subsidiaries become systemically relevant
Suppose there is a banking group of roughly equal systemic relevance in the home country and the
host country. The home country supervisor is the consolidating supervisor and coordinates the
activities vis-à-vis the group. If cooperation works well, the host supervisor will receive information
from the home supervisor. But in the event of a crisis in the banking group, all authorities have a clear
mandate to only protect their depositors and systems. One can easily imagine a situation where, as in
my earlier example, the group has surplus capital in one of its parts, extra liquidity in another and the
cause of the problem is in a third part. The lack of coordination might very well result in a worse (more
costly) outcome for all involved.
If the presence in the host country is a branch and not a subsidiary, the host supervisor has only
limited means of obtaining information about - or taking actions against - the bank. In the event of a
crisis it can only hope that the home country will take the host country's situation into account when
managing the crisis. The home country, on the other hand, faces a situation where it could be
necessary for its central bank to provide emergency liquidity assistance (ELA) to support a bank which
has a large part of its activities in other countries. Should the bank need to be reconstructed it would
be the home country's tax payers that would have to foot the bill - either by supplying the necessary
capital to the bank or by supporting the deposit guarantee system with the funds needed to pay out
insurance to the bank's depositors.
The imbalance between home and host countries may be further deepened by differences in size
between the two countries. One case will be that of a big home country and a smaller host country.
The banking group's exposure to the host country is then probably relatively small on a consolidated
basis. This results in the home country authorities spending relatively limited resources - in terms of
staff - on the foreign subsidiary's activities in the host country. If such a banking group runs into
problems, the home country authorities will not necessarily view it as systemic, while the host country
authorities certainly will do.
How to deal with the home-host asymmetry?
In all these examples host authorities have a legitimate interest in being able to influence supervision,
share assessments and have a say in the event of a crisis situation. They have been given the task of
protecting the soundness and stability of their financial sector and the general public in the host
country will rightly expect their authorities to be able to do this. At the same time, the home authorities
should have an interest in sharing resources in crisis prevention and risks and costs in crisis
management and resolution with the host countries. In the current setting, however, this is only
possible to a very limited extent.
First, there is a need to share information between the home and the host. This should be the least
difficult, but in practice everyone who has tried to share information between authorities knows it can
be a complicated and cumbersome process, at least until there is an established routine. Even when
there are no confidentiality concerns there are many practical obstacles to overcome. Information
sharing is not only about sending data back and forth, but more importantly, it is about explaining
information and sharing assessments. As long as hosts are under the impression that they know a lot
less than the home, it will be very tricky to cooperate.
Second, there is a need to cooperate on actions vis-à-vis the bank or the group and its components. If
hosts cannot influence the process of supervision or crisis management, their trust in and use of the
information from the home authority will be very limited.
Sharing information and cooperating on regulatory actions may be problematic already in normal
times, but is probably much more difficult in a crisis situation when economic risks and costs are
clearly visible. So far, cooperation and coordination in crisis situations is dealt with in the EU by
various Memoranda of Understanding. Even if these MoUs are not legally binding, they are valuable
documents. They provide a basis from which more operational crisis cooperation agreements can be
developed by the countries and authorities that see the need to do so.
But looking at this increasingly complex patchwork of supervisory colleges, central bank networks and
MoUs that we are now creating, one cannot help to wonder if there are not any better alternatives for
cross-border cooperation.
Future alternatives to the home-host model
What are, in the long term, the alternative models to the current home-host set-up? In the EU, we are
committed to creating a single market for financial services. If we take off our national central bank and
supervisor hats, are we really convinced that the home-host model is the best one in the long run?
After all, several serious alternative models have been suggested. The pros and cons of the three
main models are reviewed in an interesting paper by Oosterloo and Schoenmaker.3 I will briefly
comment on these.
Three alternatives for supervision
The first alternative is to give the home supervisor the role of lead supervisor with full responsibility for
EU operations, branches as well as subsidiaries. This is the proposal from the European Financial
Services Roundtable (EFR). The lead supervisor would be the single point of contact for reporting and
would validate and authorise internal models, approve capital and liquidity allocations, decide about
on-site inspections. In short, the lead supervisor would have full supervisory responsibility. The role of
host supervisors would be as advisers in a college of supervisors. However, host supervisors would
have no formal power. Also, when it comes to financial stability and crisis management, the lead
supervisor would only have a national mandate. Thus, there would still be a need for cross-border
regulatory cooperation.
The second alternative, which is put forward by the two authors, is to give the home supervisor the
role of lead supervisor with an EU mandate. The lead supervisor would work as in the EFR model,
with the difference that the lead supervisor is given a "European mandate to ensure that the interests
of all depositors/countries are taken into account". In this model there is a decision-making agency of
European Financial Supervisors at the centre, which is delegating the task of supervision to each
respective home supervisor. Regarding financial stability issues, the home country central bank would
also be involved, acting on behalf of the European System of Central Banks (ESCB).
The third alternative is both the most obvious and the most radical and would be to create a European
Financial Supervisor (for example put forth by Breuer). This simply means having one authority acting
with full supervisory powers over branches and subsidiaries of cross-border European banks. The
system could be tiered (like in the US) in the sense that the EU supervisor would only be responsible
for banks and banking groups with significant cross-border operations, while purely domestic banks
could remain the responsibility of the national supervisors.
A European financial supervisor
All three of these alternatives, even the first one, are considerably more far-reaching than what is
currently under construction. I do not think many authorities find the first alternative with a lead
supervisor very appealing. It addresses the problem only from the cross-border bank's perspective of
minimising the regulatory burden. This is important but does not solve the underlying conflicts of
interest between the home and the host countries. In short, it is a model which will only work in normal
times when the weather is nice, if even then. The second alternative - the lead supervisor with an EU
mandate - seems nice in theory and aims at solving the conflicts of interest by creating a central
decision-making body. In practice, however, it could easily become very bureaucratic and inefficient. If
we are establishing a central decision-making body anyway, why act through 25 different authorities?
Both the first and the second alternatives are half-way compromises trying to please different interests.
My own view is that the third alternative, although radical, is the logical solution. There are two main
arguments against the idea of a European Financial Supervisor - one relevant and one not very
relevant.
The not very relevant argument is that the supervisor needs proximity to have knowledge about the
markets where the institution operates. First, this is already a problem with the home-host model.
Second, this is an organisational problem that can be solved. An EU supervisor would certainly
employ staff from all EU countries and have local offices in the national financial centres. For instance,
for a regional cross-border banking group, I imagine the supervisory team to be based in the relevant
region, perhaps in the same premises as the national FSA, and to consist of staff from that region.
The relevant argument against an EU supervisor is that supervisory power ultimately needs to be
backed by financial muscle. In the present set-up, the financial muscle derives from the national
central bank's ability to act as a lender of last resort and the government's ability to raise taxes. The
EU lacks such power.
However, this problem is hardly unsolvable. For instance, one could think of the EU building up a
deposit insurance fund for cross-border banks supervised by the EU supervisor, which would be able
to handle all but the largest banking failures. In fact, such an EU fund would be better diversified than
the national funds are today, which all else equal would enable it to charge lower fees or hold a bigger
risk-adjusted buffer. In the event of really large banks or several large banks failing, there could be an
established system of committed drawing rights, where the EU fund has the right to raise funds
through national governments' ability to raise tax. Regarding liquidity support, the ECB would be given
the role as lender of last resort.
To convince national governments to commit such guarantees would of course demand very strict and
well thought-out rules governing what actions the EU fund should be allowed to take in the case of a
bank failure. These rules could be inspired by the US FDIC's very strict mandate to always choose the
least cost solution. Among other things, this would in some cases mean allowing shareholders as well
as uninsured depositors and debt holders to lose their money. Since to my knowledge most EU
countries lack the rules on how to handle large bank failures, it would also be very positive from a
contingency planning and moral hazard point of view. With a strong legal framework, the EU would be
able to let investors in even the biggest banks take full financial responsibility.
Concluding remarks
I remember once hearing Tommaso Padoa-Schioppa, the outgoing member of the executive board of
the ECB, saying that there is no need for a European supervisor if national supervisors can prove that,
when needed, they are able to act as one. Personally, I find it hard to see how, in the long run, the EU
could avoid establishing an EU financial supervisor. At the moment, we are spending considerable
supervisory and central bank resources on trying to construct arrangements that will enable us to work
and act as one. Why not instead become one, and spend the resources on supervision and
monitoring?
Coming back to the title of this address, I would like to conclude that even though financial stability and
supervision has been divorced in most EU countries there are few reasons to expect the life of central
bankers and supervisors to be very stable in the coming years. It will probably not happen overnight,
but the integration of European financial institutions and markets will eventually mean big changes
also for the financial authorities. To ensure a good outcome for the European financial market, central
banks and supervisors will have to be flexible and reinvent their roles and tools.