Jürgen Stark: Macro-prudential supervision and financial integration -
the ESRB at 1
Diner speech by Mr Jürgen Stark, Member of the Executive Board of the European Central
Bank, at the SUERF/Deutsche Bundesbank Conference 2011/IMFS - The ESRB at 1, Berlin,
8 November 2011.
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Ladies and gentlemen,
It is a great pleasure for me to be here this evening. The growing integration of Europe's
financial markets and the financial crisis of 2007-2009 have raised important questions
about the design of European banking supervision. If we had relied on effective
macroprudential oversight and policy instruments back then, one can argue that the social and
economic costs of the crisis would have been much lower. Crucial improvements to the
financial system were needed, and are still needed, to prevent and mitigate systemic risk. In
particular, financial institutions should be allowed to fail without imposing unacceptable costs
on the rest of society. Tonight, I shall reflect on the recent developments in European
macroprudential supervision and try to clarify our understanding of what European
macroprudential policy is and what it is not, and what it can achieve and what it cannot.
To start with, I would like to quickly review the root causes of the global financial crisis, which
give you the background to why and how the European Systemic Risk Board (ESRB) was
set up. Then I will dwell on the inherent tensions that exist between a need for financial
integration within European Monetary Union (EMU) and the micro-prudential supervision and
fiscal policies that have remained national competencies. Finally, I will take a critical look at
the role, power and limitations of the European Supervisory Authorities (ESAs), which I see
as significant steps in the right direction towards shaping a system that will ensure financial
stability.
Let me begin by looking back. The causes of the recent crisis have been attributed to
macroeconomic factors, to major weaknesses in corporate governance in financial
institutions and, also, to an inadequate level of supervision and regulation. At the
macroeconomic level, rapid credit expansion over a protracted period of time in a benign
environment of low inflation, high growth and large and persisting imbalances fostered
important leverage and maturity transformations, as well as a significant underpricing of risk.
At the same time, at the microeconomic level, financial innovations were implemented in a
manner that fostered wrong incentives, notably in the securitisation process, which should
have helped, in principle, to better diversify and manage economic risk. The securitisation of
assets made it possible for financial institutions to sell loans within complex and opaque
financial products and to take them off their balance sheets. These financial techniques
weakened incentives for the prudent screening and monitoring of credit risk and led to banks
loosening their lending standards. Eventually, when the global financial system was thrown
into crisis, many policy-makers were shocked to discover that they did not have the
macroprudential tools to deal with part of the financial system spiralling out of control. Up until then,
the common view in policy circles had been that the whole financial system would be stable
as long as its single parts were sound. The financial crisis painfully demonstrated how
supervisory arrangements have not been sufficiently focused on ensuring the stability of the
financial system as a whole. Therefore, to be able to monitor, assess and mitigate systemic
risk, policy-makers have been working on creating new tools for a new policy area, namely
giving a macro-prudential orientation to financial regulation and supervision.
The European Systemic Risk Board (ESRB) was established as the main body for
macroprudential oversight and surveillance of EU financial markets.
As you probably know, the European Central Bank (ECB) has close links with the ESRB.
These include, first, a personal link: the President of the ECB also serves as the Chairperson
of the ESRB. Second, the ECB provides logistical and administrative support by hosting the
ESRB secretariat. And lastly, the ECB provides analytical and statistical support, collecting
and processing information that feed into the ESRB's discussions.
Despite this, however, the ESRB remains a body that is quite distinct and separate from the
ECB. The ESRB does not change in any way the functioning of the ECB's statutory role and
its unambiguous primary mandate for delivering price stability. The new institutional set-up,
and the ECB's role in it, rests on solid institutional and legal foundations. The ECB has
participated closely and constructively in the legislative process leading to the establishment
of the ESRB. It has thus focused on establishing in Europe the most effective and robust
macro-prudential supervision set-up possible to prevent and mitigate systemic risk.
The question remains, however, as to whether, within this new macro-prudential framework,
there might not be some tension between inter-connectedness born out of the growing
integration of financial markets and matters of national competencies. Let me look at two of
the challenges we currently face.
First, increasing financial integration, both in Europe and globally, has had important
implications for the cross-border propagation of systemic risk. Since the introduction of the
euro, we have seen growing integration of European financial markets. This has been
illustrated by a significant convergence in interest rate differentials in wholesale and
interbank markets, by a significant degree of convergence for the cost of capital for equity
and debt issuance across countries and, by a gradually decreasing home bias in the
composition of asset classes in most regulated investment funds. This closer integration has
been facilitated by the growing importance of the euro as a reserve currency, as well as by
the rapid technological advances that have enabled markets to operate more easily in a
cross-border environment. As financial markets have become more inter-connected, the
structure of banking markets and their management has also changed significantly. Large
banking groups have been created from a growing number of cross-border bank mergers.
Today, many banking groups have major operations in multiple jurisdictions, where they can
pose systemic risk to a host banking system.
At the same time, over the last decade, EU legislation has been growing dramatically in
scope and coverage for many areas and segments of financial markets. However, the
implementation and enforcement of this legislation has been ultimately left to the discretion
and authority of supervisors in the individual Member States, based on the principle of home
country control and mutual recognition. The recent financial crisis has clearly illustrated these
substantial cross-border implications and the need for a more robust macro-prudential
supervisory framework and micro-prudential supervisory regime.
The second challenge concerns another aspect of policy-making left to the authorities in the
individual Member States: namely, of course, fiscal policies. A consequence of financial
integration is that European banks are exposed to a wide range of risks in European
government debt and not only to domestic sovereign risk. This implies that, in a crisis,
distressed government debt tends to become a common liability for all governments, at least
through the interdependence of banking system vulnerabilities across jurisdictions. The
current sovereign debt crisis in Europe is proving to us that fiscal policy should be more
grounded - in a similar way to monetary policy - within a rules-based framework with clear
medium-term objectives. And for rules and sanctions to be fully credible, they should be
stricter, automatic, and as free as possible from the political process, so that countries have
the right incentives to address their problems. This calls for substantial improvements in the
quality of fiscal institutions and policy frameworks in Europe.
All in all, a lesson to take from the current sovereign debt crisis is that there is an undeniable
tension between, on the one hand, the need for financial integration to ensure a smooth
functioning of Monetary Union, and, on the other hand, micro-prudential and fiscal
competencies that have remained at the local level. And this tension has the potential to
exacerbate the risk of future financial crises and hinder effective crisis management. We
need bold steps towards a fiscal union. We need to go beyond and create a financial union.
In one word, the crisis has clearly shown us that we need "more Europe".
The new EU supervisory framework is actually based on two pillars: first, the ESRB for
macro-prudential supervision and, for micro-prudential supervision, a second pillar
comprising three different European Supervisory Authorities (ESAs) - one for banking, one
for insurance and one for the securities markets. This framework provides a more
consolidated and rational institutional design for linking the micro-prudential supervision of
individual institutions with the supervision of linkages between institutions and within the
broader system.
However, as the ESAs were only established at the beginning of 2011, they are too young for
us to judge their effectiveness. Under the current framework, all supervisors in the Member
States continue to be responsible for assuming their individual supervisory functions, but
they have to report on their practices to the relevant authority. The ESAs' regulations provide
for a review of the new institutional arrangements by the European Commission in early
2014. Should the ESAs be deemed not to have adequate tools and powers, there may be a
case for greater integration of the supervisory framework - including tools for crisis
management and resolution. There may indeed also be some support for a single EU
financial supervisor. The main argument for such an institutional consolidation is that given
the growing financial "inter-connectedness" of Europe, a centralised supervisory body would
promote a more efficient level playing field in supervisory practices. Moreover, it might
enhance both the efficacy of supervision and the crisis management capabilities over credit
institutions with a strong cross-border presence. Although there are obvious benefits of such
a centralised institutional structure, there are also obvious concerns about the issue of
national sovereignty.
Let me wrap up and conclude. By providing the basis for payments and by acting as the
principal intermediary between savers and borrowers, the banking system plays a role similar
to the electricity supply network as a vital part of the economic infrastructure. However, as
recent experience has shown, if the stability of the system is undermined, considerable
disruption can ensue, leading to considerable effects on social and economic costs.
For these reasons, financial stability may be seen as a "public good" which requires
adequate regulation. Regulators need to tread a careful path between controls that ensure
the stability of the financial system and over-bearing regulation, which would hinder
competition and efficiency.
The new regulatory reform and the macro-prudential oversight now in place constitute an
unprecedented achievement. At the same time, key challenges remain, in particular
regarding the interaction between macro-prudential and micro-prudential authorities,
especially against a background of growing inter-connectedness of financial markets and the
sovereign debt crisis. Looking forward, the coming years will be crucial to judge the
functioning of the new financial supervision framework, to assess the efficiency of the new
tools and methodologies that are being developed as academic research progresses in this
field, and to minimise and correct potential inefficiencies. The achievements made so far are
clearly a major step towards creating a safer financial system, but further ambitious
arrangements may be needed to enhance the robustness of our financial systems. Not only
stricter fiscal rules and the creation of a fiscal union are needed, but it has to be
complemented with a financial union.
Thank you for your attention.