Communication from the Commission to the European Parliament and the Council - Europe's financial system: adapting to change - Contribution of the Commission to the European Council
Date: 2008-02-27
Institutions: European Commission
Subjects: capital market, economic fluctuation, economic stabilisation, financial legislation, financial market, financial situation

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 27.2.2008 
COM(2008) 122 final 

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN 
PARLIAMENT AND THE COUNCIL 

Europe's financial system: adapting to change 

Contribution of the Commission to the European Council 

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COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN 
PARLIAMENT AND THE COUNCIL 

Europe's financial system: adapting to change 

Contribution of the Commission to the European Council 

(Text with EEA relevance) 

INTRODUCTION 

The Spring European Council meets at a time when difficulties in the international financial 
sector are still working their way through the system. With globalisation and real time inter 
connections  between  financial  markets,  problems  in  one  part  of  the  world  quickly  have  an 
impact  on  others.  Recent  events  have  had  an  impact  on  international  banks,  multinational 
companies  and  individuals  who  are  beginning  to  face  tightening  credit  conditions,  with 
consequences ranging from companies' ability to invest and grow, to home ownership and the 
disposable income of households. Many Europeans are worried about what this will mean for 
the  economies  of  their  country  and  for  their  own  financial  and  employment  security.  These 
concerns call for an explanation of what is being done at national, EU and international level 
to reassure Europeans that they can have confidence in the way financial markets operate and 
in  the  EU's  economic  framework.  Recent  experience  has  shown  that  there  are  important 
weaknesses  in  the  international  financial  system  which  need  to  be  remedied,  particularly 
improving the quality of information available to all investors, whilst strengthening prudential 
control and risk management. Discussions at the Spring European Council should be used to 
determine the next steps in the EU’s response to these challenges. 

THE CURRENT ECONOMIC CLIMATE 

The  global  economic  situation  and  outlook  remain  unusually  uncertain  at  the  start  of  2008, 
with  turmoil  in  financial  markets,  a  US  slowdown  and  soaring  commodity  prices  all  key 
factors. In these circumstances, the high degree of stability offered by the euro is particularly 
welcome.  

So far, the European economy has responded relatively well to this challenge. Key indicators 
such as savings rates and the current account offered real protection against the consequences 
of financial turmoil. However, confidence peaked last summer, and as expected, GDP growth 
slowed in the last quarter of 2007.  

The latest forecasts from the Commission saw annual GDP growth revised downwards, to a 
GDP  projection  of  2.0%  for  the  EU  and  1.8%  for  the  euro  area.  At  the  same  time,  high 
commodity prices have fed into rising inflation, up to 2.9% in the EU and 2.6% in the euro 
area. But with the fundamentals looking sound in the EU and governments taking care over 
public  finances,  growth  in  2008  can  still  be  expected  to  stay  reasonably  close  to  the  EU's 
potential.  

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REFORMS WHICH PROTECT CITIZENS 

Overall, the way for the EU to cope with the current shocks facing the global economy is to 
maintain  sound  and  stable  macro-economic  policies  supporting  a  balanced  policy-mix  and 
continue the course of structural reforms. With the Lisbon strategy for growth and jobs, the 
EU has the right policies and instruments to help it weather the current storms and continue to 
deliver growth and  jobs. A  strategy targeted on growth for the  long-term  is the  best  way to 
limit  the  effects  of  a  temporary  slowdown.  Past  efforts  to  achieve  budgetary  balance  or 
surpluses in line with the preventive part of the Stability and Growth Pact are paying off as 
automatic stabilisers and can now play their full role in most cases. For a number of Member 
States  the  2008  budgets  foresee  also  tax  cuts.  A  fundamentally  sound  growth-orientated 
economy is the  best platform to resist a downturn.  All  Member States have national reform 
programmes that are peer reviewed at EU level. Member States have agreed country specific 
recommendations that are not yet fully implemented. At EU level there is strong convergence 
on the areas where further reforms are needed. The Commission has grouped them into four 
priority areas and set out actions that need to be taken at EU level in the Community Lisbon 
Programme: 

–  investing in people and modernising labour markets; 

–  unlocking business potential; 

–  investing in knowledge and innovation ; 

–  helping the EU to become a low carbon economy. 

A  concerted  effort  to  accelerate  the  pace  of  reform  and  fully  implement  these  policies  will 
show  citizens  that  policy  makers  are  neither  powerless  nor  inactive.  The  Spring  European 
Council is scheduled to adopt the next three year cycle of the Lisbon strategy, ensuring that 
the process of reform and modernisation will continue to deliver results in the EU, providing 
additional security against turbulence in international markets. 

REGULATING EUROPE’S FINANCIAL MARKETS 

Financial markets are well regulated in the EU. Long before the current turmoil in financial 
markets, the EU has been working to promote financial stability, proposing rules to strengthen 
the prudential mechanisms of the EU financial system through a mix of regulation, soft law 
and  industry-led  self  regulation  initiatives.  Whilst  day  to  day  supervision  and  regulation  of 
financial markets is done at national level, the development of the EU’s framework rules for a 
single capital market has led to new cross border financial products and services coming on 
stream, requiring in consequence a more coherent supervisory framework at EU level.  

The European capital market is now the biggest in the world, and has grown strongly over the 
last decade, with the added stimulus of the euro. The European framework is composed of a 
series of comprehensive rules covering the securities, banks, insurance company law, auditing 
and  accounting  sectors.  These  rules  set  high  standards  of  prudential  control  and  investor 
protection,  whilst  encouraging  competition  and  innovation.  The  rules  require  regulators  and 
supervisors  to  cooperate  across  sectors  and  Member  States.  Thanks  to  the  development  of 
these policies, Member State supervisory authorities are working closely to reinforce further 

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co-operation on crisis prevention management and resolution1. Such cooperation is also active 
at  the  global  level,  where  regulatory  dialogue  and  co-operation,  for  example  in  the  Basle 
Committee,  and  between  the  EU  and  the  US  authorities,  demonstrate  successful  ways  of 
identifying and responding to challenges in financial markets. 

EUROPE’S INITIAL RESPONSE 

However,  global  financial  markets  are  constantly  innovating  and  evolving;  policy  makers 
need to be vigilant if regulation is to do its job effectively. In the immediate aftermath of the 
US  sub-prime  crisis  the  ECB  and  other  central  banks  reacted  effectively  to  deal  with  the 
liquidity  pressures  coming  from  disruption  in  many  key  financial  markets.  The  recent 
financial  turmoil  has  revealed  gaps  in  the  framework  of  regulations  that  govern  the 
international  financial  system,  in  particular  in  respect  of  transparency  of  operation, 
predictability  of  rules  and  quality  of  risk  management.  Therefore,  in  October  2007  the 
ECOFIN Council adopted an action plan setting out very precise measures which need to be 
taken  in  the  coming  months  to  reinforce  that  regulatory  framework.  The  plan  is  focused  on 
four  key  areas  of  work: 
transparency;  valuation  of  financial  products; 
strengthening  prudential  requirements;  and  making  markets  function  better  (e.g.  through 
better  credit  rating  policy).  These  policy  priorities  remain  fully  valid.  Work  has  been 
proceeding  apace  in  the  different  fora.  ECOFIN  Ministers  will  consider  at  their  meeting  in 
March an interim report to the European Council setting out the progress made on the various 
issues. 

improving 

SOVEREIGN WEALTH FUNDS 

The  current  international  financial  situation  has  illustrated  how  sovereign  wealth  funds  can 
help  to  stabilise  markets  by  providing  much  needed  sources  of  liquidity  and  investment. 
However, concerns have also been expressed about the motivation and lack of transparency of 
certain  of  these  funds.  In  the  accompanying  Communication,  the  Commission  sets  out  its 
analysis of sovereign wealth funds, proposes principles for a common EU approach and sets 
out  guidelines  which  could  be  reflected  in  an  internationally-agreed  code  of  conduct  to  be 
adopted by the operators of the Funds. 

STATE AIDS 

When companies or banks find themselves in financial difficulties, this is usually the result of 
excessive  risk-taking  or  management  error.  Unchecked  subsidies  to  companies  or  banks  in 
this situation distort the market, undermining the reward and sanction system which makes it 
work.  Such  subsidies  can  also  put  the  burden  of  structural  adjustment  to  those  managing 
without  aid.  That  is  why  state  aid  control  is  needed,  to  ensure  that  aid  to  undertakings  in 
difficulties and the ensuing distortions of competition are limited to the minimum.  

There is a particular need for vigilance in the case of banks, where problems in a particular 
bank can quickly spill over to the banking sector in particular, and the financial system as a 
whole. In these situations, decisive action and close co-operation between the Member State 
concerned  and  the  European  Commission  is  essential  to  achieve  the  goal  of  contributing  to 

1 

This work takes place in the Lamfalussy L3 Committees. 

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financial  stability.  State  aid  procedures  have  shown  themselves  equal  to  the  task  of 
intervening effectively. 

THE NEXT STEPS FOR THE EUROPEAN UNION 

Despite its size and the importance of its financial markets, the EU cannot resolve all of the 
problems in financial markets on its own. There are steps which can be taken by the EU to 
strengthen and protect its own financial markets, but the EU also needs to act in tandem with 
other international partners to build a safer and more transparent international environment for 
investors, both big and small. The important role for the EU in contributing to a co-ordinated 
global response also reflects the emergence of the euro as a major currency. The weight of the 
euro  in  the  international  financial  system  implies  a  particular  responsibility  for  the  EU,  and 
more particularly the euro-area Member States, in playing a leading role in efforts to address 
weaknesses exposed by the recent turmoil. 

Against a background of intensifying globalisation, the EU and its partners need a framework 
which offers the right incentives for long term financial efficiency and stability. This must be 
an open framework in which investment decisions can be taken with confidence in regulatory 
systems.  This  confidence  requires  that  these  systems  are  equipped  to  perform  their 
supervisory  roles,  working  in  close  co-operation  with  each  other,  reflecting  the  truly 
international  nature  of  financial  markets,  and  capable  of  preventing  and/or  managing  future 
cross border crises. 

The  ECOFIN  action  plan  identifies  a  set  of  concrete  steps  for  the  EU  to  take.  The  Spring 
European  Council  can  build  on  this  and  go  one  step  further.  It  offers  an  opportunity  for  all 
Member States to confirm the principles which will guide the EU in its internal work and in 
international  fora  such  as  the  G8,  the  OECD  and  the  Financial  Stability  Forum.  These 
principles should include: 

–  primary  responsibility  for  managing  risks  rests  with  individual  financial 

institutions and investors; 

–  national  regulatory  and  supervisory  frameworks  must  be  equal  to  the  task  in 

increasingly complex and innovative financial systems; 

–  co-operation  between  regulatory  authorities  in  the  EU  and  internationally  to 
prevent  and  manage  risks  must  match  the  needs  of  a  progressively  globalised 
financial system. 

The EU should agree to work together with other international partners to: 

–  improve  information  provided  by  credit  ratings  agencies  to  ensure  that  investors 
can  understand  the  risks  associated  with  complex  financial  products  and  that 
ratings are provided on a solid basis. Credit ratings agencies need to improve their 
governance  to  show  that  they  can  guard  against  conflicts  of  interest.  If  these 
agencies prove unable or unwilling to act to address their weaknesses then the EU 
and others will come forward with regulatory measures. 

–  Update accounting and valuation rules to obtain consistent information on banks 
and other financial institutions’ exposure to off balance sheet vehicles, and ensure 

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that  clear  and  consistent  guidance  on  valuation  and  disclosure  of  such  risks  is 
made available. 

–  Encourage prompt and full disclosure of losses by financial institutions.  

–  Improve EU early warning systems on financial stability through regular reporting 

from the Level 3 Committees. 

–  Foster the effectiveness of EU networks of financial supervisors and ensure strong 

and effective supervision of cross border groups. 

–  Work  on  a  common  practical  framework  for  the  assessment  of  the  systemic 
implications  of  a  potential  crisis,  including  common  guidelines  for  crisis 
management, and improved information exchange. 

–  Seek a political agreement between the Commission, the Council of Ministers and 
the  European  Parliament  to  deliver  the  necessary  legislative  changes  (e.g. 
amendment of the Capital Requirements Directive) before April 2009 – and agree 
on rapid implementation. 

******* 

Current economic pressures pose a challenge to growth and jobs – in Europe, and worldwide. 
Policymakers and regulators need to remain alive to changing circumstances, to be ready to 
adapt and to choose the right response at the right moment. The European Union has proved 
its ability to develop the prudential rules needed and to oversee a vibrant financial market in 
Europe. It has strengthened the fundamentals of the economy and is better placed to withstand 
the financial turmoil and limit the effect on growth. It can best retain the confidence of market 
operators and consumers alike by remaining vigilant and determined at times of added stress 
in  the  financial  markets,  working  with  international  partners  to  identify  weaknesses  and  to 
address  these  swiftly  and  effectively.  The  Commission  will  continue  to  play  its  role  in 
promoting financial stability by coming forward with proposals as needed. 

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