Twin peaks for Europe
We argue that the European supervisory architecture should eventually move to a twin peaks model for three main reasons. First, banks and insurers are often part of a financial conglomerate, which warrants integrated banking-insurance supervision. Second, the EU27 will need to upgrade the supervision of its capital markets after Brexit. A dedicated markets supervisor can adapt quickly to this new reality. Third, prudential supervision and markets and conduct-of-business supervision require different skills and approaches. While the first deals more with technical capital adequacy issues and requires staff trained in economics, finance and/or accountancy, the second is more behavioural and legalistic (Goodhart et al, 2002). This behavioural and legalistic approach concerns policing the conduct of financial institutions in the markets (eg insider trading, market abuse, disclosure) and towards clients (eg adequate information provision, duty of care, know your customer).
We frame our recommendation for twin peaks supervision in the EU as a long-term aspirational goal. Defining a long-term goal is important for taking decisions on short-term issues, such as the relocation of the European Banking Authority from London to the EU27 and the upgrading of ESMA.
Prudential supervision
Close interaction between banking and insurance supervision is needed for the effective supervision of financial conglomerates that combine banking and insurance. Figure 2 shows that 31 percent of banks and 36 percent of insurers belong to a financial conglomerate. These percentages are for 2015 and measured in assets (ie bank conglomerate assets as a share of total banking assets and total insurance assets).
Why is such close interaction necessary? During the financial crisis, several financial institutions experienced solvency problems. These could emerge in any part of the financial institution (eg sub-prime mortgages in the bank or on the insurance balance sheet). It appeared that several financial conglomerates made use of double counting and thus had insufficient capital. Double counting (also known as double gearing) is the practice whereby the same capital base at the holding level of a financial conglomerate is counted as regulatory capital for both the banking activities and the insurance activities.
Figure 2: Share of financial conglomerates in banking and insurance at EU level (2015)
Source: Bruegel based on Joint Committee (2016). Note: The graph shows the share of EU banks and insurance groups that are part of a financial conglomerate.
Such double counting was, and still is, allowed because of the fragmented financial architecture, both on the rule-making and supervisory sides. On the regulatory front, the so-called Danish compromise, agreed in the process of EU transposition of the Basel III capital accord and enshrined in the EU Capital Requirements Regulation, allows double counting of capital (Financial Times, 2012). On the supervisory front, the absence of an integrated focus (the supervisory focus is on the banking and insurance parts but not on the aggregate) leaves no-one responsible for the overall capitalisation of financial conglomerates. The current weak form of supplementary supervision of financial conglomerates, in which either the banking or insurance supervisor has some responsibilities for the supervision of conglomerates, cannot replace proper integrated supervision.
Nevertheless, the industry and the supervisory authorities are keen to preserve the current sectoral structure and unwilling to adopt a twin peaks model (European Commission, 2017b). From a political economy point of view, this position is understandable. Financial institutions and their supervisors are keen to preserve the status quo, including any cosy relationships between the main players. In particular, the insurance sector is afraid that a merged banking/insurance prudential authority would be dominated by banking regulatory approaches. By contrast, some stakeholders, mainly from academia, are critical of the sectoral supervision model on the basis that it is outdated and ignores the reality of the retail financial markets in Europe (Huang and Schoenmaker, 2015; European Commission, 2017b). Finally, consumer and public-interest advocacy organisations also support a twin peak model of supervision that would separate market conduct from prudential supervision for reasons mentioned above (eg Lenz, 2017).
On the political front, Table 2 shows that financial conglomerates have a substantial presence in the largest EU27 countries. In Germany, France and Italy, conglomerates make up 20 to 90 percent of the respective banking and insurance sectors. So, these large countries have an interest in appropriate supervisory arrangements for financial conglomerates.
Table 2: Share of financial conglomerates in banking and insurance at country level (2015)
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Austria
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24%
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37%
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Belgium
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40%
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22%
|
|
Denmark
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43%
|
17%
|
|
Finland
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19%
|
82%
|
|
France
|
88%
|
22%
|
|
Germany
|
27%
|
28%
|
|
Italy
|
19%
|
47%
|
|
Malta
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15%
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0%
|
|
Netherlands
|
17%
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59%
|
|
Spain
|
14%
|
3%
|
|
Sweden
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45%
|
27%
|
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United Kingdom
|
10%
|
17%
|
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EU
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31%
|
36%
|
Source: Bruegel based on Joint Committee (2016). Note: The table shows the share of EU banks and insurance groups that are part of a financial conglomerate. At the country level, only countries are shown where the head or parent company of a financial conglomerate is located. At the EU level, all financial conglomerates with the headquarters located in the EU are shown.
How can close cooperation between banking and insurance supervision be implemented in order to enable a joined-up view of the capital adequacy of financial conglomerates? On the banking side, the Single Supervisory Mechanism (SSM) is responsible for the supervision of the banks in the euro area. The non-euro area member states can join the EU banking union through the mechanism of close cooperation set out in the SSM Regulation. Given the cross-border banking links between EU member states, it is plausible that most, if not all, non-euro area countries might join the banking union at some future stage (Hüttl and Schoenmaker, 2016). In early July 2017, both Denmark and Sweden indicated they would consider such close cooperation by 2019.
The European insurance sector is highly integrated with a large and rising share of cross-border business. On average, insurance groups conduct 29 percent of their business in other EU countries. For the large insurers, this percentage even increases to about 50 percent (Schoenmaker, 2016). While the global financial crisis led to a reversal in banking integration, there is no evidence for that in insurance. These large insurers run the asset management and risk management functions from the head office in an integrated way. The Solvency II directive was implemented in 2016, allowing insurers to use their internal models for capital purposes. Given the strong cross-border nature of the large European insurers, the European Insurance and Occupational Pensions Authority (EIOPA) should become responsible for the approval and monitoring of these internal models (Schoenmaker, 2016; European Commission, 2017d). EIOPA might thus be given responsibility for direct supervisory tasks in relation to the large insurers in the European Union.
A full merger of EIOPA and the ECB (as the SSM’s central supervisor) is not possible without treaty change. Article 127(6) of the Treaty on the Functioning of the European Union allows the ECB to conduct “prudential supervision of credit institutions and other financial institutions with the exception of insurance undertakings”. This means the ECB is not allowed to supervise insurance companies and only allowed to do prudential supervision (ie no conduct-of-business supervision) of banks. Nevertheless, close interaction between EIOPA and the ECB in the prudential supervision of financial conglomerates is possible. It is already facilitated by both institutions being located in Frankfurt and could be further improved by physical co-location.
A final question on the prudential side is the future of the European Banking Authority after Brexit. The European Banking Authority is needed for technical rule-making and supervisory convergence, as long as the SSM does not cover all EU countries. The European Banking Authority is able to balance the interests between the ‘ins’ and ‘outs’ of the banking union. In the long term, EIOPA could be responsible for the technical rules on insurance supervision as well as the direct supervision of the large insurers. If all ‘outs’ eventually join the banking union, the ECB could take over the European Banking Authority’s current responsibilities, including the preparation of binding technical standards for the prudential supervision of banks.
Markets and conduct-of-business
On the second peak, it is useful to make a distinction between supervising financial firms’ conduct in wholesale markets and financial firms’ conduct in relation to their retail clients. London is currently the wholesale markets hub of Europe, providing corporate and investment banking services to the EU’s 28 countries and well beyond. Assuming the UK leaves the EEA and its single market for financial services, UK-based financial firms would consequently lose their passports to do direct business with EU27 clients, and Brexit would thus lead to a partial migration of wholesale market activities from London to the EU27.
A possible fragmentation of trading activity across several EU27 countries might result in increased costs and reduced access to capital for companies. A related risk is that of a regulatory race to the bottom among the EU27, leading to misconduct, loss of market integrity and possibly financial instability. On the upside, Brexit is also an opportunity to build more integrated and vibrant capital markets in the EU27 that would better serve all member economies, to improve risk sharing to withstand local shocks and to make the EU27 an attractive place to do global financial business. This would speed up the rebalancing from a primarily bank-based to a relatively more market-based financial system, an objective inherent to the EU’s Capital Markets Union (CMU) policy, which was launched in 2014.
To prevent intra-EU27 financial market fragmentation with higher financing costs, Sapir et al (2017) argue that a single set of rules (or single rulebook) is necessary but not sufficient. To achieve cross-border integration, consistent oversight of wholesale markets and enforcement of relevant regulation are critical. This requires integration of the institutional architecture, for which the tried-and-tested model in the EU is a hub-and-spoke design, which has long been used for competition policy and, more recently, for banking supervision. The straightforward way of implementing this approach, without the need for changes to the EU treaties, would be through the build-up of ESMA, which has already a direct EU-wide supervisory role but only for limited market segments. The European Commission has recently proposed moving in that direction (European Commission, 2017c and 2017d).
A broadening of ESMA’s scope would require reform of its governance and funding, which currently limit its independence and capacity. Such reform should not disrupt ESMA’s operations, but should align them with better designed institutions, including the ECB’s Supervisory Board and the Single Resolution Board. ESMA should be managed by an executive board of five or six full-time members vetted by the European Parliament, in place of the current supervisory board of national representatives (in which the chair cannot even cast a vote). This would help to overcome distortions arising from influential local interests and reduce regulatory capture. In line with international practice, ESMA’s funding should rely on a small levy on capital markets activity, under the scrutiny of the European Parliament, instead of the current political bargaining through the general EU budget.
The new areas of responsibility for the reformed ESMA should be focused on those market segments where EU activity is currently most concentrated in London:
- Supervision of markets and infrastructure;
- Wholesale market activities of investment banks;
- Corporate accounting and auditing;
- Non-EU firms.
While financial infrastructure (eg clearing houses), accounting and auditing and non-EU (third-country) firms have already been mentioned in a March 2017 consultation document published by the European Commission (2017a), Sapir, Schoenmaker and Véron (2017) argue that market oversight and specifically the conduct supervision of investment banks are also important tasks for ESMA to ensure effective and efficient supervision of the newly emerging wholesale markets in the EU27 in the context of Brexit. It should be noted that both the infrastructure and the markets are integrating in the EU27. An early example is Euronext, covering the stock exchanges of France, the Netherlands, Belgium and Portugal. Another example is Nasdaq Nordic (formerly known as OMX), covering the exchanges of the Nordic countries (Helsinki, Copenhagen, Stockholm, Iceland) and Baltic countries (Riga, Tallinn and Vilnius). It would be far more effective and efficient to make ESMA responsible for the direct supervision of these platforms (in a hub-and-spoke model, with relevant operational tasks duly delegated to national market supervisors) instead of four (in the case of Euronext) or seven (in the case of Nasdaq Nordic) separate local national market authorities. ESMA would thus become responsible for safeguarding the integrity of markets and avoiding insider trading and market abuse.
The wholesale market activities of the large players, comprising the large European universal banks and the US, UK, Swiss and Japanese investment banks, which will partly relocate to the EU27, also need to be supervised. This supervision covers the wholesale banking aspects of the Markets in Financial instruments Directive (MiFID).
For other aspects, such as authorisations of initial public offerings and fund management registrations, ESMA’s policy-setting role should be strengthened but individual decisions could continue to be taken by national authorities for the foreseeable future. Similarly, the conduct-of-business supervision of smaller investment and insurance intermediaries to protect retail investors can stay at the national level. These activities – IPOs, fund management and intermediaries – comprise the bulk of the current workload of the national markets authorities. This would remain at the national level, in line with the subsidiarity principle, with ESMA given greater authority to ensure supervisory consistency in line with the European Commission’s recent proposals (European Commission, 2017d).
