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FRANKFURTER ALLGEMEINE CONFERENCE
Madrid, 17 March 2003
By David W Green
Head of International Policy,
Financial Services Authority, UK

Introduction

1. This discussion is timely. There are great debates afoot over the future shape and direction of Europe. Enlargement of the Union is almost upon us. The Constitutional Convention is edging towards making its final recommendations. There are new opportunities to exploit the latest technologies. These technologies in turn are underpinning much greater cross-border activity in financial services. And all this activity is being stimulated by the move towards a Single Market and, for a large proportion of EU business, the elimination of exchange risk and other costs resulting from the creation of the euro.

2. Against this background I want to pose a number of questions this morning.

3. As cross-border activity increases we are forced to confront questions about the scale and pace of increased financial integration. When and by how much should fiscal, legal or regulatory differences be narrowed? Should harmonisation - a word of ambiguous meaning that I often think should be banned in the EU - follow market developments, or should it precede them? Who should take such decisions and how? Perhaps most pertinently for this discussion we need to ask how we can agree on the best structures and techniques for regulating the European financial services sector.

So my first big question is: are we a long way from a single deep and liquid capital market?

4. In comparison with the United States, Europe’s financial markets remain fragmented. The average size of mutual funds is significantly lower, although the UCITS directives have stimulated some cross border activity. Little capital is raised beyond national boundaries. And there has been relatively little in the way of cross-border life insurance or pensions business.

5. This fragmentation may be partly attributable to regulatory obstacles. But of course there are different tax regimes and recent studies have found that tax arrangements play a major role in deterring both cross-border sales and branching. We have different structures of long-term savings, which in many cases have deep cultural roots which are not likely to be altered in the short run by regulatory changes. The high cost of retail cross-border payments is a familiar issue. Other obstacles, such as obtaining secure legal title to collateral, can be significant. These factors tend to be more powerful at the retail level.

6. I also suspect there are some natural obstacles to cross-border trade in financial services. Differences in language would certainly appear to be a rather fundamental one. And we are naturally not very knowledgeable of each other's legal systems and complaints and redress arrangements.

7. So I am sceptical of some of the more striking estimates of the economic growth that might result from moves towards a single financial market. But the creation of such a market will still have benefit for Europe’s citizens. It should stimulate economic growth through a lowering of costs and enhanced competition. And a deeper and more liquid capital market will give them more choice to meet their financial needs. Many of the benefits will be achieved from reform of the wholesale markets. I think the benefits in retail markets will be harder to achieve because of the larger and more deep-rooted obstacles I have mentioned. These will probably also require more institutional consolidation of provider firms than we have so far seen, to which there are also cultural as well as legal obstacles.

8. My first conclusion would have to be that we are a fair way from a truly single financial market for European consumers. And in the context of this discussion, my suspicion is that regulatory harmonisation in itself is unlikely to deliver that single market.

My second question is: are there defects in our legislative arrangements?

9. The effort to derive common standards has unearthed the vast diversity of existing arrangements, even for wholesale corporate securities markets. This has renewed a debate about whether we have a defect in our legislative ambitions and about how much harmonisation is appropriate to produce economic benefits. On the one hand, it can be argued that not much advantage is gained unless arrangements are made identical. On the other hand, enforcing uniformity could very well inhibit legitimate competition and innovation, as well as imposing disproportionate costs. It is not always evident whether resistance to uniformity is protectionist or pro-competitive.

10. An enormous amount of intellectual energy has been devoted to answering this question. The group led by Professor Lamfalussy has offered us their conclusion. We now have a new legislative process of separate committees of finance ministries and regulators, and a different approach to directives themselves. The pure message of the Lamfalussy doctrine - which has not been followed in every respect - was that we should be looking, in future, at framework directives, with the detail fleshed out by a committee of European securities regulators made up of Europe’s national regulators, working together in a new and more intensive way.

11. We are convinced that mutual recognition based on harmonised core standards is the best way to go. The trick, of course, is to identify just which standards need to be harmonised, and which can be left to local discretion without damaging the integrity of a single financial market.

12. The Lamfalussy Group set out some principles which ought to govern the preparation of directives. This includes the important notion of subsidiarity.

13. These principles are:

• To ensure that regulation is efficient as well as encouraging, not discouraging, innovation.
• To promote competition and ensure that the Community competition rules are fully respected.
• To ensure appropriate levels of consumer protection proportionate to the different degrees of risk involved.
• To respect the subsidiarity and proportionality principles of the Treaty.
• To take account of the European as well as the wider international dimension of markets.

1. Regulatory change always involves a certain leap of faith. We need to apply these principles to each element of regulation in order to determine whether we should be aiming for complete standardisation, for harmonisation at differing degrees or whether leaving national arrangements in place is the right answer.

2. If there is a legislative defect, I would argue that it is because these principles are insufficiently followed. They should be embedded into the legislative process. And they should perhaps be brought into a revised European Treaty.

Are there gaps in our basic supervisory arrangements?

3. How are the current arrangements for supervisory financial soundness coping? Do we have gaps arising from the growth in cross-border groups that must be filled? From my own experience I would suggest that the arrangements for supervising cross-border groups within Europe are pretty robust.

4. It is true that the creation of cross-border operations is a new experience in some parts of Europe. But the phenomenon is not at all new at the wholesale level for larger European banks and where London, for example, has operated for long as the main EU inter-bank centre, though not, of course, the only one. Incidentally, nearly a quarter of the total business of banks in the UK is denominated in euro.

5. Some supervisory developments have been facilitated by the EU’s legislative programme, others stimulated by the political commitment to create a more joined-up regulatory environment. I suspect that we would not have seen a merged entity like Euronext without such a commitment. It would have been more difficult for regulators to oversee such a network in the past, before the basic work on agreeing common approaches to many elements of securities regulation had been done. Indeed, the regulators themselves have formed a network to co-operate jointly in the supervision of the different elements in Euronext-LIFFE.

6. With these kinds of co-operative arrangements already in place, cross border supervision seems pretty robust.

Is there a gap related to the formulation of conglomerates?

7. We hear calls for a new agency to supervise pan-EU conglomerates. But many of the most important groups also have very sizeable operations outside the EU. Within Europe, cross-border branches have for the last ten years been subject to supervision by the home country supervisor and, where there are cross-border subsidiaries, arrangements are in place for exchange of information between home and host supervisors. This information exchange has been supported for many years on the banking side by a very practical and effective committee - the Groupe de Contact - consisting of all European banking supervisors, which can discuss any common issues or problems which may arise and there are analogous groups for securities and insurance. Bilateral MoUs are in place between all relevant pairings of EEA supervisory authorities and the Conglomerates Directive, explicitly designed formally to plug any remaining gaps, including the inclusion of insurance operations and providing for the appointment of a lead supervisor for each group, is ready for implementation.

8. Thus on conglomerates, whether cross-border or not, I feel confident in arguing there should be no gaps. We have arrangements in place already.

Is there a gap in relation to crisis management?

9. If our arrangements for everyday supervision are satisfactory and work well when things are calm, is there a gap in relation to crisis management? Does not the cross-border angle still complicate things? And what about the impact of a cross-border crisis on the payments system and other possible systemic effects?

10. The EU Economic and Financial Committee has reviewed the issues several times. Ministers and Governors have been reassured by its reports on financial stability and crisis management. We are confident that there are sound mechanisms in place. Furthermore, arrangements for co-ordination of crisis liquidity support, if it were to be needed, are in place within the Eurosystem.

11. The EU central banks and banking supervisors meet together regularly in the ECB’s Banking Supervision Committee. It has agreed arrangements for information exchange between the supervisory and central banking functions within Europe whenever and wherever the need arises, precisely to deal with the possibility of systemic disturbances affecting more than one Member State.

12. We are reassured that the main elements to help manage crises have been put in place.

So where is this gap?

13. The interesting question is less whether there is a gap in the legislative, supervisory or central banking arrangements, but what common vision we have for the EU’s single market. How do we, for instance, achieve a single, more or less seamless integrated equities market?

14. In the UK Sir Nigel Wicks has led a group of people in setting out some principles and practices to help in working out how best to forge the way ahead. The Paris-based Eurofi initiative has also sought to plot a way forward. These initiatives have looked at the challenge of the Financial Services Action Plan from different points of view. Both are works in progress. And both are actively soliciting more input.

15. The overall Eurofi vision proposes the ultimate objective of an EU market where there are common rules, standards and procedures. To this end it proposes a Treaty change to enable the establishment of a "European Regulatory and Supervisory System" that could be based on the model of the European System of Central Banks and would effectively introduce identical supervisory arrangements across the Union. It is hard to object to the welcome proposition of Eurofi that EU financial services regulation as a whole needs to be devised and implemented on an integrated, cross-sectoral basis. However, the creation of a new centralised decision-making institution modelled on ESCB lines raises considerably more complex issues than we faced with the creation of the ECB and the ESCB, not least in relation to its governance.

16. The ESCB might perhaps itself be looked to to assume for the role of the centralised policy maker, building on Article 105(6) of the Treaty to add insurance and securities. M de Larosière has said that - like the ESCB - the European Regulatory and Supervisory System should be "independent". Indeed, he implied that this would be a key advance from the present arrangements involving decision-making at the EU level by the Council, Parliament and Commission, with all the democratic checks and balances involved.

17. But is the same concept of independence appropriate for supervision? Accountability is a fundamental issue in relation to supervision. Complete independence in policy-making is increasingly the norm internationally for central banks in their monetary policy function. But, so far as I am aware, it is without precedent for supervision (leaving aside the quite different issue of regulatory decision-making in individual cases).

18. The prospect of a European Regulatory and Supervisory System prompts reflection on the many practical questions. How would it be structured? What would be the reporting lines in the proposed new system? How would accountability function between the system and finance ministries? And how would accountability be provided to the European Parliament and to national parliaments? What sort of relationship would there be with the European Commission? It is difficult to see how this proposal would work or indeed make a significant difference if it did not involve identical implementation and, crucially, enforcement in each member state. This would logically require much greater harmonisation of civil and criminal enforcement powers than currently foreseen elsewhere. And, as I have argued above, the desirability of total standardisation of regulation is, to say the least, doubtful.

19. But I think there is another - bigger – question playing behind these ideas. National governments have a role as rescuer-of-last-resort. At the national level we have principles about the distribution of taxpayers money. Central banks and supervisors cannot provide solvency support. This can only ultimately be provided, once the protection given by deposit compensation arrangements for retail depositors are exhausted, by the relevant fiscal authorities. And centralised fiscal rescue facilities do not exist at the EU level.

20. I do not see any desire or willingness to go down the route of a pan-EU fiscal authority, resourced and able to make such transfers from the citizens of one country to bail out depositors or investors in another. Can we envisage a single EU rescuer-of-last-resort without far more radical centralisation of fiscal decisions than we are likely to be looking at in other parts of the next Treaty Amendment?

21. Fortunately, other mechanisms to deal with the increasing complexity of cross-border business exist. There are networks of national regulators in each of the disciplines - insurance, banking and securities - who are able co-operatively to devise policy, when and as it is required, to handle integration and to deal with the practical supervision of firms and markets wherever they operate within the EU. These networks are being reinforced by their new role in the Lamfalussy legislative process. This process still needs some adjustment here and there, but calls for such adjustment should not obscure the underlying achievement of the pan-European co-operation achieved on a day-to-day basis.

So let me conclude on a further practical note

22. When does harmonisation promote competition and when does it not? What are the costs of doing it, as well as the as the benefits?

23. In the debate about the Prospectuses Directive discussion surfaced about measures which could set maximum harmonisation at levels which could damage competition, particularly globally. They could undermine the sort of super-equivalence that we need to enhance rather than destroy competition.

24. Disproportionate costs are more likely in measures affecting the retail markets. If I am right that the obstacles are not just or principally legislative, then a harmonising regulation could be very costly, but may not deliver much benefit in terms of increased cross-border competition. It may not increase availability or cut the price of financial products.

25. Cross-border mergers or acquisition could be part of the answer. Agreement on a cross-border Takeover Directive, and the disallowing of protectionist policies on the cross-border takeover of financial services firms, could provide the greatest benefits in terms of enhanced competition in both product and price.

26. When we review new legislation to enhance the single market in financial services we need to pay more attention to the tests that will show if the change is necessary. We should also be realistic. There are limits to what the single market in financial services can achieve over the medium and long term. However, this does not mean that there are not areas where great benefits may not still be achieved for both firms and consumers, for borrowers and for investors, with positive consequences for economic growth as a whole. And, as I have outlined above, we have tools to enable us to distinguish which changes in regulation are likely to bring benefits and which not.

27. Under these circumstances, it is a little frustrating that the issue of further regulatory innovation, and perhaps a single European regulator, continues to be raised. But what is clear is that to indulge ourselves now in philosophical debates about future institutional structures may be a luxury, carrying a risk that we take our eye off the ball. So for the time being, as practical people, we at the FSA focus on developing the regulatory network, and on delivering results.