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Scrap the Single Regulator and make way for European supervision Back  
Ray Kinsella argues that it is still not too late to ditch the whole principle of a single regulatory authority for financial services and to support moves for the European Central Bank to have a real role in financial supervision.
The Report of the Implementation Group on the Single Financial Regulator (The McDowell Group) has been ‘on ice’ for about a year. The Group of Experts was established by the Dail, following on an evaluation of failures in governance within the financial sector. The Government’s intentions in regard to institutional arrangements for a single regulator remain to be clarified: whether, for example, the Single Regulator is to be located within a revamped Central Bank or within a new ‘greenfield’ institution. Similarly, the scope and mandate of the proposed new Single Regulator has not been announced; specifically, whether it is to encompass consumer protection as well as prudential regulation. Policy uncertainty is the last thing one wants in the financial sector, more especially within an environment of change and uncertainty. The issue is hugely important: it needs to be resolved.

Reasons to re-think
My argument is that, in this instance, the delay that has occurred (for whatever reason) has, in fact, been fortuitous. Notwithstanding the rigor of the Group’s analysis, the whole project needs to be completely rethought from scratch. There are a number of reasons for this.

The first relates to a ‘gap’ in the governance and regulation of the international financial system. In an environment which is now truly global, and in which market and systems integration will continue to increase, there is, quite simply, no one in charge. The nearest we have to a global regulator is a committee of the Bank for International Settlements (BIS). It has played an absolutely indispensable role in the oversight of international financial stability, but its writ is not universal nor do its recommendations have a binding force except via national authority. The IMF, in the wake of the ‘Asian Crisis’, is acutely conscious of the impact of instability on global macroeconomic conditions, is seemingly aiming to fill this leadership gap, but this would require a change in its statutes. However this issue is resolved, it is clear that a major international regulatory initiative - my guess would be as part of the programme of the incoming post-Clinton US Administration - is on the way. Pre-empting this global uncertainty here in Ireland makes no sense.

Then there is the EU. At the heart of the Maastricht Treaty on EMU, there is a fundamental flaw. This ‘Black Hole’ has to do with Article 105 (of which more below) and will have to be addressed in order to support the ESCB EU-wide monetary policy mandate with appropriate prudential responsibilities. A ‘fudge’ is probable but an amendment of the Treaty is what is really required. Whatever option is adopted, there will be important knock-on implications for the regulatory/supervisory capabilities of the European Central Bank (ECB). To proceed with the Single Regulator at this stage - to second-guess what may come out of the Article 105 issue - would be to risk undermining the future relevance and effectiveness of Ireland’s Regulatory System.

A third reason has to do with rapidly developing internet-based crime and how regulatory authorities should deal with it. The problem is again a global one: the transition to internet banking represents a paradigm shift for national regulators. Law-enforcement agencies around the world are rapidly accumulating experience of new forms of net-based financial crime. The stakes are incalculable.

In this regard, the words of former Bank of England Regulator Brian Quinn - ‘Regulators usually arrive a little breathless and a little late’: - are more than a little chilling.

Much of the experience that is now available on the regulation of internet-based crime was not factored into the discussions of the structure and the mandate of the Single Regulator. This, in itself, would be a sufficient for saying ‘OK - better do this again from scratch and be sure we get it right’. But when one also considers the uncertainty and problematic regulatory environment at the global and EU level, as well as the technological changes impacting on the robustness of prudential regulation - the case for starting over becomes nothing less than compelling. It is important to go back to basics to underpin the strength of this argument.

Back to basics
There are two reasons why the regulation and supervision of financial services are justified. It is useful to spell them out because it provides an insight into how the regulatory/supervisory function is best organised in terms of institutional arrangements here in Ireland.

The first reason has to do with consumer protection. The argument here is broadly similar to that which applies to other key services/utilities, e.g. telecoms. That is, individual consumers are disadvantaged because of a lack of information necessary to make an informed decision. This justifies intervention in the form of regulation, to inform and protect the consumer. The extent of regulation may be a matter of degree. Large corporate customers will be in a better position to make informed decisions on using a service, compared with, say, retail customers. This is reinforced by the fact that certain financial services transactions are hugely important for an individual: e.g. taking out a mortgage. The cost to an individual of such a transaction going wrong is pretty important. That is why the Director of Consumer Affairs’ mandate needs to be strengthened in any future regulatory/supervisory arrangement.

A second reason has to do with the prudent management of institutions in the interests of the stability of the wider financial system, and it has two separate, but related parts. The first part has to do with the need for a credible - and hence independent - external regulation to ensure that depositors’ funds - the very basis of intermediation - are not put at risk because of deficiencies in a firm in e.g. the calibre of management, the quality of internal controls and, more generally, the capacity of the institution to manage (in the broadest sense of the word) risk. Capital adequacy (and, in the case of insurance, solvency margins) play a particularly important role in this regard.

The second part relates to the need to maintain market confidence - in an institution, a market or an exchange - so as to avoid, or mitigate, the social costs (quite apart, that is, from the private losses to share/bond holders) of ‘contagion’, which may follow a collapse in confidence.

And the importance of this prudential role hinges on the crucial role played by institutions within the wider economy - their role in money transactions and the key role of their liabilities - and, also, on the leverage built into the structure of their balance sheet. These qualities make banks uniquely important - and uniquely vulnerable: the consequence of a failure (or even the threat of a failure) generates consequences (‘externalities’) that greatly exceed the private costs of failure. So much for the basic rationale for regulation and supervision which should be built into a robust institutional structure for Ireland. Against this background, it may be useful to develop some of the key points summarised earlier.

Maastricht: regulatory ‘black hole’
The primary influence on Irish financial regulations has been the EU. The Single Market Programme (SMP), in particular, has largely determined the substantive content and scope of national regulation. Having said that, the SMP did not affect existing institutional arrangements in respect of financial regulation.

In Ireland, the Central Bank has in recent years evolved into the de facto Single Regulator (aside from insurance) alongside its primary monetary policy role. It is scheduled to take responsibility for insurance intermediaries later this year: Given market developments (bancassurance), there is a compelling case for the transfer of responsibility for solvency of insurance companies to the Central Bank, just as it supervises capital adequacy for the banking sector.

The introduction of EMU has effected a separation between, on the one hand, the EU-wide jurisdictions of the Single Monetary policy (the domain of the ECB) and national regulatory and supervisory policy (as provided for in Article 105 of the Maastricht Treaty). This dichotomy has further exacerbated the ECB’s lack of capacity in regard to prudential regulation - a ‘black hole’ in the Maastricht Treaty on EMU.

EU policy gaps
The logic of the Euro and the Single Monetary Policy for the EU requires that the ECB should have a substantial regulatory capacity - enshrined proactively in the Treaty - in order to safeguard stability and, where appropriate, to intervene, in order to mitigate the effects of contagion or arising systemic ‘shocks’.

That is not what was provided for in the Treaty. In sharp contrast to the Delors framework for EMU, the provisions of the Maastricht model are tortuous: the basic premise is that responsibility for supervision should remain at the national level, with the ECB playing a minor supporting role. Article 105 (5) assigns to the ECB the task of:
• “contributing to the smooth conduct of national policy pursued by competent authority relating to the prudential supervision of credit institutions and the stability of the system”
This resonates with a recent perspective of the ECB:
• ‘The overall framework for cooperation within the Euro area essentially aims at reinforcing preventive measures against bank fragility.

However, in cases of instability, the same framework can be used to deal with any cross-border implications of such a crises and to limit contagion.

Supervisions stand ready to inform the Euro-system as soon as a banking crisis arises, and the BSC is in a position to address the relevant issues.

The need for a timely exchange of information is essential in order to enable competent national authorities to deal with cross-border implications. (Source: ECB Bulletin, April 2000).

It is clear that the development of policy remains at the national level with the ECB having a purely supportive role, ‘contributing to the… conduct of national policy’. Even in Stage I, it was clear that this was a misjudgment: a black hole at the centre of the EU financial system. The extent of structural change, including increased linkages across the EU that have occurred since then, has reinforced the gap between the national perspective built into the treaty and where the market is at.

More recently, the ECB has moved to address the latent difficulties inherent in its lack of regulatory/supervisory capability. It has, notably, established a Banking Supervisory Committee (BSC) which directly and through sub-groups have identified key issues and how they might be addressed. By bringing together officials from both the ECB and national authorities, it has also strengthened cooperation in financial supervision.

This reactive national, perspective built into the ECB, via Article 105 (5), is wholly at variance with the nature of developments in EU financial markets, and the potential threats they face. These threats include:
• The significant, M&A driven, process of market concentration in banks, insurance and capital markets.
• The development of complex trans-EU (and global) financial conglomerates.
• The significant increase in cross-border transactions, including money market inter-bank transactions created by the Single monetary policy.
• The near explosive growth of internet-based financial service providers and the threat of technological subversion which cannot be addressed, let alone resolved, at a national level.

Each one of these factors reinforces the case for the EU having a substantial responsibility for, and capacity in, prudential regulation. In aggregate, however, these factors constitute a compelling case for a revision of the Treaty, to ensure that the ECB (and, by extension, the EU itself) has the capacity to protect the stability of the markets through which its money policy is transmitted. And, as financial institutions grow, through mergers, into EU (rather than national) entities, there is surely an unarguable case for adapting prudential structures to this new EU-regime.

The Asian Banking crises of the late 1990s, and the Long Term Capital Management debacle, highlighted how crises are now truly global in nature. The international community - including the EU - was caught flat-footed. The New York Fed (which encompasses prudential authority with its monetary policy role) intervened to resolve both crises.

We may not be so lucky next time. The idea that coordination of EU national supervisory authorities (especially where a Single Regulatory may have a double focus of Consumer Protection as well as prudential responsibility) - which is the current situation - is risible. It indicates an obtuseness of the dynamics of (global) financial crises and the clout, leadership and speed of response required to address them. Hence, again, the need for the EU to get its act together and to adapt its capacities (as the IMF is) to the new global paradigm. This requires an amendment of the Treaty rather than waffle about “closer coordination”.

Optimal Regulatory arrangements
The next stage of the argument has a very direct bearing on the mandate and institutional arrangements for the proposed Single Regulator and, also, whether or not we should proceed to its establishment without further detailed consideration.

In addressing this issue there are a number of point to be made. Firstly, there are a wide variety of institutional arrangements in relation to supervision across the Community. In most countries the Central Bank is either the prudential regulator or has a major role. These differences reflect unique national peculiarities of culture and customs. But the more important issue is whether, in principle, one institutional structure is inherently more robust to existing and future challenges and efficient. In addressing this issue, two propositions can be advanced.

The first is, quite simply, that where a Central Bank has responsibility for the implementation and/or the conduct of monetary policy, it should also have responsibility for the stability and integrity of the institutions, exchanges and markets through which monetary policy is transmitted that is my first Proposition.

There are several reasons for this. In the event of a systemic shock, the capacity of the Central Bank to manage the provision of liquidity - to act as lender of last resort - is easier, where it has a close working relationship based on detailed supervisory knowledge with institutions. Equally, in carrying out its monetary policy role, its prudential responsibilities provide important information, which facilitates the conduct of monetary policy.

My second proposition is that consumer protection and prudential regulation are quite distinct disciplines. They may, of course, overlap. Consumer protection is more easily assured when a bank is well capitalised and appropriately regulated.

Transparency and accountability are more easily ensured - and potential conflict of focus avoided - when consumer protection is managed separately from prudential regulation.

Consumer protection is focussed on micro issues, such as conduct of business rules, whereas prudential regulation is concerned with macro, or systemic, effects: The consequence of deficient prudential regulation (as we have seen time and time again in the 1990s) are potentially enormously costly. They are also highly time-sensitive: the impact is now and is transmitted with biological sensitivity throughout highly integrated markets. Finally, the skills and competences required in each discipline are quite distinct.

Global governance
There is a widening gap in global financial governance. This is not to say that there is not intensive cooperation among prudential authorities within, and across, markets. There is. There has been considerable progress in developing sets of principles and Codes of Best Practice. Moreover, there is an intensive dialogue between the leading banks and the regulatory authorities in regard to utilising new risk metrics, which will contribute to prudential stability. These are important developments.

But there is a growing recognition that a legitimate, accountable, global system of prudential regulation simply does not exist at present. The NY Fed held the line when LTCM, and the Asian Bank crises, threatened global financial - and macroeconomic - instability. But they may not next time. Some form of major initiative, possibly involving the IMF in cooperation with the BIS, is inescapable. And soon.

The ECB, for its part, needs to participate in this debate as a principal. There are forceful arguments for the ECB accepting responsibility for EU-wide prudential regulation as a response to market developments that could threaten the stability of the EU-system and, equally, as natural complement to its primary monetary policymandate.

No short cuts
Against this background, Ireland’s Single Regulator initiative should be deferred. There are no short cuts to stability. Instead, the Government should - for all of the reasons set out above - establish a Banking Commission (there are important precedents in Ireland’s financial history) to address appropriate forms of regulation within the broader context of structural change in Ireland’s financial markets. At the same time, it should publish a consultative paper, which could serve as the basis for much needed rigorous debate and consultation (external as well as domestic) on the issues. The 1990s have seen a veritable deluge of financial/supervisory legislation in Ireland. The work of a Banking Commission would provide time to address the process of consolidating this plethora of legislation and greatly contribute to the operational effectiveness of whatever institutional arrangements for regulation are put forward by the commission.

And Finally…
My own evaluation is that what is required is to:
• retain prudential regulation within the Central Bank for all financial institutes, markets and exchanges. While commissioning a fundamental review of how internal structures of the Bank should be reconfigured (Mission - Principles - Objectives - Instruments - Skills/Competencies - Procedures - Controls - Oversights) to accommodate this new mandate.
• extend and develop the Office of the Director of Consumer Affairs (it also needs a new name) to encompass Consumer Protection across all (financial) products and services.
• a co-ordinating Financial Compliance Directorate, supported by investment in MIS systems, to facilitate information flows.
• establish a consultative Financial market forum, chaired by the Secretary General of the Department of Finance with a brief to bridge the regulatory market divide and to ensure worldclass standards (informed by market investment in this field) in riskmetrics, and also to evaluate the strategic implications for Ireland of ongoing structural change in EU and global financial markets and architecture.
• a programme of consolidating and rationalising financial services regulatory legislation, within an electronic template, as an urgent priority.

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