Safety net in the European Union - challenges for the new members

A R G U M E N T A OECONOMICA N o 1-2(17)2005 P L ISSN 1233-5835

Małgorzata Iwanicz-Drozdowska

SAFETY NET IN THE EUROPEAN UNION -

CHALLENGES FOR NEW MEMBERS

T h e p a p e r is devoted to the safety net in the European U nion w ith special interest on issues im p o rta n t for the new EU M em b ers. T he author analyzed th e current structure o f the safety n et in 25 countries and p ointed out the differences and th e w eaknesses o f ccrtain solutions. T h is analysis is followed by th e presentation of the p o ssib le future scenarios o f the changes in th e safety net with the stress on the need to reduce the p o tential for contagion effect.

K e y w o r d s : regulation, supervision, d ep o sit guarantee, financial stab ility

INTRODUCTORY REMARKS

T here is no consensus in the economic literature how to regard a safety net. Is that a remedy for keeping banks safe and sound or is that a poison for the m arket power and its philosophy. Here we treat the safety net as a fundam ental part of the financial infrastructure and w e are not going to discuss the pros and cons for establishing it. In m ost countries around the world the existence of the safety net is a fact. Though w e need to keep in mind that a safety net for banks is difficult to design and adm inister because it has the conflicting objectives o f protecting bank custom ers and reducing banks’ incentives to engage in risky activities (D em irguc-K unt, Huizinga, 2000). T his is also the case in the enlarged European U nion, where safety nets in all 25 countries are designed differently and particular countries may have different priorities for the future solutions in that area.

T he safety net is defined here as all the institutions and regulations established to limit the risk in the sector of the financial intermediaries (within banks). It embraces central bank (only for banks) as the lender of the last resort, regulatory and supervisory authorities (in the case of integrated supervision - an authority) to safeguard safety and soundness, as well as consum er protection schemes (in the case of integrated protection - a scheme) to maintain consum ers confidence in the providers of financial services.

T h e p u rp o se of this p a p e r is to review the c u rre n t structure of the safety n e t across EU c o u n trie s and discuss the b e st solutions for the fu tu re in teg rated European m a rk e t with special a tte n tio n to the banking sec to r an d with a stress on the problem s that new E U m em ber countries may fa c e . The structure and ro le o f the central b an k s, although they are an im p o rtan t part of the safety net, shall not be d isc u sse d here, since th eir ta sk to provide liqu id ity is explicitly defin ed and com patible in E U -25.

1. CURRENT STRUCTURE OF THE SAFETY NET

B e lo w we shall elab o rate on the structure o f th e supervisory and re g u la to ry authorities as w ell as the structure o f the consum er p ro te c tio n . In both areas, b an k s shall be treated as th e leading financial in te rm e d ia rie s, since th e ir sta k e in financial se rv ic e s market is p re v a ilin g . Thus the main fo c u s will be on the so lu tio n s applied for banks.

1.1. Supervision and regulation

S u p e rv isio n and regulation ov er banking a c tiv itie s in the EU are based on three pillars (W eltek e, 2000):

• h arm onization of the p ru d e n tia l regulations,

• a ssig n in g the authority to supervise banks at n a tio n a l level, • b i- and m ultilateral co -o p era tio n .

W e u sed the notion „ su p e rv isio n and regulation o v er the banking a c tiv itie s ” instead of “b a n k in g supervision and re g u la tio n ” . It was aim ed at stressing that in m an y EU countries th e re is an integrated su p e rv isio n over the fin an c ial m arket and fin a n c ia l interm ediaries (b a n k s, insurers, brokers, asse t m anagem ent c o m p a n ie s). Due to the fact that b a n k s are perform ing w ith in the holding s tru c tu re s, the assessm ent o f the b a n k s ’ safety and so u n d n e ss should be c o n d u c te d together with the a sse ssm e n t of other in stitu tio n s being a part o f th e holding in order to a v o id o r m inim ize the c o n ta g io n effect. The c o n ta g io n effect consists o f tra n sm ittin g some tu rb u le n c e from one country to the other (cross- b o rd e r co n tag io n ) or from o n e en tity from a ce rtain se c to r to another in the sa m e sector (in tra-secto r co ntagion) or b etw e en different sectors (c ro ss-se c to r contagion). T he developm ent of the c r e d it derivatives and

se c u ritiz a tio n caused that the m ost im portant b a n k in g risk - the credit risk - w a s also transferred to o th e r financial in te rm e d ia rie s.

B oth at the European (K re m e rs et al, 2003 and H ein em an n , Schuler, 200 2 ) an d local (P aw łow icz, 2 0 0 3 ) levels there are d iscu ssio n s on the fu tu re o f the supervision o v e r banking activities an d the regulation o f m u ltin a tio n a l banks (C a lz o la ri, Loranth, 2005). T h e m ain question is w h e th e r the integrated fin a n c ia l m arket in the EU sh o u ld be supervised at a lo c a l level or should th e re be a pan-E uropean supervisory body. A n o th e r question is how to p ro te c t consum ers in the in teg ra te d financial m arket in order to reduce h o m e and host country c o n flic ts (Eisenbeis, 2004).

A n sw e rs to these qu estio n s are extrem ely im p o rta n t both for new EU m em b er countries and for th e accessing countries. T h e reason is quite sim p le - the share of fo re ig n capital in fin a n c ia l sectors (banks, b ro k e ra g e , insurance) o f th ese countries is sig n ific a n t. E .g., in Poland fo reig n investors control a b o u t 65% of banking s e c to r ’s assets, in L ith u a n ia - 78% , but in E sto n ia - 99% (for fu rth e r d e ta ils see table 1).

T abic 1

A s se ts in financial sectors co n tro lled by foreign capital in selected EU countries C o u n try A ssets c o n tro lle d b y

fo reig n c a p ita l (% ) D enm ark 0 Finland 6 Germ any 4 G reat Britain 46 G reece 11 Italy 6 Luxem burg 95 N etherlands 2 Portugal 18 Spain 9 C yprus 13 Estonia 99 Hungary 89 Lithuania 78 Poland 65 Slovenia 21

S o u rce: Schocnm aker, O osterloo, S ep tem b er 2004

S in c e the intra-sector (e.g. b an k in g ) regulations a re harm onized, this is o nly to m ention that th ere is a kind of E uropean “ p a s s p o rt” and many re g u la tio n s related to risk -ta k in g and risk m o n ito rin g . T he European p a ssp o rt m eans that if the lic e n c e is issued by any lo cal authority, any

fin a n c ia l interm ediary co u ld provide services via branches set up in o th e r co u n trie s or on a cro ss-b o rd er basis. T h e m ost im portant re g u la tio n s regarding banks are defined in D ire ctiv e 12/2000 and CA D , i.e. e x p o su re limits and ca p ita l adequacy. Due to th e adoption of C apital R e q u ire m e n ts D irective (C R D - this is Basel II tran sp o sitio n into the E u ro p e a n regulatory fra m e w o rk ) by the E u ro p e a n Parliam ent in S e p te m b e r 2005, these D ire c tiv e s were am ended. C R D will com e into fo rce fro m 1 January 2007.

M o re im portant seem s to be the structure o f th e supervision. In E u ro p e a n countries there are th ree main types o f th e institutional form o f th e sup erv isio n (Iw anicz-D rozdow ska, 2004):

• stan d -a lo n e (solo) su p e rv isio n - each se g m e n t o f the financial m a rk e t has its own su p erv iso ry authority; the su p e rv iso ry authority for the b a n k in g sector is eith e r th e independent in stitu tio n or part of the c e n tra l bank; co-operation a m o n g supervisors is p o ssib le ;

• m ix ed supervision - th e supervisory a u th o rity responsible for b an k s is also supervising o th e r types of financial in term ed iaries, except in su ra n c e com panies and sim ila r; this supervisory a u th o rity is either an in d e p e n d e n t institution or is a part of the ce n tral ban k ; co-operation w ith o th e r supervisors is p o ssib le ;

• in teg ra te d supervision (o n e supervisor fo r th e w hole financial m a rk e t), w hich is either the independent institution o r is a part of the ce n tral bank.

In 7 out of 15 “old” E U m em b er countries th e re is the integrated su p e rv isio n model (A ustria, B elgium , D enm ark, G erm any, Ireland, S w e d e n , U nited Kingdom , ta b le 2). This type o f su p e rv isio n is gaining in p o p u la rity . In the last few years such ty p e o f supervision was in tro d u c e d in 4 countries (A u stria 2002, B elgium 2004, Germ any -2 00 -2 , Irelan d - -2003). In th e rem aining “old ” E U m em ber countries th ere a re m ixed supervisors w ith in the central b a n k s. An interesting e x a m p le is the N etherlands, w h e re in 2004 the re sp o n sib ility for the p ru d e n tia l supervision o f fin a n c ia l interm ediaries (are the financial in te rm e d ia rie s reliable?), e x c e p t insurers and p e n sio n funds (institution re sp o n sib le for their su p erv isio n is Pensioen- & V erzek erin g sk am er), was a ssig n e d to the central b an k , while the au th o rity fo r supervising the c o n d u c t o f business (are the financial in term ed iarie s managed in a p ro p e r w ay and do they h av e p ro p e r inform ation at disp o sal?) was left in the h an d s o f a separate in stitu tio n (A utoriteit F in a n c ie le M arkten).

A m o n g 10 new EU m e m b e r countries the sta n d -a lo n e supervision b e in g a part of the ce n tral bank is prevailing (6 countries: C yprus, C zec h R epublic, L ith u an ia, Poland, Slovak R e p u b lic , Slovenia). In o th e r new m em ber c o u n trie s there are in teg rated supervisors located w ith in th e central bank (e x c e p t Estonia).

T able 2

T ypes of supervision o v e r the banking activities in the E U countries

T y p e o f su p erv isio n N u m b e r o f “ old ” EU c o u n tr ie s

N u m b e r o f “ n e w ” EU c o u n tr ie s

T otal n u m b er

S olo (stan d -alo n e) - 6 6

M ix ed supervision 8 - 8

In teg ra te d supervision 7 4 11

S o u rc e : central banks’ and su p e rv iso ry authorities w ebsites; o w n preparation

A c c o rd in g to our p re v io u s research (Iw an icz -D ro z d o w sk a, 2004) the s tru c tu re o f the financial m a rk e t was not d e te rm in in g the type o f s u p e rv isio n . For exam ple, in such countries lik e France and the N e th e rla n d s where the in su ra n c e market is very w ell developed there w as a m ixed supervision. W h ile the integrated su p e rv isio n model w as a p p lie d in those co u n tries w h ere the insurance m ark et was not so stro n g .

A s p o in ted out above, th e institutional form o f su pervision over the b a n k in g activities varies a c ro ss the EU c o u n trie s. This creates an o b s ta c le to introducing a u n ifo rm e d and ce n tralized form of supervision o v e r th e banking activ ities an d - in a broader se n se - over the w hole fin a n c ia l m arket. H ow ever, th e institutional s tru c tu re o f the safety net is not th e only barrier for s e ttin g up pan-E uropean su p erv isio n over the fin a n c ia l m arket. B eside institu tio n al h a rm o n iz a tio n there are the fo llo w in g (Iw an icz-D ro zd o w sk a, 2004):

• re g u lato ry - stan d ard iz ed prudential re g u la tio n s;

• an aly tical - a sta n d a rd iz e d method of a s s e ss in g banks in order to u n d e rta k e appropriate a c tio n s in a clear and u n e q u iv o c a l manner;

• inform ation - a stan d ard iz ed m anner o f inform ing m arket p a rtic ip a n ts about the c o n d itio n o f the banking se c to r.

A s m entioned before, th e level of the re g u la to ry intra-sector h a rm o n iz a tio n is high, a lth o u g h Basel II (C R D ) m ay introduce som e d is ru p tio n s because o f th e sp a c e left to su p e rv iso rs for introducing

lo c a lly -o rie n te d solutions. T h e cro ss-secto r h arm o n iz atio n is low due to the fa c t th at the way in w h ich the risk is a d d re sse d in insurance b u sin ess is not com parable to that used for the b an k in g sector and in v e stm e n t com panies. In o rd e r to achieve th e h ig h er level of h arm o n iz atio n it will be n e c e ssa ry to create m easu res o f financial risk c o m p a ra b le between individual sectors of the fin a n c ia l m arket, which w ould fa c ilita te a creation o f a standardized m a n n e r of m easuring capital ad e quacy and e x p o su re limits. Solvency II - a project to m easure th e solvency in the in su ran c e sector in a w ay sim ila r to Basel II is a g o o d starting point. A c c o rd in g to the recent a g e n d a , it will com e into fo rc e in 2010.

T h e level of both an a ly tical and inform ation h arm onization was asse sse d as low. In order to p ro p e rly execute su p e rv isio n it is necessary to in c re a s e analytical h arm o n iz atio n , which w o u ld facilitate a c o m p a ra b le assessm ent o f individual institutions, as well as the fin an c ial conglom erates. It is particu larly im portant to standardize the e v a lu a tio n grades, whilst sta n d a rd iz in g the m eth o d o lo g y of evaluation is up fo r d iscussion, providing th e fundam ental p rin c ip le s are the same.

It is d iffic u lt to talk abo u t an integrated fin an c ial m arket w ithout u n ifo rm inform ation about it. T h e status quo is not satisfacto ry in that field. T h e frequency of p u b lic a tio n of in fo rm atio n concerning the c o n d itio n o f the banking se c to r and other sectors o f th e financial m arket should be recom m ended at the EU level. The sta n d a rd iz e d m anner of p re se n tin g this inform ation as fa r as the basic d a ta is concerned, i.e. fin an cial profits, assets, sh a re h o ld e rs ’ equity, etc. fo r the individual seg m en ts o f the financial m ark et is also n e c essary to increase its tra n sp a re n c y .

1.2. Consumer protection

C o n su m e r protection in th e financial services in d u stry should consist o f p ro te c tin g custom ers in th e case o f the fa ilu re o f any financial in te rm e d ia ry (anti-bankruptcy protection). This re q u ire m e n t is fulfilled for th e banking sector (d e p o sit protection) an d fo r investm ent c o m p a n ie s (investors co m p en sa tio n ). The situation is different in the in su ra n c e industry, in which anti-bankruptcy p ro te c tio n is rare and not fo rm a liz e d in EU regulations. A s m entioned ab o v e, w e shall focus on the s o lu tio n s adopted for the b anking industry as th e main sector of fin an c ial interm ediaries in E u ro p e .

O n 3 0 M ay 1994, the E u ro p e a n Parliam ent an d th e C ouncil passed the D ire c tiv e on deposit g u aran tee schem es ( 9 4 / 19/EC). The m ain o b je c tiv e o f this D irective w as to protect th ro u g h o u t the European U nion th e depositors o f all cred it institutions an d to safeguard the s ta b ility o f the banking sy ste m as a whole.

T h e E C Directive set th e m inim um re q u ire m e n t for the deposit g u a ra n te e - 20,000 euros p e r d ep o sito r with at le a st 90% coverage from the sc h e m e (i.e. up to 10% o f depositor own re sp o n sib ility , so-called c o -in su ra n c e ), the b asic definitions and so m e organizational re q u ire m e n ts for the schem e.

T h e m ost im portant issu e s regulated by th e D irective are the fo llo w in g :

• E ac h M em ber S tate sh all ensure that w ith in its territory one or m o re deposit-guarantee sch e m e s are in tro d u c e d and officially re c o g n iz e d . The M em ber S ta te may exem pt a c re d it institution from e n te rin g into the d e p o sit-g u aran tee scheme if the in stitu tio n belongs to a sy ste m w hich protects d e p o sito rs at least the sam e lev el.

• T h e schem es shall be in a position to pay d e p o sits within three m o n th s from the date o f d e c la rin g them as u n a v a ila b le . In special cases this tim e lim it may be e x te n d e d to a m axim um o f th re e m onths.

• S o m e depositors or d e p o sits may be ex c lu d e d from the guarantees or e n jo y low er ones. T h ese are deposits e.g. fro m fin an cial institutions, g o v e rn m e n t and central ad m in istrativ e a u th o ritie s, local authorities, p e n s io n and retirem ent fu n d s, and credit in s titu tio n ’s own directors, m a n a g e rs and holders o f at least 5% of its c a p ita l, as well as n o n ­ n o m in a tiv e deposits.

• T h e credit institutions shall make av ailab le to present and future d e p o s ito rs the inform ation necessary for th e id en tificatio n of the d e p o sit-g u a ra n te e schem e by which the in s titu tio n ’s deposits are c o v e re d .

T h e D irective regulated th e fundam entals o f d e p o sit insurance, but th e re w e re several issues le ft to national re g u la to rs. T his caused a w ide v a rie ty o f differences a c ro ss countries, which is u n fav o u rab le from the fin a n c ia l m arket integration perspective.

T h e re are two m ain a sp e c ts that should b e identified from the c o n s u m e r protection p o in t o f view , i.e. the level o f protection and the re lia b ility o f the schem e (Iw an icz-D ro zd o w sk a, 2 0 0 5 ).

T ab le 3

Level o f p ro tectio n and its relation to G D P

C o u n t r y C o v e r a g e l im it to GDI* p e r c a p ita C o v e r a g e lim it in eu ro s

A u stria 72.75% 20,000 B elg iu m 76.90% 20,000 C y p ru s 150.94% 20.000 C zech R e p u b lic 344.71% 25,000 D e n m ark 124.03% 40,363 E sto n ia 119.71% 6,391 F in lan d 91.41% 25,000 Fran ce 276.40% 70,000 G e rm a n y 77.51% 20,000 G reat B rita in 209.14% 52,000 G re e ce 144.72% 20,000 H u n g a ry 341.92% 23,694 Ireland 67.90% 23,000 Italy 456.33% 103,291 L ith u an ia 333.31% 14,481 L u x e m b o u rg 38.34% 20,000 L atv ia 231.32% 9,000 M alta 210.14% 20,000 N e th e rla n d s 71.29% 20,000 Poland 449.07% 22,500 P o rtu g al 196.16% 25,000 S lovak R e p u b lic 402.67% 20,000 S lo v e n ia 185.77% 21,282 Spain 109.77% 20,000 S w ed en 98.39% 33,063

S ource: B ank G uarantee Fund o f P o la n d , Eurostat; own preparation

As presented above (table 3), the level of consum er protection differs among E U countries at both the nom inal level and the relative level (to GDP per capita). In new EU M embers the relative level of protection is high in com parison to most of the highly industrialized EU-15 countries. In October 2004, the European Commission opened the discussion on the scope of the review o f the Directive. The obligatory item for review is the level of the guarantees. Even without the in-depth analysis of the d ata included in table 3, let us draw a conclusion that it would be difficult to find a new optimal level o f guarantees. New EU countries have coverage hig h er than twice GDP per capita (277% for EU-10). Additionally, three B altic States enjoy a transitional period for reaching a 20,000 euros limit (till the beginning of 2008). It seem s that from the consum er protection point o f view “old” and “new ” EU M embers may have different objectives for setting the guarantee limit.

T ab le 4

Some features o f th e d e p o sit guarantee schem es in th e EU

N u m b e r o f N u m b e r o f N u m b e r of schem es C o u n tr ie s risk m in im iz e r schem es w ith ex w ith risk -b ased

s c h e m e s ante fu n d in g p re m iu m s

EU - 2 5 , and within: 8 18 6

EU - 10 2 8 0

S o u rce: B ank Guarantee Fund o f P o lan d ; own preparation

T he reliability of the deposit guarantee scheme m ay be linked to its financial strength and powers. T he financial strength is based on:

• the type of financing - ex-ante (funds accum ulated by the guarantee schem e) o r ex-post (funds retained in banks, but being called upon in case of the b a n k ’s failure);

• the way of premium calculation - risk-based prem ium s (differentiated according to the risk of the individual banks) or flat premiums (not differentiated)

In U E countries the ex-ante financing is prevailing (see table 4). It was im plem ented in 18 countries, w hile mixed financing in 2 countries (Great Britain and Poland), and ex-post in 5 countries (Austria, Italy, Luxembourg, N etherlands and Slovenia).

For the financial stability and reliability of the guarantee scheme the desirable solution is ex-ante o r mixed financing. B oth of them allow accum ulating certain financial resources for probable future deposit payouts. The financial strength of the guarantee scheme should be the focus for all the safety net players and the m em bers o f the scheme. It is also important for the guarantee scheme to have access to emergency financing (from the central bank or from the market). Explicit emergency financing is available in 20 out of 25 countries in the EU, except Italy, Luxembourg, Portugal, Slovenia and Sweden.

B oth ex-ante and mixed financing require setting up a target fund, which varies across EU countries from 0.5% (Belgium) to 10% (Finland - Finland is not typical; the typical level o f the target fund ratio is 3% ) of guaranteed deposits. Sometim es the target fund is set in the nom inal value (Denmark), which is rather less flexible.

The pow ers of the schemes also differ across countries. In 8 of them the schemes are risk-minimizers with the power to intervene and to minimize the risk for the guarantee scheme w ith the use of the least lost rule. Having such broad pow ers is an advantage for financial stability — even with some

lim ita tio n s related to the m oral hazard - due to th e fa c t that there is an in stitu tio n which has been assig n e d a task of su p p o rtin g the financial re s tru c tu rin g of the bank. T h e opposite model o f th e pow ers is a p ay­ box sy ste m , responsible only fo r deposit payouts.

T h e re is one more issue stric tly connected w ith th e reliability of the sch e m e , i.e. public aw areness. C onsum ers need to b e acquainted with the ru le s o f consum er p ro te c tio n in the area o f fin a n c ia l services. To this aim the guarantee sc h e m e shall conduct p ro p e r inform ation c a m p a ig n s, not only at the b eg in n in g of its o p e ra tio n s, but keep the c u sto m e rs inform ed p erm an en tly , especially in ca se o f any changes in re g u la tio n s.

In th e case of investor co m p en sa tio n , regulation w as adopted in 1997 (9 7 /9 /E C ) and the level o f c o v e ra g e and principles o f p ayout are sim ilar to th o se presented for the b a n k in g sector. A d iffe re n t solution was ad o p te d fo r the insurance in d u stry . First of all, th e E U regulations in that a re a regard only m otor in su ran c e (from D irectiv e 72/166/E E C to 5lh M o to r Insurance D irective 2 0 0 5 /14/EC). T he p u rp o se of M otor In su ra n c e D irectives is to e n su re the free m ovem ent o f vehicles in the EU. T o so m e extent those re g u la tio n s protect c o n su m e rs, but not in the an ti-b a n k ru p tc y sense. T hey p ro v id e protection to v ic tim s of accidents, e s p e c ia lly those caused by u n id en tified or u n in su re d vehicles. Only a few c o u n trie s (M onkiew icz, 2 0 0 5 ) provide a n ti-b a n k ru p tc y protection for th e p o licy holder, at least fo r m otor vehicles co m p u lso ry policies. In E U -15 th e se are: France, G re a t B ritain and S pain. S u ch a solution was also a d o p te d in Poland (fo r th e coverage of life in su ran c e policies as w ell). T h is situation creates an im balance in th e sc o p e of consum er p ro te c tio n in certain segm ents o f the financial m ark e t. Due to grow ing c o n s u m e r aw areness, the lack o f coverage for life in su ran c e policies in the c a se o f insurer b ankruptcy m ay reduce the s h a re o f this financial asse t in th e savings portfolio.

T h e institutional structure o f regulation and su p erv isio n has been e la b o ra te d on in section 2.1. W ith reference to c o n su m e r protection sc h e m e s, the question arises if any changes are n e c e ssa ry in the future. F irst o f all, we can state th at the current in stitu tio n al structure of the g u a ra n te e schem es is less d ev e lo p e d (see table 5 fo r d etails) than in the field o f the regulation and superv isio n . The a sse ssm e n t of being less d e v e lo p e d is related to the ev o lu tio n path of the fin a n c ia l market in the EU , w h ich is to be the in teg ra te d one.

T abic 5

Institutional stru ctu re o f the guarantee schem es in th e E U

C o u n tr y S ta n d - a lo n e g u a r a n te e sc h e m e M ixed g u a r a n te e schem e In teg ra te d g u a ra n te e schem e EU - 25, a n d within 18 6 1 EU - 10 8 2 0

S o u rce: B ank Guarantee Fund o f P o la n d ; own preparation

T here is only one integrated guarantee scheme in the EU (in Great B ritain), but all around the w orld there are a total o f two (except Great Britain also in Korea). Six schem es are mixed ones (i.e. combine deposit guarantee and investors’ com pensation). These are: Belgium, Denmark, Estonia (also pension funds), Lithuania, France and the Netherlands. In our opinion the institutional structure of the consumer protection shall be related to the structure of regulation and supervision in the integrated European financial market.

2. THE FUTURE AND THE CHALLENGES FOR THE SAFETY NET IN THE EU

J.M . Krem ers et al (2003) defined the nine basis models for the supervision and regulation over the financial market, w hich is illustrated in table 6.

T able 6

M odels o f supervision o v e r the financial m arket in th e EU L o c a l c r o s s - s c c t o r i n t e g r a t i o n / C r o s s - b o r d e r i n t e g r a t i o n I. S e c to r II. C ro s s-s e c to r - fu n ctio n al* I I I . C ro s s-s e c to r - in te g ra te d * * A. D e c e n t r a l i z a t i o n a n d c o - o p e r a t i o n C o-operation in sector co m m ittees C o-operation in functio n al com m ittees C o -o p eratio n am ong local integrated su p erv iso rs B. C o - o r d i n a t i o n C o-ordination a m o n g local sector supervisors

C o-ordination am ong local functional supervisors C o -o rd in atio n am ong local integrated s u p erv iso rs C . C e n t r a l i z a t i o n European sc c to r supervisors E uropean functional supervisors E u ro p ean inlegrated s u p erv isio n

* - m e a n s separate institution for p ru d en tial supervision and for the con d u ct o f business ** - m e a n s one supervisory au th o rity o v e r the financial m arket.

T he above models could be treated as a framework fo r defining the future m odel o f both supervision and consum er protection in the EU, The status quo for supervision is described by model A-I, but - as mentioned before - the integrated supervision m odel was applied in 11 out o f 25 EU countries. So that is not a “pure” A-I m odel. After the adoption o f the Lamfalussy process, co-operation on the EU level is a sector one:

• for the banking industry, it is the EB C (European Banking C om m ittee) supported by the CEBS (Committee o f European Banking Supervisors);

• fo r the capital market, it is the ESC (European Securities Committee) supported by the CESR (C om m ittee of European S ecurities Regulators);

• fo r the insurance and pension fund industry, it is the EIOPC (E uropean Insurance and O ccupational Pensions S upervision Committee) supported by the CEIOPS (Com m ittee of E uropean Insurance and O ccupational Pensions Supervisors).

T hus, there is an asymmetry betw een the integrated m odel at a local level and secto r model of co-operation at the EU level in those 11 countries. The current structure of the supervision authorities in EU countries as well as co­ operation at the EU level appear to be not adequate to the challenges which are deriving from the possible contagion effect, risk shifting and the integrated financial market.

In the case of consumer protection, status quo is also described by A-I, except G reat Britain.

T he fundamental question is what should be the target model for the safety net for the EU. Finding the right answer to that question is important for academ ics, bankers, as well as for decision m akers. However, defining objective criteria for finding an optimal solution seem s to be an extremely difficult task. As the history o f banking and financial crises showed, most of the ch an g es in the regulatory structure were introduced after any kind of unexpected event or shock. T he European financial m arket has been stable for a very long time, except the cases of transformation crises in many EU- 10 countries and some distress in the banking sectors in Spain, Finland and Sw eden. Till now, there has been only one case of cross-border problem related to the BCCI affair, after which the D irective on consolidated supervision was adopted. R egulators and decision m akers seem not to be w illing to introduce any radical changes in the structure o f the safety net because the current structure has not shown so far any m ajo r weaknesses.

A s a proper criterion for assessing models described in table 6 we found the adequacy of the structure o f the safety net to the structure of integrating financial market (1) on a cross-sector basis and (2) on a cross-border basis. T here is also a limitation in the form of national interests. We need to point out that the goal is to address the problems that m ight occur in the future in the integrated financial m arket, especially in new m em ber countries.

O n ly three out of nine basis models fulfil the criterion of adequacy on a cro ss-secto r basis. These are: A -III, B-III and C-III. If the financial market in the E U is integrated on a cross-sector basis in the future, the only adequate structure is integrated supervision. The introduction of local integrated supervision and consumer protection in the EU w ould be consistent with the cro ss-secto r integration of the financial market at the EU level. The target m odel fo r each country should then be the integrated supervision model, but the schedule for im plem entation should be adequate to the specific features and state o f the local financial m arkets. The efforts m ake to centralize such a decision might destabilize the financial markets. T hus, the examination of the safety and soundness o f the financial market as w ell as the quality of supervision in each segm ent o f the financial m arket should precede the introduction of integrated supervision. Integrated supervision is essential due to the fact that banks - especially the big ones of system ic importance - are a part o f the financial conglom erates. Types: A-II, B -II and C-II are less adeq u ate to the integrated - on a cross-sector basis - financial market and types: A -I, B-I and C-I need to be rejected.

W ith regards to cross-border integration, the adequate models o f supervision are: C-I, C-II and C -III. Less adequate are: B-I, B-II and B-III and the remaining models have to be rejected.

T able 7

M odels acccpted for cross-sector integration (striped) and for cross-border integration (gray)

S o u rce: ow n preparation

A ccording to our criteria, only C-III - European integrated supervisory body and consumer protection schem e - fulfils both o f them . But this model w ould b e very difficult to agree upon at the EU level. T h e principal obstacle is the political willingness to leave capital control over local financial m arkets to local capital. A ccording to Boot (1999) the local financial

interm ediaries are protected from take-overs by foreign capital. This is the case not only in those countries, w here the governments com m it easily on banking sector issues (e.g. F rance, Italy), but also in those where the governm ent does not intervene in the banking sector (e.g. T he Netherlands). This view is supported by the fact that cross-border m ergers and acquisitions have been rather rare, except fo r the case of the N ordea group and U nicredito with HVB. Setting up a single supervisory authority would deprive the governments o f the power to protect local financial interm ediaries from foreign capital control.

N ational interests as a lim itation undermine the argum ents for C-III model implementation. C ross-border integration seems, in our opinion, to be more politically sensitive than cross-sector integration, upon which the market participants decide them selves. We decided to treat cross-sector integration as more important. T hus, for the m edium -term perspective, the target m odel should be B-III - the co-ordination am ong local integrated supervisors and consumer protection schemes. This m odel seems to be a good com prom ise. It was adequate for cross-sector integration and less adequate fo r cross-border integration.

As pointed out before, in new EU member states the sector of financial interm ediaries is controlled by foreign capital. From this perspective the most im portant factor affecting financial stability is the potential contagion effect. Is m odel B-III appropriate fo r minimizing the contagion effect?

T he contagion effect should be analysed with regard to two types of shocks: m acro (Staub, 1999) and micro (de Brandt, Hartmann, 2000). M acro-shocks are resulting from the economic dow nturn or other factors like: interest rates, foreign exchange rates, and prices o f securities. Micro­ shocks could be transmitted w ith the use of two channels, i.e. information channel (psychological contagion) or exposure channel in the inter-bank m arket or in the payment system (domino effect). One m ore channel should be identified, i.e. significant capital stakes’ channel.

T he cross-sector contagion is to result e.g. from using the same logo. The lost o f trust could be transferred to other entities even if they are not “guilty” (psychological contagion).

A ccording to Schiiler (2002) the risk of cross-border contagion has considerably increased during the last 15 years in E U countries, which supports the idea of regulating and supervising financial market at the EU level. H ow ever, the author has not formulated any proposals.

In th e case of cross-border contagion it is w orth analyzing the capital stakes channels. The two types o f risk of transferring that contagion shall be distinguished:

• subsidiary transferring risk to parent company, • parent company transferring risk to its subsidiary.

T h e first type of risk has been already regulated at the EU level. There is a supervisory body responsible for the consolidated supervision of the whole group, and the supervisory authorities from the host countries are obliged to provide the home country supervisor with all the necessary information. The ow nership structure in the financial intermediaries sector in new EU countries put pressure on the second type of risk. In P oland this problem was discussed mostly by Paw łow icz (2003), who underlined that there is a potential for the nationalization of losses and internationalization of profits.

N one o f the analyzed m odels is dealing explicite with the contagion effect, so we need to define additional instruments for solving that problem. O ne solution worth recom m ending is giving to the local (host) supervisors som e additional tools to intervene if the financial standing or the activities of the parent company could destroy the situation o f the subsidiary. To this aim , th e local supervisors should have adequate access to information on the parent com pany and its risks.

T h e other solution is setting up a pan-European additional supervisory authority over the m ultinational financial holdings. T his would be reasonable only in cases where the countries in which the foreign capital in financial interm ediaries sector prevails had an adequate representation in decision m aking bodies in a position to protect their interests. In the case of lack of adequate representation this solution seems to be ineffective for new EU m em bers.

T h e structure of consum er protection should follow the structure of supervision over the financial market also with special attention to the reduction of the contagion effect. To this aim, the review of home country and host country deposit guarantee schemes responsibility is necessary. A ccording to the regulations in force, the home country deposit guarantee schem e is responsible abroad for deposit protection o f all branches and not subsidiaries. In the case o f contagion effect com ing from the parent com pany, the deposit protection scheme in the country where the subsidiary is located has to pay for the contagion. So, the guilty party is shifting risk to the o th er parties. We shall revert to that issue later on.

B esides, there is an asym m etry in the scope to w hich consumers are p rotected in particular segm ents o f the financial services market. This is the

case in the insurance market, w here - according to EU regulations - no anti­ bankruptcy protection is provided. First of all, this change shall be regarded as necessary for the integrating financial market. L eaving this difference unchanged may create a significant obstacle to the integration of consumer protection. Additionally, European company statutes m ay shine new light on consum er protection. If any bank (e.g. Nordea) decides to change its status into a European company, it m ight also move its headquarters to any EU country, w hich could be problem atic for the local deposit guarantee scheme. In order to maintain financial stability, it would be reasonable to set up a com plem entary EU consum er protection scheme to protect in a proper m anner the interests of the consum er and local markets.

A fter Financial Services A ction Plan (FSAP), the E uropean Commission issued in December 2005, after public consultation, a White Paper - Financial Services Policy 2005-2010. Four goals for the period 2005-2010 were defined there, among them the enhancement o f supervisory co­ operation and convergence in the EU. The commission put a stress on co­ operation and not on changes in the regulatory structure. As written in the W hite Paper: “Any evolution o f prudential supervisory structures in the EU away from the current arrangem ents raises difficult issues of political and financial accountability, especially when support from the public purse might be called upon. The C om m ission advocates an evolutionary approach, responding to demonstrated problem s, striking the right balance between more efficient and consolidated supervisory arrangem ents and ensuring financial stability all over the E U .”

As noticed, any significant changes are implemented after an unexpected event or shock. It seems that they could be introduced only in an evolutionary way with many political influences to protect national interests. With reference to the national interests there is an im portant question of covering the cost of a possible crisis. So far, any banking or financial crisis has been o f a local (national) character. There was no real evidence of a contagion effect in the EU, so each country covered the costs of its own crisis. But how should costs be distributed in case o f a contagion effect? That problem has not been addressed properly so far. In the European C om m ission White Paper (2005), it was only m entioned that „co-operation in a crisis situation has to be secure”. Such a general remark is the continuation of a general description of crisis m anagem ent in the m em orandum of understanding (signed on 14 May 2005) on co-operation between banking supervisors, central banks and finance ministries of the European Union in financial crisis situations. The M oU is not a binding act,

but the interested parties avoided mentioning any p roblem of cost sharing. The only details relate to the principles and procedures for sharing inform ation, views and assessm ents. The question o f sharing the cost of financial crisis is especially im portant for new EU m em bers, given the high share o f foreign capital. New E U members shall raise this problem at the EU level and work for setting m ore detailed rules for crisis management. Putting the supervisory structure aside, the rules of cost sharing shall identify the guilty party who caused the contagion. Countries absorbing foreign capital have - under the current regulations - no instrum ent to intervene. The possible consequences shall be covered, but there is an open issue - by whom - by the guilty party or the affected country. According to Ch. G o o d h art’s proposal (2004), the European Central B ank might develop a role as an independent, unbiased and expert arbiter on handling such financial crises. The idea to assign this responsibility to the ECB seems reasonable, but this solution or any other to define the rules for cost sharing requires political willingness to do that before any real contagion effect occurs. T his is extremely im portant for EU-10 countries in order not to be left alone in the case of the contagion.

CONCLUDING REMARKS

T he future structure of the safety net in the EU will be the result of political com prom ise. The integration o f the financial market will not be complete without changes in the structure and philosophy of the regulation, supervision and consum er protection. In this paper we tried to present the current structure of the safety net, its weaknesses and possible solutions for strengthening it in the future. Special attention was paid to the situation of the new EU member countries, where foreign capital is controlling a significant part of the sector of the financial intermediaries. In those countries there is a potential for a contagion effect deriving from parent companies via the capital stake channel. In order to reduce the likelihood o f such contagion, the supervisory authorities should be granted new instrum ents and powers. This is also important for the consum er protection and its costs.

R ecent years showed that the European financial m arket is stable, so the decision makers have no incentive to solve the problem o f crisis management, especially cost distribution. H ow ever, this period of stability seems to be a very good time for discussions involving academics, at the local, regional and European levels.

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