The best chance for supervisory efficiency?

European banking supervision is undergoing major changes. One of the key questions it is facing is which structure would best ensure stability in European financial markets. I personally believe that consolidated supervision is the only mechanism which can deliver an efficient supervisory environment for banks active across borders in the EU.

In October 2005, Callum McCarthy, the chairman of the Financial Services Authority (FSA), gave a speech in Harvard in which he set out his objections to the lead, or consolidating, supervisor model. In that speech, he quoted HL Mencken: ‘For every human problem there is a neat, simple solution – and it is always wrong.’ It does not seem to me that any of the proponents of consolidated supervision believe it to be a simple solution. We are at the beginning of a long debate, which must be allowed to run its course.

There is much work to be done to put the right environment in place. But if a more suitable framework is not found for international banks, the status quo will not only be an obstacle to the single market, it will also be dangerously ill-equipped to deal with the growing complexity of financial institutions.

Putting supervision in context

You cannot just look at the EU context; you must also bear in mind the wider global situation. The decision made at the end of 2005 by US agencies to delay the implementation of Basel II throws up a whole range of home/host questions. It also highlights the importance of the Lamfalussy process in allowing Europeans to change the Annexes of the Capital Requirements Directive (CRD). There is still a possibility that the US could seek substantive changes to the framework in Basel, in which case the EU must move quickly to accommodate any such changes if necessary. If European institutions cannot react swiftly, a lack of supervisory coordination at a global level, notwithstanding the work of the Basel Committee’s Accord Implementation Group (AIG), could lead to serious difficulties for international banking groups.

Consolidated supervision is key to these groups. Banking groups such as BNP Paribas are managed in an integrated and centralised manner on the basis of business lines and central functions. Risks must be measured consistently and aggregated so that they can be efficiently managed by a risk management system operated on a group-wide basis. The Basel Committee acknowledged this by applying the three pillars of the Basel Accord (minimum capital requirements, supervisory review and market discipline) at a consolidated level. Pillar 2 alone is designed to help both the institution and the supervisors to better understand and manage the risks of the group. Yet it is applied at a solo entity level in Europe.

In the EU, banking groups are faced every day with the difficulties of applying many national discretions across different jurisdictions. Again, this is not a problem with a simple solution. European Directives must accommodate different cultures and structures. However, this is no reason to continue living with an unequal playing field indefinitely.

We are subject to duplicative and extensive  reporting requirements, which are not only a burden for banks but also an inefficient use
of resources for supervisors. Banks also fear that overly detailed guidelines could result in supervisory guidelines forcing them
to change practices for no particular reason. If these guidelines are applied inconsistently, the problem becomes even more complex.
The list goes on. There is great uncertainty over how Pillar 2 will work in practice, how our  Advanced Measurement Approach (AMA) for
operational risk will be set up for subsidiaries and what exactly the involvement of host supervisors will actually be. We are dealing with
significant variations in the interpretation of different aspects of the CRD, such as the use test, calculations for the parallel run and, most
importantly, definitions of materiality. While the home/ host framework proposed by the Committee of European Supervisors (CEBS) will go some way  towards alleviating the problem, it is not a perfect solution.

So what is the current situation? The window of opportunity for putting full, consolidated supervision in place with the CRD has closed, but the
enhanced role of the home supervisor under Article 129 represents a welcome step forward. We hope that the European Commission will build on this in future legislation. However, it is not enough to really
move us forward from the mismatch between supervision and industry practice in Europe. Ultimately, the host supervisors still reach agreement on validation and are the co-addressees of the
application. Even though it makes little sense not to have a main point of contact for validation purposes, the host supervisors can still ask questions on the application and make information requests.

Road Map For The Future

Consolidated supervision in Europe is not possible at this point in time; the legal framework only allows limited delegation of responsibilities between supervisors. Again and again in this debate we keep coming back to the current legal framework and its imitations. This is proof that the boundaries of the legal framework need to be extended or used to deliver a more efficient system.

CEBS is working to deliver supervisory convergence in the EU. It is actively developing mechanisms to increase the trust and cooperation between its members. Progress has already been made and this needs to be built upon. Convergence is the cornerstone of the future of European banking supervision.

A road map is needed to take supervision forward in Europe. The road map should take a building block approach in addressing each of the obstacles to consolidated supervision, starting with crisis management arrangements and liquidity risk management, to take account of the increasingly centralised funding within banking groups and the fact that risks are continuously transferred within a banking group. Supervisory convergence should be the overarching theme of the road map.

In my view, the EU approach to applying Basel II at all levels could exacerbate the fragmentation of national regulation. This will only happen if we allow it to. Regulators and industry must work together to identify and remove the existing obstacles to consolidated supervision.

A common framework must be found which is acceptable to both regulators and politicians, and reflects the reality of an increasingly global financial sector. That is the challenge we are faced  with. The banking industry needs consolidated supervision, and it needs it sooner rather than later. It is not a simple solution, but it will allow us to build on what we already have, and to evolve. If that does not work, perhaps we need to look at more fundamental changes.