The Jean Monnet Program
European Union Jean Monnet Chair
Jean Monnet Working Paper 7/03
Yannis V. Avgerinos
EU Financial Market Supervision Revisited:
The European Securities Regulator
NYU School of Law New York, NY 10012
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without permission of the author.
© Yannis V. Avgerinos 2003
New York University School of Law
New York, NY 10012
EU Financial Market Supervision Revisited:
The European Securities Regulator
Dr Yannis V. Avgerinos
LL.M(Warwick), Ph.D(London), Visiting Lecturer, University of London
Research Fellow, British Institute of International & Comparative Law
Lawyer, Avgerinos & Partners
This paper deals with the regulation and supervision of financial markets within the European Union (EU). Recent developments in financial services at EU level as well as regulatory and institutional developments at national level have recently moved the question of the institutional structure of the EU financial services regulation and supervision beyond the purely academic domain to form the subject of specific political debate. The new Lamfalussy method promises a fast-track decision-making structure, which will be more transparent, flexible and effective. Specific legal, economic and institutional hurdles, however, will further slow down and undermine the creation of the Single Financial Market. The aim of this paper is to contribute to this debate by critically assessing the current regulatory and supervisory regime in EU financial services with a view to drawing policy lessons and recommendations on more effective and efficient institutional alternatives.
Table of Contents
A. Prologue: financial market revolution and regulatory evolution in the EU
B. The legal basis for a Single Regulator
1. The extent of legal authority
2. Is a Treaty amendment required?
2.1 Establishment of a European Securities Regulator without a Treaty amendment
2.1.1 Choice of legal basis
184.108.40.206 Article 86 EC (former Article 90)
220.127.116.11 Article 95 EC (former Article 100a)
18.104.22.168 Article 308 EC (former Article 235)
2.2 Establishment of a European Securities Regulator with a Treaty amendment
2.2.1 The European Investment Bank (EIB) and the European Central Bank (ECB)
2.2.2 A time-consuming process?
3. The need for a ‘hard’ Regulator
C. The rationale for a Single Regulator
1. Transaction costs
1.1 Institutional or direct cost
1.2 Compliance cost and legal certainty
1.3 Indirect cost
2. Independence and accountability
2.1 Public choice theory and independence
2.3 Transparency and accountability
3. Legislative delay and inflexibility: the Lamfalussy proposals and the harmonisation prerequisite
3.1 Regulating after Lamfalussy
3.2 Is there a need for further harmonisation before the creation of the ESR?
4. Securities exchanges consolidation and alliances
4.2 Clearing and settlement
5. The euro as a catalyst
5.1 EMU and supervisory concerns
5.2 Impact on financial institutions
5.2.1 Consolidation and competition
5.2.2 The European Company (Societas Europeae - SE) Project
6. Externalities and crisis management
6.1 The BCCI
6.2 Crisis management and pre-crisis analysis
7. Imperfect information and deficient cooperation
7.2 Is cooperation adequate?
8. Relationship with third non-EU countries
D. The political conundrum: real drawbacks or political unwillingness?
EU Financial Market Supervision Revisited:
the European Securities Regulator*
A. Prologue: financial market revolution and regulatory evolution in the EU
European financial markets witness an era of breathtaking change. Over the past dozen years, the European Union (EU)1 has experienced a revolutionary change regarding investment and financial services. From the introduction of the euro and the creation of the European Central Bank (ECB) to the dominant appearance of financial conglomerates, complex financial products and the electronisation of securities markets, the revolution is more than evident.
The European financial market industry has changed dramatically. This can be seen chiefly as the consequence of the globalisation of financial services in general. Developments, such as fast storage, transmission and processing of information, increasing consolidation and conglomeration and electronic commerce, cause institutions not only to reconsider their geographical structure, to move bulk processing to lower cost centres and to outsource, but also oblige them to adjust their management structures and traditions based on location and regional geography. Globalisation and the need to create an appropriate and efficient regulatory and supervisory framework of the global economy form part of the background to the current debate. More developments are to come in the future, which will require imaginative and innovative responses from supervisory authorities. The impetus for some of these changes can be sourced to the European Economic and Monetary Union (EMU). Yet, there are other powerful forces at work such as technological changes and new competitive dynamics.2
The financial revolution notwithstanding, European financial markets are currently going through a difficult period, reflecting the uncertain global macro-economic situation. These difficulties have been compounded by a number of factors such as the severe correction in stock market valuations since 2000, increased risk-aversion by investors triggered by a series of corporate governance scandals, and the war in Iraq. The overall outlook strengthens the political case further for the completion of the Financial Services Action Plan (FSAP)3 and the subsequent regulatory integration.
Moving to the regulatory sphere, one cannot ignore the considerable progress made over the last twenty years. The starting point for EU financial services regulation and supervision is that their regulatory and supervisory framework matters as a precondition for the objectives of financial stability, consumer protection and competition promotion.4 Supervisors acknowledge that consumers want fair, honest, orderly, effective and efficient financial markets. This is an important matter of public interest and regulators should take necessary actions to promote these objectives. Moreover, past and recent financial institutions’ failures worldwide justify the attention currently given to the reinforcement, or even to the complete reform, of current regulatory and supervisory arrangements.
In keeping with the overall objectives of the EC Treaty, mainly the concepts of freedom of establishment (Articles 49-55 EC) and freedom to provide services (Articles 43-48 EC), the European Union has been concerned to create an environment, in which all financial institutions within the EU and the European Economic Area (EEA) should be able to offer their services throughout the Union on the same, or a similar, supervisory foundation. Investment and financial services regulation is based on the Treaty objective of developing a common market.5 The Internal Market in financial services, introduced by the European Commission’s 1985 White Paper6 constitutes part of a wider project to create a single market comprising ‘an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured’.7 Accordingly, capital markets have been liberalised and integrated, their access has been freed, rules in all the fifteen Member States are more or less harmonised and services circulate freely all over Europe under the ‘European passport’ and homogenous prudential rules, all of which have resulted in a true European securities market carried within a single currency. These achievements are far from negligible. However, the cessation of any substantial developments during the last ten years – i.e. after the Investment Services Directive (ISD) and the Second Banking Directive (SBD)8 – makes one wonder: could there have been more liberalisation and could it have been better?
As envisaged in the European Commission’s White Paper of 1985 and adopted by subsequent secondary EU law, European financial sector liberalisation is based on the three principles of minimum harmonisation, mutual recognition and home country control.9 Following the failure of previous complete harmonisation efforts by the European Community, this approach has been seen as the most appropriate to achieve a single market and has been subsequently followed by financial services secondary legislation. Its advantages are obvious: mutual recognition allows products and services legally circulated in one Member State to be admitted to other Member States without being required to meet additional regulatory requirements. Costly duplications are thus theoretically avoided without the need for complete harmonisation of national legislation at Community level. Thanks to mutual recognition, not all sectors of the Single Market needed to be harmonised, or harmonisation has been restricted to the ‘essential requirements’. Hence, minimum harmonisation of basic standards allows a certain degree of regulatory competition between Member States and accommodates flexibility, innovation, simplification and experimentation. Furthermore, and perhaps most importantly, EU policy and law making remains sensible to local and regional interests, while the maintenance of specific national characteristics is ensured.
Albeit their initial success, however, a debate has started in Europe regarding the current status of the principles and their applicability to modern financial institutions and markets. Especially acute are the problems arising from the principles of home country control and mutual recognition, as originated and developed by the Basel Committee on Banking Supervision and the European Court of Justice. The 1985 Internal Market Programme has created a complex web of harmonised EU rules and un-harmonised national regimes while many exceptions apply to home country control and mutual recognition.
Even in areas where harmonisation has been achieved, this should not be seen as an attempt to apply uniformity of laws and regulations throughout the Union. There remain differences in national laws implementing secondary legislation. Divergences can also be observed in the laws on the supervision of financial services providers. As a result, the focus has been concentrated on the determination of the respective supervisory roles of EU institutions and Member States on the one hand, and of home and host Member States on the other. The relevant investment services and other financial services directives hardly manage to face the challenge and solve the problem.10 In addition, the principle of subsidiarity, as introduced by the Maastricht Treaty and set out in Article 5 EC (former Article 3b) and revisited by the members of the European Convention, has brought about a major shift in EU policy and law making. Ambiguous and controversial, this principle has impacted on the form, length and content of legislation and has the potential to undermine the full liberalisation of investment services and the integration of financial markets.
These major regulatory developments have not been followed by increased financial cross-border flows, as one would expect. Regretfully, the European picture resulting from this restructuring process is not very clear. One thing, however, is certain: cross-border market integration remains very limited. Cross-border merger and acquisition (M&A) activity could reduce operating costs by as much as 1.2 to 1.3 per cent. Capital and financial service markets are also reflecting the deterioration of general business conditions: stock market capitalisation of domestic firms fell 3.8 per cent in 2000 compared to the previous year.11 Moreover, the market share of branches and subsidiaries from other EU and EEA countries is still limited in most EU countries.
Towards the aforementioned evolving environment, the current structure of investment services supervision appears old-fashioned and anachronistic. Rules and provisions of the 1992 ‘new approach’ are now becoming out of date and require a thorough overhauling. The current debate among academic scholars, EU institutions’ and Member States’ representatives and – lately – members of the Lamfalussy Committee12 and the Financial Services Committee (FSC),13 leaves a feeling that something is moving at European level in financial regulation. The FSAP supports this assumption. Economic governance also constitutes one of the issues discussed in the European Convention. Yet financial supervision deliberately remains out of the agenda.
Admittedly, the task of financial services supervision is very different today from what it was a decade ago. With the loss of the local or domestic character of the securities markets and the cross-border provision of investment services, national supervisory authorities suddenly found themselves exposed to new problems and challenges. As a result of historic market structures, traditional administrative approaches and existing European constitutional realities, supervisors are often thinking (only) in terms of national jurisdictions. As markets change, inadequate supervision can jeopardise the stability of the European and world financial system, competition neutrality and consumer protection.
The logical method for defining the trade-off relationship between effectiveness of supervision and its costs is built upon a simple three-step axiom. The first step is the definition of the objectives and rationale for financial supervision in the EU. Second, the marginal analysis of the current home country based supervisory arrangements in connection with the aforementioned objectives. If the current structure provides overall costs charged on market participants so higher than marginal benefits, so as to make the Internal Market and investment services unable to function and compete with other markets, the third step must follow: the examination of alternative arrangements and the possibility of transferring policy at a more centralised EU level. An analysis of the issue of Member State competence versus federal EU competence involves identifying the costs and benefits of each. Accordingly, action at EU level is justified by way of two criteria, complementary to one another:
The absence of action at the European level might have negative consequences for the effectiveness of instruments envisaged by the Member States and/or be contrary to the requirements of the Treaty.
Action at Community level would produce clear benefits by reason of its scale or effects compared with action at the level of the Member States.14
Where Union action is required, the combination of different policy tools should be considered.15 Does Europe need a pan-European securities regulator? If yes, is the creation of such a body feasible within the legal, political and economic context of Europe? These questions have recently gone beyond the purely academic domain to form the subject of specific political debate between regulators, practitioners and market participants. Although the results of these debates usually end up giving a negative dimension to such a suggestion,16 the very fact that this question is raised up in this particular period of time reveals that something is wrong with the present regulatory and supervisory financial architecture.
It is argued that, in order to prevent institutional structure from being a purely arbitrary and ad hoc process, several key issues need to be considered, such as the clarity of regulatory agencies' remit, the costs of a particular institutional structure, the accountability of regulatory agencies, questions relating to the efficiency of the regulatory process, the merits of a degree of competition in regulation and issues relating to the concentration of power.17 In addition to these, the following paragraphs suggest the need for examining three more issues: issues relating to administrative efficiency, externalities and enforcement. At the end of the day, the solid rationale of a single ESR stands on whether the financial supervisory objectives will significantly be better served under the proposed centralised regime.
For the purposes of this discussion and because law on its own may not provide sufficiently accurate and reliable standards for evaluating the effects of legal rules and institutional structures, economic theory will also be incorporated into this legal analysis. In this light, by stressing the need to take the effects of the proposed action into account, the EC Treaty itself also rejects a pure legal formalistic approach.18
Naturally, as in any great reform, bringing investment services supervision to the centre of Europe may involve the imposition of legal hurdles or practical drawbacks. Some scholars do not find centralisation particularly attractive, since such a move could open the way to excessive federalism and over-regulation, resulting from the lack of regulatory competition, and the disregard of the special characteristics of national markets.19 However, vertical centralisation of investment services supervision responds to the need for an authority free not only from all national leanings but also from other EU institutions. Therefore, regulatory and supervisory centralisation could also be seen as decentralisation at horizontal level, as far as certain Community competences are moved to a specialised pan-European authority.
In addressing the effect of different supervision policies, it is an important part of any policy assessment to weigh the costs and benefits of alternative proposals. Although a number of factors cause significant difficulty for such an approach, it is still worth considering the cost and benefit analysis of the choice of the relevant supervisor within a structured framework. When the regulatory and supervisory divergence of home country control and mutual recognition fails to deliver in the EU, centralisation appears to be the best solution for free and efficient movement of investment services. Many commentators maintain that the present arrangement of supervisory tasks at national level cannot be sustained in a monetary union.20 The following paragraphs argue that economies of scale and great power over individual regulated entities should make a EU securities supervisor more effective than national competent authorities. In turn, the reduction in the latter’s responsibilities would permit more resources to be devoted to the more local areas that remain within their supervisory power, increasing their effectiveness. Centralisation in supervision and more flexible regulation will be the only answer to the hurdles of inconsistencies and loopholes, systemic inflexibility, high transaction cost, problematic cooperation and coordination and the Union’s failure to ‘speak with one voice’ at international negotiations.
This paper considers the case for an alternative supervisory approach within the field of EU investment services, namely the establishment of a European Securities Regulator (ESR). It signals the ways – if any - in which the EU institutional structure might be changed in order to remedy legal, economic and political problems. To this end, this paper provides a cost-benefit analysis for centralisation and the potential establishment of a pan-European Securities Regulator by explaining its legal base with or without a Treaty amendment, its rationale and its legal, political and economic position within the Single Financial Market. More specifically, the second Part will discuss the legal base of a European Supervisor with or without a Treaty amendment. The third Part will analyse the rationale for establishing a central regulatory body, by focusing on issues regarding transaction costs, independence and accountability, legislative incapacity, consolidation and alliances of securities markets, the impact of the euro, crisis management, imperfect information and deficient cooperation of national authorities and the relationship with third countries. Finally, the question will be raised, whether at the end of the day the reasons for ‘sabotaging’ the establishment of the single regulator do not relate with its ‘drawbacks’ but with the political unwillingness of national regulators to lose their sovereignty. The final Part of this paper will draw its main conclusions.