The High level Group on Financial Supervision in the EU has published its long-awaited report. The group is chaired by Jacques de Larosière, and includes Leszek Balcerowicz and Otmar Issing, among others.
The report first analyses the causes of the financial crisis. One of the main reasons in the report is that “very low US interest rates helped create a widespread housing bubble“.The report claims that “the credit expansion in the US was financed by massive capital inflows from the major emerging countries with external surpluses, notably China”.
The HLG believes that there have been fundamental failures in the assessment of risk, both by financial firms and by those who regulated and supervised them. The members of the group believe that insufficient attention was given to the liquidity of markets. An important point of the report is that regulators and supervisors focused on the micro-prudential supervision of individual financial institutions and not sufficiently on the macro-systemic risks of a contagion of correlated horizontal shocks.
The report suggests some counter-cyclical regulation measures:
– introducing dynamic provisioning or counter-cyclical reserves on banks in “good times” to limit credit expansion and so alleviate pro-cyclicality effects in the “bad times”;
– making rules on loans to value more restrictive;
– modifying tax rules that excessively stimulate the demand for assets.
The HLG believes that the Basel 2 framework nevertheless needs fundamental review. The report suggests that:
• the assets of the banking system should be examined in terms not only of their levels, but also of their quality;
• stricter rules should be applied for off-balance sheet vehicles;
• the EU should agree on a clear, common and comprehensive definition of own funds.
As for credit rating agencies (CRA), the report suggests a fundamental review of CRAs’ business model, its financing and of the scope for separating rating and advisory activities should be undertaken. More, the report demands that the use of ratings in financial regulations should be significantly reduced over time.
Some of the other important ideas include:
• at least one well-capitalised central clearing house for credit default swaps in the EU;
• the assessment of bonuses for should be set in a multi-year framework, spreading bonus payments over the cycle;
• Deposit Guarantee Schemes (DGS) in the EU should be harmonized and preferably be pre-funded by the private sector.
The HLG states that “while the Group supports an extended role for the ECB in macro-prudential oversight, it does not support any role for the ECB for micro-prudential supervision“. The report suggests a new group, replacing the current Banking Supervision Committee (BSC) of the ECB, called the European Systemic Risk Council (ESRC) should be set up under the auspices and with the logistical support of the ECB. Its task would be to form judgements and make recommendations on macroprudential policy, issue risk warnings, compare observations on macro-economic and prudential developments and give direction on these issues.