Martin Wolf's Exchange

How should the European Union regulate its banking system? What discretion should be granted to member states in deciding how safe their banking systems should be?

On these vital issues, the EU is coming to the wrong conclusions. That is the UK’s view. I agree with it. But the UK is, once again, in a minority of one.

This time the dispute is over the EU’s implementation of rules on bank capital, leverage, liquidity and risk management, agreed in late 2010 by the Basel Committee on Banking Supervision in its “Basel III accord”. These rules are to be implemented in the EU via the Capital Requirements Directive IV/Capital Requirements Regulation (CRD IV/CRR). The details are complex: take a look at the document from the European Commission entitled “CRD IV: Overview and issues at stake”. The proposal is also controversial.

In ministerial discussions last week, two issues proved particularly significant.

The first was whether the proposed directive implements Basel III correctly. The UK argues that the rules have been bent to favour the interests of French and German banks. I would have thought that any such bending of the rules must be a serious error, particularly in view of the mess created by the EU’s seriously undercapitalised financial institutions, a point made in the International Monetary Fund’s latest Global Financial Stability Report.

The second issue, on which I will focus below, concerns national discretion in setting rules for a member’s banks. The UK wants to preserve its discretion in raising capital requirements, on the grounds that the consequences of failing to do so would fall on its own economy and taxpayers: responsibility should align with consequences. The proposal, in contrast, seeks to limit such freedom.

The idea that member states should be prevented from making their banking systems “too safe” goes under the rubric of “maximum harmonisation”. It is a weird notion. Suppose the EU proposed a directive that prevented the introduction of improved car seats, on the grounds that they might make children “too safe” or force other countries to improve their own standards. It would be judged to have gone mad. So how can the EU defend this idea, particularly when the EU is in the middle of a crisis triggered, in part, by the very fact that its banks proved unsafe?

The official argument starts from two propositions: the EU needs both macro-prudential flexibility and a single rule book for banks operating in the single market.

The first point, on macro-prudential flexibility, is by now uncontroversial. We know that financial developments in individual states can be destabilising. It is necessary, therefore, for regulators to have the ability to counteract such developments via higher capital standards or other regulatory interventions.

Andrea Enria, chairman of the European Banking Authority has put the second point, on the case for a single rule book, as follows:

“the key prudential requirements for financial institutions should be defined through EU regulations, which are directly applicable to all financial institutions operating in the single market, without leaving space for arbitrary national adjustments.”

Yet, we should note, even if the case for macro-prudential flexibility is accepted, it is necessary to decide who has the power to make relevant decisions. Concern about where the power is going to lie is even more obvious in the case of a single EU rule book directly applicable to all financial institutions. A cynical view that what is going on is largely a grab for power by the EU authorities.

That would be less plausible if the EU were only asking for harmonisation of minimum standards. That obviously makes sense: much damage has, after all, been done by the willingness of national regulatory authorities to allow banks to operate without adequate oversight. Yet why should a member care if others decided to make their banks “too safe”? Why, in sum, should anybody complain about a “race to the top” in banking?

The arguments for such maximum harmonisation seem to be four:

1. Minimum harmonisation has, in Mr Enria’s words, “delivered an extremely diverse regulatory environment, prone to regulatory competition”. Moreover, “the heterogeneity of the regulatory environment also complicated significantly the effective supervision of cross-border groups”.
2. If a country were to insist on higher capital, lending by its banks might shrink within other member countries, with serious macroeconomic consequences.
3. If a country were to raise its standards, customers might seek loans from banks based in other member countries (as is legal under the EU’s regulations), thereby making the latter riskier.
4. A race to the top on capital standards might stop growth, by accelerating deleveraging.

Here are my counter-arguments, in order:

1. It does make sense to work with common definitions of regulatory requirements. But, once those common definitions have been agreed, there is no reason why maxima are necessarily needed on any of them.
2. It cannot be legitimate for the European regulators, who are not fiscally accountable, to force member states to bear risks that its nationally accountable regulators view as excessive. This would not be a problem if banks could be resolved without adverse economic, financial and fiscal consequences. But that is not the case.
3. While negative spillovers from higher standards are conceivable, a far greater danger is that of negative spillovers from low standards, as we are seeing today. This is not a small risk, because the Basel III rules on capital, even with the various buffers, contain what are almost certainty excessively low standards. They do not represent a good benchmark. Not only are the risk-weightings grossly unreliable, as was proved during the crisis, but leverage remains too high. There is a good argument that the leverage of banks should never exceed 10:1. It could prove immensely damaging if the weak Basel III norms were to set a ceiling on the regulatory ambitions of the EU for the indefinite future. It would be better for everybody therefore if there were indeed to be a race to the top.
4. Yes, there is indeed a question of transition. But these regulations are likely to be in force for decades. They should not be overly concerned with the short term. The aim about the costs of raising capital in banks can, in any case, be met, without rapid deleveraging, by preventing dividend payouts until required standards are being achieved.

I would argue that national regulators must also have discretion to operate national macro-prudential policies as they see fit so long as the EU does not posses a federal banking system backed by a federal fiscal authority. It is the national regulators who have both the interest and the knowledge needed to implement such policies, as Adair Turner, Chairman of the UK’s Financial Services Authority, has noted in a recent speech.

Moreover, particularly in view of the questionable basis of the Basel III rules on capital and the dangers to which an over-leveraged banking system expose a country, no limits should be set on how prudent such national regulators may be. This is particularly true for retail banking, which remains overwhelmingly national.

Yes, the single market is indeed important. But it is not as important as preserving fiscal solvency and economic stability. Remember that the single market is made for Europeans, not Europeans for the single market. So long as the EU remains a union of fiscally independent states, its members must be allowed the freedom to safeguard their essential interests. By reducing the dangers of negative spillovers from failing banks, they will also help one another.

Remember that the fiscal compact does not try to prevent countries from running their fiscal policies “too prudently”. The same principle should apply to the regulation of banks where the danger of spillovers is far greater. Limits on the discretion of member states to choose greater safety are, in both respects, objectionable. They should be rejected.