The European Union financial system after Lehman: policy and regulatory responses

When addressing European matters we must remember that European construction is still a work in progress, with its peculiar architecture subject to a long-term evolutionary process. As normally happens with unfinished projects, the constituent, national, parts do not properly fit in the general design. This consistency gap persists, and may even widen as the system design itself evolves over time. Beyond the potential deficiencies of the projected architecture, its unfinished character may prove a serious threat when individual imbalances spill over into general fragilities. In other words, European construction is characterised by a largely unproven design, by its evolution over time, and by the ‘traverse’ problem coming from the adjustment of heterogeneous national conditions to the ‘acquis communautaire’. Structural socio-political and economic changes induced by the integration process take time, with different adjustment rates in different member countries; enforcement may become feeble and moral hazard a recurring danger for the decision process. The evolution of the architecture is far from being the result of unanimous national approaches, with the necessary compromises leaving room to the persistence of ample degrees of national discretion and specificities. In the past serious problems were often addressed through architectural reforms, sometimes leading, as in the case of Economic and Monetary Union, to the deepening of certain features of the unification process. The recent crisis could have led to a breakdown in European construction, especially in its later phase characterised by potential sovereign debt defaults. On the contrary, however, the response to the Lehman debacle was to reaffirm the acceleration in the convergence process sanctioned by the Lisbon Treaty. The lesson drawn from the crisis has been to re-draft the European institutional architecture, not just for the financial sphere. Common goals have been re-focused and the institutional set up redesigned, not secondarily aiming at more limited national discretion and increased enforcement of common rules. The reforms of the financial sector must then be analysed as part of the reshaping of the entire design. The EU design derives its strong peculiarities from the cohabitation of Member State sovereignty with the goal of a single market. Enhancement of harmonisation and convergence necessarily requires a complex political process, with Member States willing to pass on some parts of their sovereignty to collegial decisions, increasingly taken without veto powers. The wisdom of the EU decision process lies in seeking unanimity or large convergences wherever possible. Compromise solutions are, then, a necessary trait of the EU construction. In normal times it is easier for each Member State to be satisfied with the balance of its own benefits, although distribution within the Union may not be uniform. Analogously to the Minsky process, it is in normal times that the fragility of the construction may increase. Not driven by apparent threats, the enforcement mechanisms may significantly lag behind in the desirable advance towards harmonisation, thus leaving room for the accumulation of various sorts of imbalances. When a shock hits the Union or part of it, those fragilities may radically change the perceived national balances of costs and benefits and their distribution within the EU. Heightened national interest may produce serious damage to the whole EU edifice. The recent crisis represented such a shock, laying the cumulated fragilities bare. The entire EU construction rests, then, on keeping economic, monetary and financial imbalances within socially and politically acceptable limits and preparing smooth resolution procedures when they occur. The three institutional legs - the broad fiscal one under the umbrella of the European Semester, the ECB and the financial regulatory and supervisory authorities - represent the result of of compromises among national 'egoisms'. As the recent crisis has shown, the efficacy of enforcement, from which their credibility derives, rests on serious shocks not seriously disturbing this fragile equilibrium. It has also made clear how the increased interconnections between member countries have entailed further individual weaknesses throughout the whole area. Light touch supervision in some countries has directly or indirectly generated cross-border negative externalities, while economic negative and positive imbalances have contributed to weakening the edifice. The present paper has repeatedly argued in favour of attempts to increase convergence primarily homogenising procedures and strengthening enforcement. The EU financial regulatory and supervisory construction requires particularly strong measures to prevent the financial sector from generating such heavy negative externalities as to disrupt the delicate equilibriums on which the European monetary and fiscal constructions rest. Although the reforms in the institutional architecture are going in the right direction, doubts can be raised as to whether, following the international approach to financial re-regulation, the European financial systems will gain the extra resilience required by the peculiar European construction. The international agenda on financial reforms does not, in fact, imply radical changes to the previous architecture. It explicitly follows the same prudential approach, seeking to reinforce its mechanisms. The point is that the increases in capital requirements are widely judged insufficient and continue to be based on discredited methodologies; the financial institutions will continue to be too big to fail and to be resolved; since the non-banking sector will continue to be regulated with a light-touch approach, leaving connectedness and contagion untouched, the focus on banks will give way to new forms of regulatory arbitrage; the ample discretion attributed to supervisors, with the problem of their capture left unsolved, adds to their regulatory status and to regulatory uncertainty. Given the dependence of the European financial systems on banking, these reforms will certainly increase their regulatory costs, probably more than in other contexts characterised by a less systemic role of the banking sector. The European banking industry is already pressing for a softer approach, pointing out the disproportionate impact of stricter requirements on Europe's already sluggish growth. It is certainly impracticable for Europe to extra-toughen requirements for banks, as it is highly improbable that it will implement nonbank international standards with stricter rules. The financial sector will continue to pose serious threats in all countries. For Europe it might jeopardise its entire construction. For a full understanding of the European responses to the crisis, help to outline both the more salient characteristics of the European financial system (section 1) and the more recent stages in the process of regulatory harmonisation (section 2), delving into the management and resolution of crossborder crises, which is a particularly crucial problem for the European Union (EU) (section 3). A brief description of the crisis in Europe from the first phase of financial turmoil to the sovereign crises (section 4) brings light to bear on the policy and regulatory responses (sections 5, 6 and 7). An analysis of the process leading to the new overall design places those responses into the broader perspective of the consistency of the entire architecture (section 8). Some conclusions are finally offered on the relevance of the financial reforms for the viability of the entire European construction and on the dangers deriving from an approach to re-regulation that seems incapable of significantly reducing systemic fragilities.