The Reform ofEU Financial Market Supervision

from the Lamfalussy committees to the setting up of the ESAs

The EU’s Role in the Regulation of Financial Markets (1985-2011)

• 1985: European Commission White Paper on reform of the internal market proposed measures for the purpose of creating a Single Market in financial service

• Three basic principles to be followed in the free movement of financial services across the EU: – the harmonisation of essential standards; – mutual recognition amongst the regulatory authorities;– and home country control (that is a financial institution’s branches

would be regulated by the authorities in the Member State where it had its registered offices)

Mutual recognition

• The Cassis de Dijon Principle in the EU belongs to the cornerstone of the EU internal market and refers to a decision of the European Court of Justice (ECJ) of 1979. At that time the German Federal Monopoly Administration for Spirits had prohibited the importation of a French red currant liqueur (cassis from Dijon), because it did not meet the German regulations in regard to the alcohol content. A lawsuit was brought, which the importer finally won.

• The ECJ stated that the limitation of the free movement of goods could only be permitted in exceptional cases, for example in order to protect the health of the public, to protect the consumers or if a general public interest existed.

• The Cassis de Dijon Principle consequently stipulates that the member States mutually recognize each of their regulations, as long as no generally binding EU regulations exist.

The EU’s Role in the Regulation of Financial Markets (1985-2007)

• Banking

– The First Banking Directive of 1977 had applied the principle of non-discrimination against businesses from other Member States to the banking sector – i.e. a bank from one Member State that wished to operate in another Member State had to be able to do so on equal terms to domestic banks.

– The Second Banking Directive of 1989 provided for minimal capital requirements for all retail banks and set out the procedure under which home country regulators would control branches of an institution in another Member State ("European Passport”: i.e. without further authorisation requirements).

The EU’s Role in the Regulation of Financial Markets (1985-2007)

• Insurance – The Single Market for insurance services was developed using the

same principles that applied to the banking sector - harmonisation and mutual recognition.

– e.g.: A 1973 directive had abolished restrictions on EU companies establishing non-life insurance businesses in other Member States. Later directives extended the scope of the Single Market in insurance.

• Investment services– The approach to investment services was similar to that of the other

two sectors. The ISD provided for a system of regulation based on single authorisation, reciprocity with third countries, common prudential rules and co-operation amongst the various national regulators.

The EU’s Role in the Regulation of Financial Markets (1985-2007)

• The Financial Services Action Plan (FSAP, 1999)

– The FSAP sought a fully integrated financial services market• the elimination of disparities in the tax treatment of savings,• and better co-ordination between national regulators.

– FSAP in four strategic objectives:• a single EU wholesale market;• open and secure retail markets;• state of the art prudential rules and supervision;• and wider conditions to create an optimal single financial market.

The EU’s Role in the Regulation of Financial Markets (1985-2007)

• The Lamfalussy process is a regulatory strategy launched in 2001 for the purpose of strengthening the European regulatory and financial sector supervision framework. It consists of four levels:

– Level 1: adoption of the framework legislation;

– Level 2: detailed implementing measures. • For the technical preparation of the implementing measures, the

European Commission was advised by committees, made up of representatives of national supervisory bodies, which exist in three sectors: banking, insurance and occupational pensions, and the securities markets (Lamfalussy committees)

The EU’s Role in the Regulation of Financial Markets (1985-2007)

– Level 3: the Lamfalussy committees contributed to the consistent implementation of EU directives in the Member States, ensuring effective cooperation between national supervisory authorities and convergence of their practices.• Lamfalussy committees (or level three committes):

– Committee of European Banking Supervisors (CEBS);– Committee of European Insurance and Occupational Pensions

Supervisors (CEIOPS);– Committee of European Securities Regulators (CESR)

– Level 4: the EU Commission’s enforcement of the timely and correct transposition of EU legislation into national law.

Pre-crisis financial market regulationThe Lamfalussy Level 3 Committees

• The three pan-European committees of financial market supervisors that operated until 2011: CESR, CEBS and CEIOPS.

• Established by the European Commission between 2001 and 2003.

• They became known, collectively, as the “Lamfalussy” or “Level 3” Committees.

• As from January 2011, the Level 3 Committees are transformed into the ESAs.

Level 3 Committees’ charachteristics

• Committee of national regulatory/supervisory authorities from member States and other EEA countries

• Bodies without legal personality

• Based in Paris (CESR), London (CEBS), Frankfurt (CEIPS) and chaired by the representative of a member State competent authority

• Modest financial resources

• At least four plenary sessions a year

• Making decision process operated on the basis on consensus

Level 3 Committees’ general tasks and powers

• fostering consistent, cooperative practices and open relations among the national supervisors

• Lack of binding regulating power

• Lack of power to impose binding decisions on the member States' competent authorities

• No direct supervisory powers in relation to individual market participants

Committee of European Securities Regulators (CESR)

• Advising the Commission on policy and on draft implementing (secondary) legislation in the field of securities

• Issuance of non-binding "Level 3" interpretative guidance, recommendations and standards

• Day-to-day co-ordination in supervision and enforcement:– CESR-Pol standing committee as a forum in which CESR members could share their

experiences concerning market surveillance and enforcement activities;– the multilateral Memorandum of Understanding between CESR Members (a general

framework for cooperation and consultation between the supervisory authorities);– protocols relating to home-host supervisory cooperation in key areas

• (i.e. supervision of branches under MiFID and passport notifications)– improvement of market transparency by mantaining a variety of databases.

• (i.e. the CESR-MiFID database containing information on shares admitted to trading on EU regulated markets, systematic internalisers, multilateral trading facilities, regulated markets and central counterparties)

Committee of European Banking Supervisors (CEBS)

• Like CESR in the securities field, CEBS’s responsibilities were – to advise the European Commission on banking policy issues and legislation– to contribute to the consistent application and implementation of EU law and to the

convergence of supervisory practices, and – to enhance supervisory cooperation and the exchange of information between national

supervisors.

• CEBS provided non-binding Level 3 standards, guidance and recommendations (since 2008 adopted on the basis of qualified majority)

• CEBS Level 3 measures could be divided broadly into four sub-categories: – guidelines relating to supervisory processes, including guidelines on cross-border

supervisory cooperation for banking and investment firm groups; – guidelines relating to model validation, external credit assessment institutions, and

prudential filters; – guidelines on the supervisory review process under the Capital Requirements Directive

(CRD);– and guidelines on financial reporting.

Committee of European Insurance and Occupational Pensions Supervisors

(CEIOPS)

• giving of technical advice to the Commission with respect to the legislative framework

(in particular the Solvency II Directive, which stipulates solvency requirements for the insurance sector)

• Cooperation with CEBS in relation to financial conglomerates

• Point of contact for regulatory dialogues with third countries (dialogues with international standardsetting bodies).

• Monitor and report periodically on main market trends within the insurance and occupational pensions sectors

The Financial crisis

• Main causes:– overextension of credit due to very low interest rates for a long period

of time;

– the overleveraging of many financial institutions directly or through derivative techniques;

– the existence of several asset bubbles, in the real estate sector, in commodities and in the equity markets, leading to over-optimism and relaxing of risk management standards;

– underestimation by CRAs of the credit default risks of instruments collateralised by subprime mortgages

The Financial crisis/2

• The traditional regulation of equity markets – in Europe mainly on the basis of ISD and later of Mifid – had become obsolete in two respects:

– trading in derivatives has increasingly replaced trading in equities; and

– trading on regulated markets is being taken over by trading on OTC markets, including dark pools of liquidity and crossing networks, that are subject to different, or often non-comparable regulations

Shortcomings of the previous system

• Lack of adequate macro-prudential supervision;

• Lack of early warning mechanisms;

• No means for national supervisors to take common decisions;

• Lack of frankness and cooperation between national supervisors;

• Failures to challenge supervisory practices on a cross-border basis;

• Lack of consistent supervisory rules, powers and sanctions across member States (EU based regulation vs member State based supervision)

• Lack of resources in the Level 3 committees.

Post-crisis reform of the structure of EU financial market supervision: overview

• The de Larosière Report, published in February 2009, marked the start of the new bolder phase in the organisation of EU-wide financial market supervision. Proposal:– to establish a macro-prudential supervisor (“ESRB”) for the purpose

of monitoring systemic risk – to replace Level 3 Committees with new EU Supervisory Authorities

(“ESAs”) and to confer on those latter certain powers:• to give binding directions to national supervisors, • to make decisions that would be binding on firms directly, • to draft binding technical standards, and • to be responsible for the licensing and direct supervision of some

specific EU-wide institutions (i.e. Credit Rate Agencies)

The new supervisory architecture

The European Parliament and the Council adopted legal texts setting up a reform of the EU framework for regulation/supervision of the financial system, aimed at eliminating deficiencies that were exposed during the financial crisis

The regulations established:● the European Systemic Risk Board (ESRB), which will provide macro-prudential

oversight of the financial system,

● and three new supervisory authorities at the micro-financial level:European Banking Authority (EBA);European Insurance and Occupational Pensions Authority (EIOPA); European Securities and Markets Authority (ESMA).

The ESRB and the EIOPA will be sited in Frankfurt, the EBA in London and the ESMA in Paris

• The new system is operational since 1 January 2011.

European System of Financial Supervision (ESFS) formed by the ESAs, their

Joint Committee, the ESRB and the national supervisors

The ESFS in light of the establishment of the SSM

+

European Systemic Risk Board (ESRB)

Members of the General Board without voting rights: • Representatives of national

supervisors• President of the Economic and

Financial Committee

European Securities and

MarketsAuthority (ESMA)

European Insurance and Occupational

Pensions Authority (EIOPA)

SSM + European Banking Authority

(EBA)

General Board • ECB President and vice-President• Governors of national central banks• a Member of the European

Commission• Chairpersons of the three European

Supervisory Authorities• Chairs and the two vice-Chairs of

the Advisory Scientific Committee• Chair of the Advisory Technical

Committee

European Supervisory Authorities (ESAs)

Micro-prudential informationMacro-prudential information, early risk

warnings and recommendations to supervisors

Macro-prudential

supervision

Micro-prudential

supervision

21

The European Systemic Risk Board (ESRB)

• ESRB Regulation (EU) No 1092/2010:

“The ESRB shall be responsible for the macro-prudential oversight of the financial system within the Union in order to contribute to the prevention or mitigation of systemic risks to financial stability in the Union that arise from developments within the financial system and taking into account macro-economic developments, so as to avoid periods of widespread financial distress. It shall contribute to the smooth functioning of the internal market and thereby ensure a sustainable contribution of the financial sector to economic growth.”

ESRB’s tasks/1

• determining and/or collecting and analysing all the relevant and necessary information;

• identifying and prioritising systemic risks;

• issuing early warnings where such systemic risks are deemed to be significant and, where appropriate, make those warnings public;

• issuing recommendations for remedial action in response to the risks identified and, where appropriate, making those recommendations public;

• when the ESRB determines that an emergency situation may arise issuing a confidential warning addressed to the Council and providing the Council with an assessment of the situation, in order to enable the Council to adopt a decision addressed to the European Supervisory Authorities (ESAs) determining the existence of an emergency situation;

ESRB’s tasks/2

• monitoring the follow-up to warnings and recommendations;

• cooperating closely with all the other parties to the European System of Financial Supervision (ESFS); where appropriate, providing the ESAs with the information on systemic risks required for the performance of their tasks; and, in particular, in collaboration with the ESAs, developing a common set of quantitative and qualitative indicators (risk dashboard) to identify and measure systemic risk;

• coordinating its actions with those of international financial organisations, particularly the International Monetary Fund (IMF) and the Financial Stability Board (FSB) as well as the relevant bodies in third countries on matters related to macro-prudential oversight;

• carrying out other related tasks as specified in Union legislation.

ESRB’s organization and structure/1

• The European Systemic Risk Board has: – a General Board

– The General Board takes the decisions necessary to ensure the performance of the tasks entrusted to the ESRB. It consists of the following members with voting rights: (i) the President and the Vice-President of the ECB; (ii) the Governors of the national central banks of the Member States; (iii) one member of the European Commission; (iv) the Chairperson of the European Banking Authority (EBA); (v) the Chairperson of the European Insurance and Occupational Pensions Authority (EIOPA); (vi) the Chairperson of the European Securities and Markets Authority (ESMA)

– the Chair and the two Vice-Chairs of the Advisory Scientific Committee (ASC) – the Chair of the Advisory Technical Committee (ATC) – a Steering Committee – a Secretariat – an Advisory Scientific Committee – an Advisory Technical Committee

ESRB’s organization and structure/2General Board (GB)

Key decision-making body Governors of NCBs, ECB President and Vice President, Chairs of the ESAs, Commission and observers.

Advisory Technical CommitteeProvide advice and assistance to the General Board

Consisting of representatives from NCBs, ECB, national supervisor authorities, ESAs, Commission and EFC

Steering CommitteePrepares the meetings of the General Board

Chair and Vice-Chair of the GB, Chairs of the ESAs, EFC President, Commission and five Governors of NCBs

ESRB SecretariatReceives instructions directly from the Chair of the General Board

Provided for by the ECB

Accountability and reporting obligations

• At least annually the Chair of the ESRB si invited to an annual hearing in the European Parliament, marking the publication of the ESRB’s annual report to the European Parliament and the Council.

• The ESRB shall also examine specific issues at the invitation of the European Parliament, the Council or the Commission.

• The European Parliament may request the Chair of the ESRB to attend a hearing of the competent Committees of the European Parliament.

Regulations establishing the ESAs

• Regulation (EU) 1093/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Banking Authority)

• Regulation (EU) 1094/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Insurance and Occupational Pensions Authority),

• Regulation (EU) No 1095/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Securities and Markets Authority)

ESAs architecture

Joint Committee EBA

ESMA

EIOPA

NSA

NSA

NSA

NSA

NSA

NSA

NSA

NSA

ESAs, overview

• Bodies with legal personality under EU law.

• Each ESA has its head office in the same place as its predecessor Level 3 Committee (London (Banking), Frankfurt (Insurance and Occupational Pensions) and Paris (Securities and Markets).

• Each ESA has a – Chairperson and an Executive Director (full-time professionals)– Board of Supervisors and a Management Board– The ECB is also represented (in a non-voting capacity) on the EBA

• The main decision-making body of each ESA will be its Board of Supervisors, consisting of the heads of the relevant national supervisors as well as the Chairperson of the respective Authority

• The ESAs are accountable to the EU Institutions via annual reporting obligations (in addition, annual and multi-annual workprogrammes must be transmitted to the EU Institutions and be made public)

ESAs: level 3 Committes successors

• The ESAs inherit all the functions that were performed by the Level 3 Committees.

• Their responsibilities and powers thus include:– writing non-binding guidelines and recommendations, – conducting peer reviews, mediating disputes between supervisors on a non-binding

basis,– promoting supervisory cooperation, convergence and coordination,– facilitating home/host MS relations, including fostering the coherent functioning of

colleges of supervisors, collecting information, establishing central databases, providing standard reporting formats, monitoring market developments and conditions generally, and providing opinions to the Union Institutions.

• Like the Level 3 Committees before them, the ESAs have a role in external relations

Internal organizationBoard of Supervisors (BoS)Key decision-making body

Independently appointed Chairperson + Heads of national supervisory authorities + observers

Management Board (MB)Ensuring that the Authority is run effectively and can performs the tasks assigned to it.

Chairperson, four elected members of the Board of Supervisors and the Commission

ESA StaffExecutes decisions by BoS and MB

The Executive Director and around 90 staff

Main supervisory (?) powers

• Drafting of technical standards;• Enforcement (?) of consistent application of EU law;• Mediation;• Action in emergency situations.

But:• Individual firm (banks, investment firms, insurance

firms) supervision stays with the national supervisors.

Technical Standards

Technical rules to ensure uniform application of EU law

Authority develops draft standards (in areas specified in EU law and respecting better regulation principles)

Endorsement by Commission

Settlement of DisagreementsOne or more national supervisors request help of the ESA in resolving a disagreement

(on a matter where EU law requires co-operation)

In rare cases of continued disagreement:ESA to take a decision

If decision not applied:ESA may adopt decision addressed to a financial institution

Consistent application of Community Law

Authority investigates cases of incorrect application of the law

ESA recommendation to national supervisor

In case of non-compliance: Commission decision

If no compliance, where directly applicable law applies, Authority can address a decision to an individual firm

Emergency situations

Determination of emergency situation by the Commission

Decision taken by the Heads ofthe national supervisors in the BoS

Coordinated action by national supervisors

Coordinated action needed to remedy serious risks for EU financial stability

Safeguard clauseAuthorities must ensure that no decision impinges

on the fiscal responsibilities of Member States MS opposes decision by the ESA

ESA decision is suspended

Council decides whether ESA decision is maintained Note: fast-track

procedure foreseen for emergency situations