Financial Market Supervision:
European Perspectives

James K. Jackson
Specialist in International Trade and Finance
August 25, 2009
Congressional Research Service
7-5700
www.crs.gov
R40788
CRS Report for Congress
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repared for Members and Committees of Congress

Financial Market Supervision: European Perspectives

Summary
The global financial crisis has sparked a debate over the cause and impact of the crisis.
Academics and policymakers are searching for changes in the financial system that can correct
any perceived weaknesses in the structure of regulation, the content of regulations, and the
coverage of financial instruments and activities. Since the onset of the crisis, numerous proposals
have been advanced to reform or amend the current financial system to help restore economic
growth. In the United States, the Obama Administration has proposed a plan to overhaul
supervision of the U.S. financial services sector. The proposal would give new authority to the
Federal Reserve, create a new Financial Services Oversight Council, create a Consumer Financial
Protection Agency, and create a new National Bank Supervisor to replace the Office of the
Comptroller of the Currency and the Office of Thrift Supervision. In contrast, Senator Collins
introduced S. 664, the Financial System Stabilization and Reform Act of 2009, with a companion
measure, H.R. 1754, that was introduced by Representative Castle in the House of
Representatives. The measures would create a Financial Stability Council and grant the Federal
Reserve the authority to examine the soundness and safety of the financial system posed by bank
holding companies. The crisis has underscored the fact that national and international financial
markets have become highly integrated, and problems in one market can trigger contagion that
can spread both among countries and into economic sectors to affect businesses, employment,
and household well being.
Similarly, governments in Europe are considering what, if any, changes they should make to their
national financial systems. Along with the United States and other countries, European countries
also are considering changes to the international systems of financial supervision and regulation
in order to ensure prosperity through the smooth operation of domestic and international financial
systems. This process may include reconsidering the roles and responsibility of the central banks
in the post-financial crisis era. Various organizations and groups are advancing a large number of
recommendations and prescriptions. Some goals for any such adjustments may include providing
an institutional structure for oversight and regulation that is robust, comprehensive, flexible, and
politically feasible while providing appropriate incentive structures to preclude excessive risk-
taking. Of course, there are no guarantees that amending the current system or employing a
different regulatory and supervisory structure will preclude a repeat of the most recent financial
crisis given that financial markets and institutions are continually growing, innovating, and
responding to government- and market-imposed constraints.
This report addresses the European perspectives on a number of proposals that are being
advanced for financial oversight and regulation in Europe. The European experience may be
instructive because financial markets in Europe are well developed, European firms often are
competitors of U.S. firms, and European governments have faced severe problems of integration
and consistency across the various financial structures that exist in Europe.

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Financial Market Supervision: European Perspectives

Contents
Overview .................................................................................................................................... 1
The European Union ................................................................................................................... 2
Financial Crisis ........................................................................................................................... 3
Other Major EU Financial Directives .................................................................................... 6
Investment Services Directive ......................................................................................... 6
Financial Services Action Plan ........................................................................................ 6
Markets in Financial Instruments Directive ..................................................................... 7
Capital Requirements Directive....................................................................................... 8
EU Financial Supervisory Authorities.................................................................................... 8
The “European Framework for Action” ............................................................................... 13
The de Larosiere Report and the European Plan for Recovery.............................................. 14
The de Larosiere Report ................................................................................................ 15
Driving European Recovery .......................................................................................... 18
Conclusions .............................................................................................................................. 20

Figures
Figure 1. Key Bodies in the EU Banking Sector-Stability Framework.......................................... 9
Figure 2. European Financial Supervision in the de Larosiere Report......................................... 17

Tables
Table 1. European Union Financial Supervisory Structures........................................................ 11

Appendixes
Appendix A. Summary of Recommendations of the de Larosiere Report on EU Financial
Market Supervision................................................................................................................ 22

Contacts
Author Contact Information ...................................................................................................... 25

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Financial Market Supervision: European Perspectives

Overview
The global financial crisis has resulted in huge losses in wealth, jobs, and economic activity. In
some cases, it has led to public demonstrations and to changes in national governments.
Academics and policymakers generally agree that the financial system can benefit from additional
supervision or regulation that addresses issues of systemic risk. Such efforts, however, likely will
require hard, and possibly politically unpopular, decisions concerning the supervision and
regulation of domestic financial markets and new layers of international coordination that could
challenge entrenched national interests. Furthermore, there are no metrics for gauging whether
such measures are a prescription for curing the current crisis or are a policy framework for
preventing the next crisis, since financial markets are constantly innovating and responding to
regulation and oversight. In addition, there are no models of market oversight or supervision that
have proven to be clearly superior. In the absence of such a model, policymakers face a blizzard
of recommendations, but few assurances that changes to domestic and international financial
frameworks, most likely achieved with considerable institutional and political resistance, will
preclude another crisis.
Currently, national governments are using a number of approaches to supervise financial markets.
While the current situation is quite fluid, there seems to be some movement in national
supervisory frameworks toward an integrated approach, as used in Great Britain and Germany.
Regardless of which structural form is employed, regulating financial activities at the national
level is complicated by the nature of modern financial markets that have become highly complex
and interdependent. While regulation is set largely in a national context, financial institutions are
international in their activities. Without consistent regulatory standards across national
boundaries, banks, insurers, and securities companies can move their activities to jurisdictions
with looser standards. National governments, however, generally are loathe to cede sovereignty to
any supra-national institution, and efforts to reshape national financial authorities often face stiff
opposition from entrenched interest groups.
Furthermore, national financial markets are not clones of one another, but reflect differences in
the way they have been organized and philosophical differences over the way they are regulated
and supervised. Indeed, national financial markets are custom-made structures that reflect
differences in national experiences, government institutions, laws, and national customs. One
thing the crisis has demonstrated, though, is that despite these differences, financial markets have
become highly integrated. As a result, it has become increasingly more difficult, as evidenced by
the current financial crisis, to contain financial problems in one market from affecting markets in
seemingly unrelated areas.
The European Union has taken a number of steps to improve financial supervision among its
members, including: strengthening the roles of advisory Committees in the areas of securities,
banking, and insurance regulators; adopting regulations on credit rating agencies; providing
funding in support of international accounting standards; and considering a measure to register
hedge funds. The EU is also considering a proposal to have a European Systemic Risk Council
and a European System of Financial Supervisors that would serve as advisors to EC members in
providing advice in both macro and micro prudential supervision. The United States has chosen to
take a different approach that could potentially strengthen the role of the Federal Reserve and
create a new consumer watchdog agency, among other proposals.
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The European Union
The European Union (EU) is a political and economic union of 27 member states, formally
established in 1993 by the Treaty of Maastricht out of existing structures that had evolved in steps
since the 1950s. The EU has worked to develop a single economic market through a standardized
system of laws which apply across all member states and which provide the freedom of
movement of people, goods, services and capital. This process of economic integration is
complicated by a dual system that gives the members of the EU significant independence within
the EU and broad discretion to interpret and implement EU directives. EU economic integration
is compounded further by sixteen member states, collectively known as the Eurozone1, which
have adopted the euro as a common currency and operate as a bloc within the EU. Major
institutions and bodies of the EU include the European Commission, the European Parliament,
the Council of the European Union, the European Council, the European Court of Justice, and the
European Central Bank (ECB). Through various Directives, the EU has moved to increase
financial integration within the Union to make the monetary union represented by the Eurozone
operate more efficiently.
Within the EU, the European Commission operates as the executive branch and is responsible for
proposing legislation, implementing decisions, upholding the Union’s treaties, and the general
day-to-day running of the Union. The Commission operates as a cabinet government, with one
Commissioner from each member. One of the 27 is the Commission President (currently José
Manuel Barroso) appointed by the European Council, with the approval of the European
Parliament, for a term of five years. Relative to the financial sector, the EU process provides for
each member to have its own institutional and legal framework, which complicates efforts to
coordinate financial policies. The Economic and Financial Affairs Council (ECOFIN) is one of
the oldest bodies within the European Council. ECOFIN is responsible for economic policy
coordination, economic surveillance, monitoring budget policy and preparing the EU’s budget.
There are three main procedures the EU uses to enact legislation. These procedures are co-
decision, assent, and consultation. The co-decision procedure, also known as the Article 251
procedure (Article 251 of the Treaty of Rome), is the main legislative process the EU employs to
adopt directives and regulations. The Council and the European Parliament jointly adopt
legislation based on a proposal by the European Commission. Both Parliament and the Council
are required to agree on an identical bill before the measure can be adopted. In general terms,
Parliament is considered to have adopted a measure if it fails to reject the proposed measure
within three months after it has been adopted by the Council. Under the assent procedure, the
Council can adopt a measure proposed by the Commission if it receives the assent of Parliament.
Under the consultation procedure, the Council, acting unanimously or as a qualified majority, can
adopt legislation developed by the Commission after it has consulted with Parliament.
Since the start of the financial crisis, the European Union has taken a number of steps to improve
supervision of financial markets. These actions include:
• Strengthened the Committee of European Securities Regulators. The Committee
is an advisory body without any regulatory authority within the European

1 Members of the euro area are Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy,
Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.
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Commission. The Directive of January 23, 2009, strengthened the Committee’s
authority to mediate and coordinate securities regulations between EU members.
• Strengthened the Committee of European Banking Supervisors. The Committee
is an advisory body without any regulatory authority that coordinates banking
supervision. The EU Directive of January 23, 2009, broadened the role of the
Committee to include supervision of financial conglomerates.
• Strengthened the Committee of European Insurance and Occupational Pensions
Supervisors. The Committee is an advisory body without any regulatory authority
within the European Commission in the areas of insurance, reinsurance, and
occupational pensions fields. The January 23, 2009, Directive authorizes the
Committee to coordinate policies among EU members and between the EU and
national governments and other bodies.
• The European Parliament and the European Council approved on April 23, 2009
new regulations on credit rating agencies that are expected to improve the quality
and transparency of the ratings agencies.
• Approved direct funding by the European Union to the International Accounting
Standards Committee Foundation, the European Financial Reporting Advisory
Group, and the Public Interest Oversight Body.
• The European Commission proposed a set of measures to register hedge fund
managers and managers of alternative investment funds and measures to regulate
executive compensation.
• Expressed support for a new European Systemic Risk Council and a European
System of Financial Supervisors.
The euro area countries initially sketched out a broad response to the financial crisis. Since then,
their response to bank foreclosures and to subsequent issues has been characterized by some as
somewhat disjointed. The financial crisis and economic downturn have exposed deep fissures
within the EU and even within the euro area countries over the policy course to follow. As a first
response to the financial crisis, EU governments and their central banks focused policy initiatives
on reassuring credit markets that there was an availability of credit and liquidity, by reducing
interest rates, and by providing foreign currency, primarily dollars, through currency
arrangements. In addition to continuing efforts to restore the financial markets, EU members also
face a worsening economic climate that has required actions by individual central banks,
international organizations, and coordinated actions by EU members and other governments.
Financial Crisis
As the loss of real and financial wealth worsened, EU governments worked both independently
and in tandem to protect financial institutions and to sustain economic growth. The actions EU
leaders take are important to the United States, because EU members comprise some of the
largest financial centers in the world, their financial markets are well developed, and European
financial firms are often competitors to those in the United States. The economic and financial
crises, however, have exposed deep philosophical differences among EU members over the most
effective policy course to pursue to address the financial crisis and the economic downturn and
problems of integration and consistency across countries. In part, these differences reflect the
dual nature of the EU system, which gives great deference to the individual members of the EU in
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interpreting and implementing EU Directives. Unlike the United States, where the Federal
government can implement policies that are applied systematically across all 50 States, EU-wide
actions reflect compromise among 27 national authorities.2
The financial crisis has made EU members especially concerned about the size and structure of
financial systems and they are pursuing changes to the international financial system. Financial
systems have become large, complex, interconnected structures that have grown so large that
some observers question whether the current financial system is compatible with maintaining
financial stability. They also raise concerns about the ability of national governments to restrain
the impact of financial firms on public resources should major financial firms face periods of
serious distress. The United Kingdom and the United States, for instance, are the two largest
international banking centers in the world. As such, they operate as major conduits, or as
intermediaries, through which capital flows from countries with excess capital to those countries
in need of capital. Banking centers in the United Kingdom, Switzerland, and elsewhere are
notable because they are large compared to their respective national gross domestic product
(GDP) and large compared to the relative size of banking centers in the United States. Bank assets
in Switzerland, for instance, are nearly nine times the size of the country’s GDP, while such assets
are over four times GDP in the United Kingdom. In Spain, Germany, France, and Ireland, bank
assets are at least double GDP, while such assets run less than 60% of GDP in the United States.
In an effort to address the prospect that large banks or financial firms may become insolvent or
fail and, thereby, cause a major disruption to the financial system, the British Parliament in
February 2009 passed the Banking Act of 2009. The Act makes permanent a set of procedures the
U.K. Government had developed to deal with troubled banks before they become insolvent or
collapse. Such procedures are being considered by other EU governments and others as they
amend their respective supervisory frameworks.
Within the EU system, the greatest share of responsibility for regulating and supervising financial
markets rest with the national governments. National authorities implement EU Directives in
ways they determine are consistent with their own national objectives and national interests, not
necessarily to benefit the EU as a whole. As a consequence of this focus at the national level,
there is some potential for nations to act in their own interests at the expense of other EU
members, especially during periods of financial and economic distress. The financial crisis also
has aggravated conflicts between broad EU-wide goals and the more focused national objectives
of the individual EU members. For instance, as financial markets faced serious shortages of
liquidity, EU members were pressed to support a broad set of measures to increase the guarantees
on bank accounts for depositors in response to actions by Ireland, Greece, and Germany. In
addition, some EU members have been considering a set of procedures to deal with the bad loans
of banks within their jurisdictions, which has pushed the EU as a whole to follow suit and
consider the best approach to deal with the toxic loans of EU banks. These differences may well
become more pronounced as multilateral discussions shift from addressing the general goal of
containing the financial crisis to the more contentious issues of specific market reforms,
regulations, and supervision.
The globalization of financial markets raises the stakes for a coordinated response within the EU
and between the EU and the United States. In various ways, globalized financial markets

2 Members of the European Union are: Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia,
Finland, France, Germany, Greece, Hungary, Republic of Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the
Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Sweden, and the United Kingdom.
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challenge the effectiveness of the current framework of financial market supervision and
coordination that is based on national interests. Significant differences remain among EU
members and between EU members and the United States over the best approach to follow to
supervise financial markets. Some EU members favor a strong central authority that can monitor
financial markets, while others favor strong national authorities with a weaker role for an
international body.
The EU approach is also complicated by the requirement that new policies must mesh with the
carefully crafted and highly negotiated Directives that already exist within the EU framework.
These Directives act as guiding principles for EU members, and include the Stability and Growth
Pact3, the Lisbon Principles,4 and the Financial Services Action Plan.5 Arguably, these agreements
have helped stabilize economic conditions in Europe by bringing down the overall rate of price
inflation and by reducing government budget deficits. In addition to these Directives, the EU
members have adopted a series of measures that deal directly with an EU-wide effort to
coordinate financial policies across all the EU members.
As part of the overall EU effort to achieve financial and economic integration, the EU members
have adopted such Directives as the Directive on Financial Services and the Financial Services
Action Plan (FSAP).The integration of the financial services sector across borders, however, has
been uneven, with integration progressing faster in the money, bond, and equity markets, and
slower in the banking sector where much of the focus on international cooperation is being
directed. According to the European Central Bank,6 retail banking services remain segmented
along national lines as a result of differences in national tax laws, costs of national registration
and compliance, and cultural preferences. Nevertheless, cross-border mergers and acquisitions
within Europe have played an important role in internationalizing banking groups, which has led
to significant cross-border banking activity. Integration within the banking sector in Europe also
has increased since the euro-area countries adopted the euro as their single currency.

3 The Stability and Growth Pact (SGP) is an agreement by European Union members to conduct their fiscal policy in a
manner that facilitates and maintains the Economic and Monetary Union of the European Union. The Pact was adopted
in 1997 and is based on Articles 99 and 104 of the European Community Treaty, or the Maastricht Treaty, and related
decisions. It consists of monitoring the fiscal policies of the members by the European Commission and the Council so
that fiscal discipline is maintained and enforced in the Economic and Monetary Union (EMU). The actual criteria that
members states must respect are: 1) an annual budget deficit no higher than 3% of GDP, and 2) a national debt lower
than 60% of GDP, or approaching that value.
4 The Lisbon Strategy for Growth and Jobs is a plan adopted by EU members to improve economic growth and
employment among the EU members by becoming the most competitive knowledge based economy in the world by
2010. The comprehensive strategy includes adopting sustainable macroeconomic policies, business friendly regulatory
and tax policies and benefits, improved education and training, and greater investment in energy efficient and
environmentally friendly technology. Two major goals include total public and private investment of 3% of Europe’s
GDP in research and employment by 2010, and an employment rate of 70% by the same date. A comprehensive report
on the Lisbon Strategy is available at: http://ec.europa.EU/growthandjobs/pdf/kok_report_en.pdf.
5 The Financial Services Action Plan replaced the Investment Services Directive and contains a set of measures that are
intended to remove the remaining formal barriers in the financial services market among EU members and to provide a
legal and regulatory environment that supports the integration of the EU financial markets. The EU Financial Services
Action Plan: A Guide
, HM Treasury, the Financial Services authority, and the Bank of England, July 31, 2003.
6 EU Banking Structures, European Central Bank, October 2008.
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Other Major EU Financial Directives
Investment Services Directive
The EU has adopted a number of directives that provide a basic framework for EU members to
coordinate financial regulation across the EU and to integrate financial sectors. One such
directive is the Investment Services Directive (ISD) that entered into force on January 1, 1996.
The ISD provided general principles for national securities regulations, with the goal of providing
mutual recognition of regulations across the EU.7 The ISD created a “European Passport” that
provided for a cross-border right of establishment for non-bank investment firms and the freedom
to provide services across borders for investment firms to carry out a wide range of investment
business. Under the passport, firms were authorized and supervised by domestic authorities, but
could still provide specified investment services in other EU countries. Such cross border services
included: collecting and executing buy and sell orders on an agency basis; dealing, managing and
underwriting portfolios; and such additional services as providing investment advice, advising on
mergers and acquisitions, safekeeping and administration of securities, and foreign exchange
transactions.
The European “passport” provision required member states to dismantle restrictive legislation
that prevented cross-border branching and freedom of services. Nevertheless, EU members
retained the responsibility for determining their own domestic laws and regulations concerning
such issues as fitness, authorization, capital requirements, and protection of client assets. EU
members could also impose rules and regulations on investment firms using the European
passport as long as the rules and regulations were, “in the interest of the general good,” and
applied to the business activities that the firms carried out in their state. The ISD opened up stock
exchange membership in all member states to all types of investment firms, whether bank or non-
bank entities. Another objective of the ISD was to eliminate the so-called concentration rule in
order to allow member states that lacked their own securities trading floor to access electronic
terminals with investment firms and banks in other member states, thereby allowing them to be
members of the markets on a remote electronic basis.
Financial Services Action Plan
In 1999, the EU replaced the Investment Services Directive with the Financial Services Action
Plan (FSAP). The Plan consists of a set of measures that are intended to remove the remaining
formal barriers in financial markets among EU members and to provide a legal and regulatory
environment that supports the integration of EU financial markets.8 Similar to the ISD, the FSAP
process supports a two pronged approach that combines EU directives with national laws. The
EU directives provide for a general level of regulation concerning the provision of financial
services across borders and the harmonization of national regulations governing cross-border
activities. EU members, however, retain the right to regulate firms within their own borders, as
long as those firms, whether foreign or domestic, are treated equally. The FSAP contains 42
articles, 38 of which were implemented, that are intended to meet 3 specific objectives: 1) a

7 Davies, Ryan J., MiFID and a Changing Competitive Landscape, July 2008, p. 3; available at
http://faculty.babson.edu/rdavies/MiFID_July2008_Davies15.pdf.
8 The EU Financial Services Action Plan: A Guide, HM Treasury, the Financial Services Authority, and the Bank of
England, July 31, 2003.
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single wholesale market; 2) an open and secure retail market; and 3) state-of-the art rules and
supervision. Wholesale measures relate to securities issuance and trading; securities settlement;
accounts; and corporate restructuring. Retail measures relate to insurance; savings through
pension funds and mutual funds; retail payments; electronic money; and money laundering.
Markets in Financial Instruments Directive
The cornerstone of the FSAP’s achievement is the Markets in Financial Instruments Directive
(MiFID), which became effective on November 1, 2007. The MiFID establishes a
comprehensive, harmonized set of rules for Europe’s securities markets so financial services
firms can provide investment services in each of the EU member states. MiFID retained the
principles of the EU “passport” and extended the list of services and financial instruments that are
covered by the passport procedures, including investment advice. MiFID also removed the so-
called concentration rule that required investment firms to route all stock transactions through
established exchanges.
MiFID introduced the concept of ‘maximum harmonization’ which places more emphasis on
home state supervision. This is a change from the prior EU financial service legislation which
featured a “minimum harmonization and mutual recognition” concept. Minimum harmonization
provides for a law or a regulation that sets a floor, or a minimum standard, that EU countries were
expected to meet in developing legislation. Maximum harmonization provides for a maximum
level of a law or a regulation that sets the maximum allowable standard that can be adopted in
domestic laws or regulations. At times some EU members have been accused of adopting
domestic measures that exceed the EU standard in a manner that acted as a protectionist barrier.
Some key elements of the MiFID are:
• Authorization, regulation and passporting. Firms covered by MiFID are
authorized and regulated in their “home state.” Once a firm is authorized, it can
use the MiFID passport to provide services to customers in other EU member
states. These services are regulated by the “home state” in which the firm is
authorized.
• Client categorization. MiFID requires firms to categorize clients as “eligible
counter-parties,” professional clients, or retail clients, with increasing levels of
protection.
• Client order handling. MiFID places requirements on information that needs to
be captured when firms accept client orders in order to ensure that a firm is
acting in a client’s best interests.
• Pre-trade transparency. MiFID requires the operators of various kinds of equity
exchanges to make the best bid and offer prices available to potential buyers and
sellers.
• Post-trade transparency. MiFID requires firms to publish the price, volume and
time of all trades in listed shares, even if executed outside of a regulated market,
unless certain requirements are met to allow for deferred publication.
• Best execution. MiFID will require that firms take all reasonable steps to obtain
the best possible result in the execution of an order for a client. The best possible
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result is not limited to execution price but also includes cost, speed, likelihood of
execution and likelihood of settlement and any other factors deemed relevant.
• Systematic Internalizer. A Systematic Internalizer is a firm that executes orders
from its clients against its own book or against orders from other clients and are
treated as mini-exchanges, which makes them subject to pre-trade and post-trade
transparency requirements
Capital Requirements Directive
The Capital Requirements Directive, which became effective in January 2007, introduced a
supervisory framework within the EU for investment management firms and banks. The purpose
of the Directive is to move the EU towards complying with the Basel II9 rules on capital
measurement, adequacy, and related market disclosure disciplines. This Directive promotes a risk
based capital management methodology through a “three pillar” structure that includes 1) new
standards that set out the minimum capital requirements that firms will be required to meet for
credit, market, and operational risk; 2) requirements that firms and supervisors must decide
whether they are holding enough capital to address the risks realized under Pillar I and act
accordingly; and 3) requirements that firms publish certain details about their risks, capital, and
risk management. The Directive also requires firms to make provision for a charge against their
capital for operational risks in order to identify, monitor, manage, and report on certain types of
external events that may have a negative effect on their capital. The Directive applies not only to
internationally active banks, which is the main focus of the Basel II approach, but it also applies
to all credit institutions and investment firms irrespective of the size, scope of activities, or levels
of sophistication. Under the Directive, firms are required to meet rules governing the minimum
amounts of their own financial resources they must have in order to cover the risks to which they
may be exposed.
EU Financial Supervisory Authorities
Within the EU, there are a number of bodies that bring together the supervisors, finance ministers,
and central bankers of the EU members, as indicated in Figure 1. These bodies are under the
direction of the European Commission and the Ministries of Finance of the individual EU
members, while they also are subject to the central banks and National Supervisors10 of each EU
member. Within the European Council, the Economic and Financial Affairs Council (ECOFIN) is
one of the oldest bodies associated with the Council. ECOFIN is responsible for coordinating
economic policy, performing economic surveillance, and for monitoring budget policy and
preparing the EU’s budget. The key bodies in the EU banking sector include the following:
European Banking Committee. The committee consists of representatives of
the ministries of finance of the EU members and advises the EU Commission on
policy issues related to banking activities and on proposals in the banking area.

9 Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by
the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that
banking regulators can use when creating regulations concerning requirements for capital adequacy that banks must
meet to guard against the types of financial and operational risks that banks face.
10 National Supervisors are one or more supervisory authorities that are authorized at the national level and are
accountable to national mechanisms to issue regulations, grant licenses, conduct supervision, and to take enforcement
action.
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Committee of European Banking Supervision. The committee is comprised of
representatives of supervisory authorities and central banks and coordinates on
regulatory and supervisory convergence.
European Central Bank. The ECB’s main role is financial stability and
monitoring in cooperation with national central banks and supervisory agencies.
Banking Supervision Committee. This committee brings together national
central banks, banking supervisory authorities, and the ECB. It monitors and
assesses developments in the euro area, analyses the impact of regulatory and
supervisory requirements on financial system stability, and it promotes
cooperation and exchange of information between central banks and supervisory
authorities on issues of common interest.
Economic and Financial Committee. The committee includes representatives of
ministries of finance, the European Commission, the ECB, and central banks to
promote high-level assessments of developments in financial markets.
Financial Stability Table. This body meets twice a year to discuss financial
stability issues.
Financial Services Committee. This committee is composed of representatives
of the ministries of finance and the European Commission and discusses and
provides guidance on cross-sector strategic and policy issues.
Figure 1. Key Bodies in the EU Banking Sector-Stability Framework

Source: OECD Economic Studies: Euro Area, Organization for Economic Cooperation and Development, 2009.
In addition to the committees and bodies indicated in Figure 1, there are other components to the
EU financial structure. Some EU members have negotiated Memorandum of Understanding
(MOU) agreements that commit the parties to a regular exchange of information and to
consultation on enforcement of regulations. EU members also have developed “Colleges” of
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supervisors that represent each EU member in coordinating policies on financial activities that
cross national borders, principally in such specific areas of financial services as insurance and
banking. In addition, three financial services committees organized under the so-called
Lamfalussy process11 promote financial sector integration in the banking, insurance, and
securities sectors. These committees are designated as Level 3 committees since they operate at
the third stage in a process designed to coordinate efforts among the EU members in order to
build support to implement legislation.
Within the EU, the structure of financial market supervision varies markedly, as indicated in
Table 1. Likewise, the objectives and mandates of the supervisory authorities, the central banks,
the Ministries of Finance, and other organizations also vary by individual country, according to a
staff report prepared by the International Monetary Fund.12 Among the 27 members of the EU, a
little more than half have a single supervisory authority overseeing the banking sector, while
slightly less than half have a sectoral model, or a supervisory authority that focuses on a
particular segment of the financial services industry. The central bank is involved in supervising
the financial markets in every EU country, but it acts as a supervisory authority in only half of the
members. In all of the EU members, the banking supervisory authority supervises banks and
insurance providers and in all but one country, the supervisory authority also supervises securities
firms. In slightly fewer countries, the banking supervisory authority also supervises the
management of pension funds. Also, in nearly every EU country, the banking supervisory
authority is responsible for maintaining stability in the financial system and for protecting the
deposits and other interests of consumers. Fewer than half of the banking supervisory authorities
are responsible for supervising the conduct of firms within the financial sector and only about
one-third are responsible for maintaining or ensuring that there is competition in the market.


11 The Lamfalussy process, named after Alesandre Lamfalussy who chaired the EU advisory committee that created it,
was adopted by the EU members in 1999 to accelerate the legislative process in the EU relative to financial services
legislation in order to meet the implementation deadline of the financial Services Action Plan by 2005. The process is
composed of four levels, each focusing on a specific stage in the implementation of legislation with the EU. Level I
establishes the core values of a law and is the traditional EU decision making, in which decisions are adopted as
Directives or Regulations proposed by the Commission and then approved under the co-decision procedure by the
European Parliament and the EU Council. At the second level, sector-specific committees and regulators provide
advice on developing the technical details of the principles that were adopted in Level I. At the third level, national
regulators work on coordinating new regulations with other nations. The fourth level involves compliance and
enforcement. This process is intended to promote consistent interpretation, convergence in national supervisory
practices, and an improvement in the quality of legislation on financial services.
12 Hardy, Daniel, A “European Mandate” for Financial Sector Authorities in the EU, in Euro Area Policies: Selected
Issues
, the International Monetary Fund, IMF Country Report No. 08/263, August 2008.
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Table 1. European Union Financial Supervisory Structures

Supervisory structure


Main tasks/areas of supervision of banking supervisory authority
Central
Central
Pension
bank as
bank
Banking
fund
Insurance Securities
Conduct
Market
Sectoral
Model by
Single
supervisory involve-
super-
super-
super-
super-
of
Consumer compe-
Country
model
objectives authority
authority
ment
vision
vision
vision
vision Stability
business protection
tition
Austria X X X X X X X X X X
Belgium X
X X X X X X X X
Bulgaria
X X
X
X
X
X
X
X
X

Czech
Rep.
X X X X X X X X X X
Cyprus
X X
X
X
X
X
X
X
X
X
Denmark X
X X X X X X X X
Estonia X X
X X X X
X X
Finland X X
X X X X
X X
France X
X X X X X X
Germany X X X
X X X X
X X
Greece
X X
X
X

X
X
X
X
X

Hungary X
X X X X X X X X X
Ireland X X X X X X X X
Italy X X
X
X
X
X
X
X
X
X
X
Latvia
X
X X X X X X X
Lithuania
X X
X
X

X
X
X
X
X
Luxembourg

X
X
X
X
X
X

Malta
X
X
X

X
X

X
X
X
Netherlands
X
X X X X X X X X X X
Poland X
X X X X X X

Portugal X X
X X X X X X X X
Romania X

X X X X X X X

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Financial Market Supervision: European Perspectives


Supervisory structure


Main tasks/areas of supervision of banking supervisory authority
Central
Central
Pension
bank as
bank
Banking
fund
Insurance Securities
Conduct
Market
Sectoral
Model by
Single
supervisory involve-
super-
super-
super-
super-
of
Consumer compe-
Country
model
objectives authority
authority
ment
vision
vision
vision
vision Stability
business protection
tition
Slovakia X X X X X X X X X X X
Slovenia
X X
X
X
X
X
X
X
X

Spain X X
X
X
X
X
X
X
X

Sweden X
X X X X X X X
United
Kingdom X X X X X X
Source: Hardy, Daniel, A “European Mandate” for Financial Sector Authorities in the EU, in Euro Area Policies: Selected Issues, International Monetary Fund. IMF Country
Report No. 08263, August 2008, p. 76.

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Financial Market Supervision: European Perspectives

The “European Framework for Action”
As an initial response to the financial crisis, the European Commission released on October 29,
2008, its “European Framework for Action” as a way to coordinate the actions of the 27 member
states of the European Union.13 On November 16, 2008, the Commission announced a more
detailed plan that brings together short-term goals to address the current economic downturn with
the longer-term goals on growth and jobs that are integral to the Lisbon Strategy for Growth and
Jobs that was adopted by the EU in 2000 and recast in 2005.14 The short-term plan focuses on a
three-part approach to an overall EU recovery action plan/framework. The three parts to the EU
framework are:
A new financial market architecture at the EU level. The basis of this
architecture involves implementing measures that EU members have announced
as well as providing for: 1) continued support for the financial system from the
European Central Bank and other central banks; 2) rapid and consistent
implementation of the bank rescue plan that has been established by the member
states; and 3) decisive measures that are designed to contain the crisis from
spreading to all of the member states. As the financial system is stabilized, the
next step is to restructure the banking sector and to return banks to the private
sector. Proposals include: deposit guarantees and capital requirements; regulation
and accounting standards; credit rating agencies; executive pay; capital market
supervision; and risk management.
Dealing with the impact on the real economy. The policy instruments that can
be employed to address the expected rise in unemployment and decline in
economic growth are in the hands of the member states. Nevertheless, the EU can
assist by adding short-term actions to its structural reform agenda, while
investing in the future through: 1) increasing investment in R&D innovation and
education; 2) promoting flexicurity15 to protect and equip people rather than
specific jobs; 3) freeing up businesses to build markets at home and
internationally; and 4) enhancing competitiveness by promoting green
technology, and overcoming energy security constraints and achieving
environmental goals. In addition, the Commission will explore a wide range of
ways in which EU members can increase their rate of economic growth.
• The impact of the financial crisis on the real economies of the EU members
likely will require adjustments to the fiscal and monetary policies of the EU
members. The Stability and Growth Pact16 of the EU members should serve as

13 From Financial Crisis to Recovery: A European Framework for Action, Communication From the Commission,
European Commission, COM(2008) 706 final, October 29, 2008.
14 The Lisbon Strategy for Growth and Jobs is a plan adopted by EU members to improve economic growth and
employment among the EU members by becoming the most competitive knowledge based economy in the world by
2010. The comprehensive strategy includes adopting sustainable macroeconomic policies, business friendly regulatory
and tax policies and benefits, improved education and training, and greater investment in energy efficient and
environmentally friendly technology. Two major goals include total public and private investment of 3% of Europe’s
GDP in research and employment by 2010, and an employment rate of 70% by the same date. A comprehensive report
on the Lisbon Strategy is available at: http://ec.europa.eu/growthandjobs/pdf/kok_report_en.pdf
15 The combination of labor market flexibility and security for workers.
16 The Stability and Growth Pact (SGP) is an agreement by European Union members to conduct their fiscal policy in a
(continued...)
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the blueprint for members facing higher than expected levels of fiscal or
monetary stimulus so that such policies should be accompanied by structural
reforms. Such reforms should aim to sustain domestic demand in the short-run,
ease transitions within and into the labor market, and increase potential growth
by directing investment into areas that will sustain employment and advance
productivity. Reforms in the finance sector should focus on enhancing the
competitive position of the European industry and finance the needs of small and
medium-sized firms. The Commission will also attempt to counter an expected
increase in unemployment by using funds provided under the European Social
Fund17 to reintroduce unemployed workers back into the work force.
A global response to the financial crisis. The financial crisis has demonstrated
the growing interaction between the financial sector and the goods- and services-
producing sectors of economies. As a result, the crisis has raised questions
concerning global governance that are relative to the financial sector and to the
need to maintain open trade markets. The EU used the November 15, 2008 multi-
nation economic summit in Washington D.C. to promote a series of measures to
reform the global financial architecture. The Commission argued that the
measures should include: 1) strengthening international regulatory standards; 2)
strengthening international coordination among financial supervisors; 3)
strengthening measures to monitor and coordinate macroeconomic policies; and
4) developing the capacity to address financial crises at the national regional and
multilateral levels. Also, a financial architecture should be constructed upon three
key principles: 1) efficiency; 2) transparency and accountability; and 3)
representation in any group should include key emerging economies.
The de Larosiere Report and the European Plan for Recovery
When the European Union released its “Framework for Action” in response to the immediate
needs of the financial crisis, it was moving to address the long-term requirements of the financial
system. As a key component of this approach, the EU commissioned a group within the EU to
assess the weaknesses of the existing EU financial architecture. It also charged this group with
developing proposals that could guide the EU in fashioning a system that would provide early
warning of areas of financial weakness and chart a way forward in erecting a stronger financial
system. As part of this way forward, the European Union issued two reports in the first quarter of
2009 that address the issue of supervision of financial markets. The first report,18 issued on
February 25, 2009, and commissioned by the European Union, was prepared by a High-Level
Group on financial supervision headed by former IMF Managing Director and ex-Bank of France

(...continued)
manner that facilitates and maintains the Economic and Monetary Union of the European Union. The Pact was adopted
in 1997 and is based on Articles 99 and 104 of the European Community Treaty, or the Maastricht Treaty, and related
decisions. It consists of monitoring the fiscal policies of the members by the European Commission and the Council so
that fiscal discipline is maintained and enforced in the European Monetary Union (EMU). The actual criteria that
member states must respect are 1) an annual budget deficit no higher than 3% of GDP , and 2) a national debt lower
than 60% of GDP or approaching that value.
17 The European Social Fund, created in 1957, is the EU’s main financial instrument for assisting members in
implementing their own plans for investing in workers.
18 Report, The High-Level Group on Financial Supervision in the EU, Chaired by Jacques de Larosiere, February 25,
2009.
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Governor Jacques de Larosiere and, therefore, is known as the de Larosiere Report. The second
report19 was published by the European Commission to chart the course ahead for the members of
the EU to reform the international financial governance system.
The de Larosiere Report
The de Larosiere Report focuses on four main issues: 1) causes of the financial crisis; 2)
organizing the supervision of financial institutions and markets in the EU; 3) strengthening
European cooperation on financial stability, oversight, early warning, and crisis mechanisms; and
4) organizing EU supervisors to cooperate globally. The report also proposes 31
recommendations on regulation and supervision of financial markets. The recommendations are
summarized in Appendix A.
The report argues that the financial crisis was characterized by a systemic failure to correctly
price the risk of financial instruments as a result of plentiful liquidity, low returns, and investors
seeking higher yields. Together, these events led to a fundamental failure by financial firms to
adequately assess the risks associated with their activities and it exposed a systemic failure on the
part of regulators and financial supervisors. In this environment, long-standing practices that
relied on the risk management capabilities of the financial institutions themselves and on the
adequacy of credit ratings all proved to be inadequate. Too much attention was paid to each
individual firm and too little attention was given to the impact of general developments on sectors
or markets as a whole. According to the report, “These developments point to serious limitations
in the existing supervisory framework globally, both in a national and cross-border context.”20
According to the report:
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. Strong international competition among financial centers also
contributed to national regulators and supervisors being reluctant to take unilateral action.21
As the financial crisis unfolded, the de Larosiere Report concludes, the regulatory response by the
European Union and its members was weakened by, “an inadequate crisis management
infrastructure in the EU.” Furthermore, the report emphasizes that an inconsistent set of rules
across the EU as a result of the closely guarded sovereignty of national financial regulators led to
a wide diversity of national regulations reflecting local traditions, legislation, and practices.
While micro-prudential supervision focused on limiting the distress of individual financial
institutions in order to protect the depositors, it neglected the broader objective of macro-
prudential supervision, which is aimed at limiting distress to the financial system as a whole in
order to protect the economy from significant losses in real output. In order to remedy this
obstacle, the report offers a two-level approach to reforming financial market supervision in the
EU. This new approach would center around new oversight of broad, system-wide risks and a
higher-level of coordination among national supervisors involved in day-to-day oversight.

19 Driving European Recovery, Communication for the Spring European Council, Commission of the European
Communities, April 3, 2009.
20 Report, The High-Level Group on Financial Supervision in the EU, Chaired by Jacques de Larosiere, February 25,
2009, p. 10.
21 Ibid., p. 11.
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Financial Market Supervision: European Perspectives

The de Larosiere Report recommends that the EU create a new macro-prudential level of
supervision called the European Systemic Risk Council (ESRC) chaired by the President of the
European Central Bank, as indicated in Figure 2. A driving force behind creating the ESRC is
that it would bring together the central banks of all of the EU members with a clear mandate to
preserve financial stability by collectively forming judgments and making recommendations on
macro-prudential policy. The ESRC would also gather information on all macro-prudential risks
in the EU, decide on macro-prudential policy, provide early risk warning to EU supervisors,
compare observations on macroeconomic and prudential developments, and give direction on the
aforementioned issues.
Next, the report recommends that the EU create a new European System of Financial Supervision
(ESFS) to transform a group of EU committees known as L3 Committees22 into EU Authorities.
The three L3 Committees are the Committee of European Securities Regulators (CESR); the
Committee of European Banking Supervisors (CEBS); and the Committee of European Insurance
and Occupational Pensions Supervisors (CEIOPS). The ESFS would maintain the decentralized
structure that characterizes the current system of national supervisors, while the ESFS would
coordinate the actions of the national authorities to maintain common high level supervisory
standards, guarantee strong cooperation with other supervisors, and guarantee that the interests of
the host supervisors are safeguarded.
Under this system, the European Central Bank (ECB) would have no micro-prudential role in
supervising banks, but it would lead efforts within the European System of Central Banks
(ESCB)23 on macro-prudential supervision. In part, these macro-prudential activities would
include analyzing financial stability; developing an early warning system to signal the emergence
of risks and vulnerabilities of the financial sector to specific shocks and to issues that have cross-
border and cross-sector dimensions; and developing macro-prudential requirements.

22 Level 3 committees represent the third level of the Lamfalussy process the EU uses to implement EU-wide policies.
At the third level, national regulators work on coordinating new regulations with other nations. and they may adopt
non-binding guidelines or common standards regarding matters not covered by EU legislation, as long as these
standards are compatible with the legislation adopted at Level 1 and Level 2.
23 The European System of Central Banks is comprised of the European Central Bank, which represents those countries
that have joined the Euro area, and the central banks of all of the members of the European Union.
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Financial Market Supervision: European Perspectives

Figure 2. European Financial Supervision in the de Larosiere Report

Source: Report, The High-Level Group on Financial Supervision in the EU, February 25, 2009.
The main tasks of the ESFS authorities would be to provide legally binding mediation between
national supervisors; adopt binding supervisory standards; adopt binding technical decisions that
apply to individual institutions; provide oversight and coordination of colleges of supervisors;
license and supervise specific EU-wide institutions; provide binding cooperation with the ESRC
to ensure that there is adequate macro-prudential supervision; and assume a strong coordinating
role in crisis situations. The main mission of the national supervisors would be to oversee the
day-to-day operation of firms.
The report envisions the creation of the ESFS as a multi-year process that would be accomplished
in two stages. The first stage would take a year and would lay the groundwork for the
transformation of the EU supervisory system by strengthening the national supervisors,
harmonizing national legislation, strengthening the Level 3 committees, and expanding the use of
supervisory colleges. In the second stage, which is expected to take two years to accomplish, the
level 3 committees would be transformed into the three Authorities previously mentioned. In
addition to continuing to perform the functions currently assigned to these committees,24 the new
European Authorities would 1) have the authority to resolve disputes between national
supervisors regarding financial institutions operating across national borders; 2) be responsible
for the licensing and direct supervision of some specific EU-wide institutions; 3) play a decisive

24 These functions include: advising the European Commission on regulatory and other issues, defining overall
supervisory policies, convergence of supervisory rules and practices, financial stability monitoring, and oversight of
supervisory colleges.
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role in the interpretation and development of technical standards; 4) be responsible for
establishing supervisory standards and practices; 5) work closely with the ESRC to assure that the
ESRC can carry out its responsibilities for macro-prudential supervision; 6) facilitate exchanges
of information in crisis situations and act as a mediator when necessary; and 7) represent EU
interests in bilateral and multilateral discussions relating to financial supervision.
The de Larosiere Report also considers a framework for dealing with distressed or failing banks,
especially when those banks have a presence across several national jurisdictions. Typically, the
report argues, distressed or failing banks should be handled by national central banks, where they
exist, because central banks likely would be the first to see signs of trouble. However,
inconsistent crisis management and resolution tools across the EU compound efforts to contain
bank crises. Similarly, EU governments have adopted different deposit guarantee schemes that are
inconsistent across the EU and seem to be geared toward a minimum coverage level. This
inconsistent approach worsens the shift of deposits among banks during periods of perceived
weakness and raises the prospect that banks of different national origin that operate within a
single country could offer different levels of depositor protection within the same country. As a
result of extensive cross-border branching by some banks, the report proposes that national
supervisory authorities have the authority to inquire whether the home countries maintain
sufficient deposit guarantees that they can protect the deposit of bank branches in host countries.
In those cases where the deposit guarantee schemes are not sufficient, the report proposes that
national supervisory authorities have the ability to curtail the cross border expansion of banks into
their jurisdictions until such deposit guarantees are provided.
The final section of the de Larosiere Report focuses on the role of financial sector supervision in
the context of highly integrated and interconnected global financial markets in which financial
problems can be transmitted quickly around the globe. The report argues that the EU should take
a leading role in reforming the international financial architecture by improving its own
regulatory and supervisory system. Next, the report argues that the EU should promote
international consistency of regulatory standards by strengthening bilateral dialogues on
regulation among the main financial centers and by providing a clear mandate for international
institutions that determine standards. In particular, the report argues that a strengthened and
broadened Financial Stability Forum (now the Financial Stability Board) would be in the best
position to coordinate international work on standards. The report also recommends that there
should be international colleges of supervisors that can supervise large complex cross-border
financial groups. In addition, the Report recommends that central banks should monitor more
closely the growth in monetary and credit aggregates and there should be greater macroeconomic
surveillance to monitoring macroeconomic policies, exchange rates and global imbalances. In
addition to strengthening the IMF’s existing macroeconomic surveillance mechanism, the
International Monetary Fund (IMF) and the FSF would be tasked with placing greater emphasis
on macro-prudential concerns to provide an early warning system that would be intended to help
prevent financial crises. In case another financial crisis should appear, the report recommends that
there should be clear multilateral arrangements for coordinating national responses.
Driving European Recovery
“Driving European Recovery,” issued by the European Commission (EC), presents a slightly
different approach to financial supervision and recovery than that proposed by the de Larosiere
group, although it accepts many of the recommendations offered by the group. The
recommendations in the report were intended to complement the economic stimulus measures
that were adopted by the EU on November 27, 2008, under the $256 billion Economic Recovery
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Plan25 that funds cross-border projects, including investments in clean energy and upgraded
telecommunications infrastructure. The plan is meant to ensure that, “all relevant actors and all
types of financial investments are subject to appropriate regulation and oversight.” In particular,
the EC plan notes that nation-based financial supervisory models are lagging behind the market
reality of a large number of financial institutions that operate across national borders.
The EC praised the de Larosiere Report for contributing “to a growing consensus about where
changes are needed.” Of particular interest to the EC were the recommendations to develop a
harmonized core set of standards that can be applied throughout the EU. The EC also supported
the concept of a new European body similar to the proposed European Systemic Risk Council to
gather and assess information on all risks to the financial sector as a whole, and it supported the
concept of reforming the current system of EU Committees that oversee the financial sector. The
EC plan, however, would accelerate the plan proposed by the de Larosiere group by combining
the two phases outlined in the report. Using the de Larosiere report as a basis, the EC is
attempting to establish a new European financial supervision system. These efforts to reform the
EC’s financial supervision system would be based on five key objectives:
• First, provide the EU with a supervisory framework that detects potential risks
early, deals with them effectively before they have an impact, and meets the
challenge of complex international financial markets. At the end of May 2009,
the EC presented a European financial supervision package to the European
Council for its consideration. The package included two elements: measures to
establish a European supervision body to oversee the macro-prudential stability
of the financial system as a whole; and proposals on the architecture of a
European financial supervision system to undertake micro-prudential
supervision.
• Second, the EC will move to reform those areas where European or national
regulation is insufficient or incomplete by proposing: a comprehensive legislative
instrument that establishes regulatory and supervisory standards for hedge funds,
private equity and other systemically important market players; a White Paper on
the necessary tools for early intervention to prevent a similar crisis; measures to
increase transparency and ensure financial stability in the area of derivatives and
other complex structured products; legislative proposals to increase the quality
and quantity of prudential capital for trading book activities and complex
securitization; and to address liquidity risk and excessive leverage; and a
program of actions to establish a more consistent set of supervisory rules.
• Third, to ensure European investors, consumers and small and medium-size
enterprises can be confident about their savings, their access to credit and their
rights, the EC will: advance a Communication on retail investment products to
strengthen the effectiveness of marketing safeguards; provide additional
measures to reinforce the protection of bank depositors, investors, and insurance
policy holders; and implement measures on responsible lending and borrowing.
• Fourth, in order to improve risk management in financial firms and to align pay
incentives with sustainable performance, the EC intends to strengthen the 2004

25 A European Economic Recovery Plan: Communication From the Commission to the European Council, Commission
of the European Communities, COM(2008) 800 final, November 26, 2008. The full report is available at
http://ec.europa.eu/commission_barroso/president/pdf/Comm_20081126.pdf
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Recommendation on the remuneration of directors and bring forward a new
Recommendation on remuneration in the financial services sector, followed by
legislative proposals to include remuneration schemes within the scope of
prudential oversight.
• Fifth, to ensure more effective sanctions against market wrongdoing, the EC
intends to: review the Market Abuse Directive,26 and make proposals on how
sanctions could be strengthened in a harmonized manner and better enforced.
Conclusions
National authorities are searching for consensus on an international framework to supervise and
regulate the complex international financial system. The financial crisis has demonstrated that
financial markets are complex, highly integrated and interconnected. At the same time, there are
important gaps in the current state of knowledge concerning the nature of the complex linkages
that characterize international financial markets. There seems to be some consensus that any new
financial architecture should correct the shortcomings of the current system by incorporating a
number of features. These features include increased transparency, greater oversight over credit
rating firms and underwriting standards, mark-to-market accounting, registration and supervision
over hedge funds and other derivative markets, and some supervision of the credit default swap
market. Beyond supporting increased supervision over these broad areas of market activities,
policymakers remain divided over the specific ways that such supervision should be
administered.
Some policymakers also argue that the international financial system can be strengthened through
improvements in the data that are collected on financial activities. The Bank of England, for one,
argues that the international financial system can benefit from collecting data on the international
flow of funds comparable to the U.S. flow of funds accounts. These accounts provide data on
financial linkages between domestic and foreign residents and between different parts of the
financial sector and the real economy.27 Policymakers are also focusing on the current size and
structure of financial systems in which some institutions have such a far-ranging effect on the
financial system that they are deemed to be too big to fail. Policymakers are weighing the benefits
of having such firms hold higher amounts of capital and liquidity or limit their activities through
regulation or oversight. This issue is particularly pressing for some European countries in which
the size of some financial firms is greater than the national GDP and the failure of such firms can
be highly destabilizing to the economy.
Furthermore, academics and policymakers are assessing various proposals to address the
tendency for the financial system and the real economy to act in a mutually reinforcing, or
procyclical, manner. During periods of rapid economic growth and appreciation in the value of
assets, the financial markets make credit more readily available, thereby reinforcing the economic
boom and the prospects for an asset bubble. Similarly, as an economic boom ends and the real

26 The Market Abuse Directive was adopted by the European Commission in April 2004. The Directive is intended to
reinforce market integrity in the EU and contribute to the harmonization of the rules against market abuse and
establishing transparency and equal treatment of market participants in such areas as accepted market practices in the
context of market manipulation, the definition of inside information relative to derivatives on commodities, and the
notification of the relevant authorities of suspicious transactions.
27 Financial Stability Report, The Bank of England, June 2009, p. 46.
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economy begins to slow down, credit markets tighten up, reinforcing the economic contraction.
Central banks and policymakers are also focusing on methods and procedures to intervene with
banks and other large financial firms that are facing insolvency or failure to provide for an orderly
resolution of the firms to maintain market stability. The UK experience with a set of procedures it
made permanent in February 2009 may prove useful to some policymakers. The EU’s de
Larosiere Report acknowledges the importance of this issue, but it has left it up to individual EU
members to develop their own approaches.
In the current environment, policymakers and academics also are reconsidering the role central
banks play as systemic risk regulators. Central banks acted swiftly to address and contain the
financial crisis, which has led some policymakers to weigh the benefits of expanding or amending
the role of central banks in the supervision of financial markets. Expanding the role of central
banks has some benefits, since central banks generally have the requisite economic resources, the
political clout, and the ability to act quickly. Some policymakers, however, question the long-term
impact of concentrating market power in an independent agency. In comparing across countries,
the statutory role of the central bank is not clear and can vary substantially. As a result, some
national governments apparently are considering altering the statutory authority of the central
bank to make risk oversight a specific responsibility.

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Appendix A. Summary of Recommendations of the
de Larosiere Report on EU Financial Market
Supervision28

1. Basel II rules should be amended to: 1) gradually increase minimum capital
requirements; 2) reduce pro-cyclicality by encouraging dynamic provisioning of
capital buffers; 3) introduce stricter rules for off-balance sheet items; 4) tighten
norms on liquidity management; 5) strengthen rules for band internal control and
risk management.
2. Adopt a common definition of regulatory capital, including which hybrid
instruments should be considered as Tier 1 capital.
3. Relative to regulating credit rating agencies: 1) credit rating agencies should be
regulated and supervised by a strengthened Committee of European Securities
Regulators (CESR); 2) the credit rating agencies’ business model should be
reviewed and an assessment should be made of separating rating and advisory
activities; 3) the use of ratings in financial regulation should be reduced; 4)
distinct codes should be introduced for rating structured products.
4. Mark-to-market accounting rules should be reviewed to: 1) expedite solutions to
the remaining accounting issues concerning complex products; 2) ensure they do
not bias business models, promote pro-cyclical behavior, or discourage long-term
investment; 3) allow the International Accounting Standard Board (IASB) or
other standards setting groups clarify and agree on a common, transparent
methodology for valuing assets in illiquid markets; 4) have the IASB open its
standard-setting process to regulatory, supervisory, and business communities; 5)
strengthen the IASB’s oversight and governance structure.
5. The Solvency 2 Directive29 regulations on insurers and reinsurers should be
adopted and include a balanced group support regime, coupled with sufficient
safeguards for host member states, a binding mediation process between
supervisors, and established harmonized insurance guarantee schemes.
6. Competent authorities in all member states must have sufficient supervisory
powers, including sanctions, to ensure the compliance of financial institutions
with the rules, and they must be equipped with strong, equivalent, and deterrent
sanctions to counter all types of financial crimes.
7. Relative to the “parallel banking system” (hedge funds, investment banks, other
funds, and mortgage banks): 1) appropriate regulations should be extended to all
firms or entities conducting financial activities of a potentially systemic nature;
2) transparency should be improved, especially for systemically important hedge
funds; there should be capital requirements on banks owning or operating hedge
funds.

28 Report, The High-Level Group on Financial Supervision in the EU, Chaired by Jacques de Larosiere, February 25,
2009.
29 The Solvency II Directive attempts by 2012 to bring insurers and reinsurers under the same regulatory regime that
will provide a single set of rules that govern what constitutes an acceptable level of insurer creditworthiness.
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8. Securitized products and derivatives markets should: 1) simplify and standardize
over-the counter-derivatives; 2) introduce and require the use of at least one well-
capitalized central clearing house for credit default swaps in the EU; 3) guarantee
that issues of securitized products retain on their books for the life of the
instrument a meaningful amount of the underlying risk.
9. Common rules should be developed for investment funds, including definitions,
codification of assets and rules for delegation, accompanied by tighter
supervisory control over the independent role of depositories and custodians.
10. Member states and the European Parliament should work toward greater
harmonization in rules by avoiding legislation that permits inconsistent
transposition and application, and they should identify national exceptions that
would improve efficiency by their removal, reduce distortions of competition and
regulatory arbitrage, or improve the efficiency of cross-border financial activity
in the EU.
11. Compensation incentives must be better aligned with shareholder interests and
long-term firm-wide profitability by basing the structure of financial sector
compensation schemes on the following principles: 1) bonuses should be set in a
multi-year framework; 2) the same set of rules should be applied to proprietary
traders and asset managers; and 3) bonuses should reflect actual performance and
not be guaranteed in advance.
12. Internal risk management should be: independent and responsible for effective,
independent stress testing; senior risk officers should hold a very high rank in the
company; and internal risk assessment and proper due diligence must not be
neglected by overreliance on external ratings.
13. The EU should have a coherent and workable regulatory framework for crisis
management; a framework that is transparent; the relevant authorities should be
equipped with appropriate and equivalent crisis prevention and crisis
management tools; and legal obstacles that prevent the use of these tools in a
cross-border crisis should be removed.
14. Deposit Guarantee Schemes should be harmonized and prefunded by the private
sector and provide high, equal protection to all bank customers throughout the
EU; the schemes should protect all customers; and the existing authorities of host
countries regarding cross-border bank branches should be reviewed.
15. Member states should agree on more detailed criteria for burden sharing
(providing financial aid from the public and private sector) than those contained
in existing agreements.
16. The EU should create a new body called the European Systemic Risk Council
(ESRC) to pool and analyze all information, relevant for financial stability,
pertaining to macro-economic conditions and to macro-prudential developments
in all the financial sectors.
17. The EU should put in place an early warning system under the auspices of the
ESRC and of the Economic and Financial Committee (EFC) to: 1) prioritize and
issue macro-prudential risk warnings; 2) direct risks that potentially could affect
the financial sector or the economy to the EFC to implement a strategy to address
those risks; 3) warn the IMF, the FSF, and the BIS if risks relate to global
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Financial Market Supervision: European Perspectives

dysfunction of the monetary and financial system; and 4) take additional action if
the response of a national supervisor is inadequate.
18. A European System of Financial Supervisors (ESFS) should be established to: 1)
work with the existing national supervisors who would continue to carry out day-
to-day supervision; 2) replace three existing structures (Committee of European
Banking Supervisors (CEBS), Committee of European Insurance and
Occupational Pensions Supervisors (CEIOPS), and the Committee of European
Securities Regulators (CESR) with three new European Authorities tasked with
coordinating supervisory standards and guaranteeing strong cooperation between
national supervisors; also 3) colleges of supervisors should be established for all
major cross-border institutions.
19. National supervisory authorities should be strengthened to upgrade the quality of
supervision, including: 1) reforming national systems by aligning supervisors’
competences and powers on a comprehensive system in the EU, increasing
supervisors’ remuneration, facilitating exchanges of personnel between the
private sector and supervisory authorities, and ensuring that all supervisory
authorities implement a modern and attractive personnel policy; and 2)
intensifying the training and personnel exchanges of the level 3 committees;
carrying out an examination of the degree of independence of all national
supervisors.
20. The EU should develop a more harmonized set of financial regulations,
supervisory powers, and sanctioning regimes.
21. The level 3 committees (national regulators) should: 1) gain a significant increase
in their resources; 2) upgrade the quality and impact of peer review processes; 3)
prepare for establishing supervisory colleges30 for all major cross-border
financial firms in the EU by the end of 2009.
22. The EU should establish an integrated European System of Financial Supervision
(ESFS) and the level 3 committees should be transformed into three European
Authorities – a European Banking Authority, a European Insurance Authority,
and a European Securities Authority – with boards comprised of the chairs of the
national supervisory authorities and have their own autonomous budget and a set
of key competencies that include: legally binding mediation between national
supervisors; adoption of binding supervisory standards; and binding technical
decisions applicable to individual financial institutions.
23. Planning for an integrated European System of Financial Supervision should
begin immediately with a detailed plan for implementation developed before the
end of 2009.
24. The ESFS should be reviewed within three years of its implementation and
additional reforms considered.
25. The Financial Stability Board should be in charge of promoting the convergence
of international financial regulation to the highest benchmarks, the Board should

30 Supervisory colleges are intended to be a formal structure that brings together the relevant national authorities under
a lead supervisor to coordinate policies on cross-border financial activities.
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Financial Market Supervision: European Perspectives

be enlarged, it should report to the IMF, and it should be transformed into a
decision-making Council.
26. Supervisory colleges for large complex, cross-border financial groups should
carry out robust, comprehensive risk assessments, should pay greater attention to
banks’ internal risk management practices and should agree on a common
approach to aligning incentives in private sector remuneration schemes.
27. The IMF should be placed in charge of developing and operating a financial
stability early warning system, accompanied by an international risk map and
credit register.
28. Efforts should be intensified to encourage jurisdictions that currently are poorly
regulated or “uncooperative” to adhere to the highest level of international
standard and to exchange information among supervisors. Supervisors should
increase capital requirements for those financial institutions that are investing in
or doing business with poorly regulated jurisdictions.
29. EU members should show their support for strengthening the role of the IMF in
macroeconomic surveillance and to contribute towards increasing the IMF’s
resources in order to strengthen its capacity to support member countries facing
acute financial or balance of payment distress.
30. The EU should organize itself so it can represent itself in a coherent manner in
the new global economic and financial architecture.
31. In its bilateral relations, the EU should intensify its financial regulatory dialogue
with key partners.

Author Contact Information

James K. Jackson

Specialist in International Trade and Finance
jjackson@crs.loc.gov, 7-7751




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