At the inception of the euro, it was thought possible to have a centralised monetary authority and decentralised bank supervision, but the inability to separate sovereign-debt problems from those of bank stability has led the leaders of the member states of the EU to agree to centralise supervision in the Single Supervisory Mechanism. While the details will be published in a Council Regulation this spring, it appears that it will be a ‘dual system’ of bank supervision with oversight powers for both the ECB and national supervisors. The similarity between European developments and the historical evolution of the US system of bank supervision suggests that there are important insights to be gained from a transatlantic perspective. Since the foundation of the modern US regime was laid in 1864, the US has managed a dual system with varying degrees of success. The differences and similarities with the Single Supervisory Mechanism point to the challenges ahead.
The US historical background
Two characteristics of US bank supervision are emerging as central features of the new European system. The first is the dual supervision of financial intermediaries at the federal and the state level and the second is the creation of multiple functional agencies to supervise banking, securities markets, and insurance.
Before the US Civil War, regulation of banks was left entirely to the individual states. Much like the pre-2012 EU system, there was a single currency and a decentralised system of bank supervision by the member states. Like the recent EU crisis, the crisis of the Civil War brought an important reform of the banking system and federal legislation in 1864 that created a system of national banks chartered, regulated and supervised by the Office of the Comptroller of the Currency. The states retained their powers to supervise the small number of state-chartered banks that seemed little threat to the stability of the new more tightly regulated national system. Now, there was a uniform monetary regime and a federal system of supervision. What was not anticipated was that the more stable national banks would fail to adequately supply credit to the economy. States made their bank regulations more attractive, than national regulations were eased by ‘competition in laxity’ between supervisors, with controls further diluted by regulatory arbitrage. States, not the federal government, regulated securities markets and insurance, leaving little oversight for interstate business. Consequently, when onerous rules, such as the prohibition on branch banking prevented banks from financing the emerging giant corporations, markets, assisted by more lightly regulated trust and insurance companies, stepped in. Yet, it was the trust companies, lacking access to emergency liquidity that caused the 1907 crisis to erupt and spread to the banks.
To remedy these defects, the Federal Reserve System, established in 1913, was to act as a lender of last resort, bringing all systemically important institutions – national banks , large state banks and trust companies – under the federal supervision of the Office of the Comptroller of the Currency or the Federal Reserve banks. Although the origins of the Great Depression are rooted in the failure of the Fed to carry out massive open market purchases, a key oversight was the Fed’s mistaken belief that failing smaller state-supervised banks could be overlooked and were not a sign of impending financial disaster. The 1930s New Deal reforms added more agencies, including the Securities Exchange Commission and the Federal Deposit Insurance Corporation, complicating political oversight by giving them distinctive missions, thereby permitting them to be pressured by their constituencies while creating ample room for competing and conflicting policies.
The Federal Deposit Insurance Corporation’s appearance meant that all insured banks had one primary federal regulator and supervisor – the Office of the Comptroller of the Currency, a Federal Reserve bank, or the Federal Deposit Insurance Corporation, although state regulators were not eliminated. To avoid excessive examinations and conflicting rules, cooperation slowly increased, joint examinations became more common, and standards were unified. But, they have not converged, especially with regard to state banks that often pressure state regulators. While there has been a long evolution to very similar prudential standards and rules, the different agencies missions continues to produce tensions. This dual supervisory structure contributed in many subtle ways to the Savings and Loan/Banking Crisis of the early 1980s and the recent banking crisis. In the booms preceding both crises, local pressures in fast-growing states induced state regulators to grant more charters to financial intermediaries, sometimes compelling federal authorities to ease regulations, revealing that even a century later a dual system induced competition in laxity and regulatory arbitrage.
The Single Supervisory Mechanism system in Europe
In a future banking union with a single resolution authority and a single system of deposit insurance, the emerging Single Supervisory Mechanism would be less prone to competition in laxity and regulatory arbitrage than the US system. Assigned the ultimate responsibility for the effectiveness and consistency of the Single Supervisory Mechanism, the ECB’s direct authority is more encompassing. Surveillance of a bank is not dependent on the geographic scope of its operations, as in the US, but on its systemic significance measured in several dimensions and whether it receives financial assistance from the European Stability Mechanism. This broad discretion granted to the ECB implies that it would not be constrained as the Federal Reserve has been in the past from extending its control over new and fast-growing banks. Nonetheless, to the extent that national supervisors are members of the ECB’s supervisory board, their influence cannot be overlooked, hence, the importance of their European mandate and governance arrangements.
A high degree of coordination, if not full centralisation is expected for licensing, sanctioning and approval of mergers and acquisitions. While the ECB will set the overall standards and directly supervise the relevant banks, national authorities appear to have an important role in their implementation. Also important will be the coordination of the Single Supervisory Mechanism with the non-euro countries' supervisors. The ECB will not be directly involved in crisis management and bank resolution, which will be the responsibility of the national authorities. This autonomy will not be incentive compatible until EU directives are adopted for a unified deposit insurance system and a funded single resolution authority.
Much like the US, European financial supervisors are separated by function – banking, securities markets, and insurance – in a relatively complex and decentralised framework enshrined in the European System of Financial Supervision that depends upon a heterogeneous group of national supervisory authorities. While the dual system of bank supervision in the EU will help to minimise the incentives that have plagued the US system, it is limited to the banks of the participating member states in the Single Supervisory Mechanism. The functional separation of supervision for securities and insurance, which will remain under national authorities, may result in regulatory arbitrage in spite of the Single Supervisory Mechanism, given the fungibility of modern finance. Improved financial stability may demand further centralisation of securities and insurance supervision as well as single rule books for these sectors.
Banking crises in the US in the 19th century and in Europe in the 21st century both led to the creation of dual systems of bank supervision. In the US, the intention was to foster the growth of safer banking institutions, in an era of minimal regulation, while in the EU the purpose has been to better control the safety net subsidies. The central role and powers of the ECB within the Single Supervisory Mechanism are intended to limit the weaknesses of a dual system of supervision as demonstrated by US history. Nevertheless, hazards remain, not only because the Single Supervisory Mechanism only covers banks, not securities, insurance and the rest of the financial system, but also because the success of the Single Supervisory Mechanism requires close coordination between national supervisors and the ECB, especially in the transition period when the safety net systems are still under the national authorities of member states. For those looking for a guide to the potential threats to financial stability under this system, understanding the US experience is relevant.
Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.
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