Images used in the front and back cover Michal Ufniak, www.sxc.hu/profile/mihow

Preface The collapse in Ireland’s economic fortunes has been a dreadful blow. It has adversely affected our reputation as a well run economy with sound public finances, a good business climate and ahead-of-the-curve policies for the attraction of foreign investment. For individuals throughout the country it has had severe effects on income, security and well being. The surge in unemployment since 2007 indicates that a heavy burden has fallen on lower-income groups, and deprivation on that score will most likely increase. Young working families have been hardest hit. Many have large mortgages and insecure income made ever more vulnerable by the forces of globalisation and the growing scarcity of jobs for life. While Keynesian economics and common decency would suggest that this is a time for enhanced budget measures to compensate the unemployed and their dependants, the condition of the Irish government’s finances is so dire and the need to control spending so compelling, that the implementation of such counteracting measures will not prove possible. The rich too have lost hugely. Their financial losses have spilt over to the banks and from there to shareholders and the taxpayer. The value of residential property has fallen by 40%, development land by over 60%, Irish bank shares have fallen by 80% and more. Pension funds and bank shareholders have suffered massive losses. Many of us expected a significant downward adjustment in property prices. A few economists and economic journalists warned of the really serious consequences if the property collapse fed into the banking system. But the extent and speed of the decline has taken most by surprise. In space of an alarmingly few years, Ireland has fallen from top of the world economy beauty parade to bare qualifier. The evidence shows that Ireland’s most respected institutions including the Central Bank, the major Irish banks, the Department of Finance, and the ESRI among others failed to grasp the massive danger to the economy posed by the property bubble. This failure is all too understandable but it is painful to admit. The key issue now is not to spend too much time in regret or in attributing blame, but to work out a strategy to extricate ourselves from the recession and from the escalating debt burden and to start the process of restoring the economy to health. There were two separate contributors to Ireland’s troubles. One was the collapse in the global banking system, beginning in the US subprime mortgage sector and rapidly spreading through Europe and the world economy. We in Ireland were in good company in failing to see this coming. The Federal Reserve, the Bank of England and some of the smartest financial brains in financial circles were caught offside. The demise of Lehmans in September 2008 came as a shock even to those closest to the market in Wall Street. Irish banks in general had broadly stayed clear of the toxic debt instruments that wreaked havoc in the US and the UK. They displayed commendable caution and canny conservatism and resisted the blandishments of easy money. Nonetheless the crisis in

confidence that these developments caused in the global banking sector impacted significantly on their access to liquidity and on the viability of their loans. The second factor was the property boom that had reached a very significant scale in Ireland even by comparison with the UK and the US. For many years to come, we will be asking how it could have happened that the major Irish banks, which had successfully weathered the wildest swings of fortune for many decades (the Bank of Ireland was founded in 1783), succumbed so badly to that most pedestrian of dangers, the property bubble. Why did the economics profession not see this coming? If some did see it, why were the warnings not expressed more vocally and urgently? And why were their warnings not listened to and acted upon in time? There are no easy answers to these questions. Nor is there any sure answer to the consequential question of how to prevent a disaster of this magnitude happening again? This study by William Scally (Reports 1 and 3) and by Shane Fitzgerald (Report 2) provides a helpful and perceptive contribution to our understanding of the issues involved and the measures currently on the table to provide better regulation. Their work was supplemented by a magnificent series of lectures on the theme of financial regulation initiated and hosted by the Institute of International and European Affairs (IIEA). The study begins with a report outlining the rationale of financial regulation. While the market clearly – especially in retrospect! – abounds in market failures, Scally’s analysis demonstrates how difficult and controversial it is to find an adequate response to these failures. His report brings the reader through the labyrinth of important concepts such as moral hazard, regulatory capture and narrow banking in a sure footed and reader-friendly way. He draws on a rich vein of contemporary literature on these topics and gives a balanced and insightful assessment of its conclusions. Shane Fitzgerald’s contribution deals with proposals for reform at a European level. His task is made especially difficult by the fact that the proposals themselves and the context for reform seems to be in a perpetual state of motion. The narrative explains and describes the evolution of proposals but does not stop there. Every so often the author treats us to his own pithy and thoughtful assessment of the merits, defects and political constraints of the various proposals. The chapter is an invaluable guide for anyone wanting a short well-informed analysis of the EU’s attempts to deal with the defects of the global financial system. The third report brings us through an analysis of what went wrong in the Irish financial system. William Scally adopts a strategy of letting the main actors speak for themselves. He makes skilful use of the reports of Oireachtas committees. His use of quotation results in some fascinating insights into the thinking of some of the key players (mainly public sector officials) who had to deal with the property bubble. He avoids cheap point-scoring and facile conclusions. All the contributors he refers to are treated in a balanced manner. He keeps his own views in the background, confining himself to brief trenchant commentaries interlaced throughout the text. He is particularly persuasive in outlining the

real difficulties involved in calling a halt to a property boom once it has got into gear. His discussion links back to the analysis of market failures and regulatory capture discussed in the first section of the study. One is left with the impression that, absent the crisis in the United States financial system, the Irish property and banking boom might well have continued for several years more. Exogenous forces brought it to an abrupt halt; internal (endogenous) regulatory and other forces showed little evidence of capacity or willingness to restrain it. Anyone reading this section of the study will come away with a deeper insight into the perspective of the Department of Finance, the Central Bank and the Financial Regulator into what we now know was, without exaggeration, a really major failure in public policy. The study provides not just a review of the past but also an insight into the direction of change necessary to prevent a recurrence of a similar disaster in the future. If the public sector merits criticism for its failure to anticipate the economic downturn, it has responded vigorously and with skill to the task of setting the economy on a more sustainable path. The financial sector is being reformed and strong action has been taken on the public finances. These measures will no doubt constitute the subject of debate and research for many years to come. Professor Dermot McAleese Chairman, IIEA International Financial Reform Working Group 4 June 2010

Acknowledgements The IIEA’s International Financial Reform Working Group came together in 2009 and evolved in various formats from then up to March 2010. Three reports, which are now published, emerged from the process. These reports do not take account of any events since April 27th, 2010. It is hoped that they will provide a basis for further discussion and research among the members of the Working Group itself, the membership of the IIEA, and a wider public. Special thanks are due to all who participated and contributed to the project whether by giving their views at meetings or in other ways. In particular, the written contributions of Denis O’Leary and Jonathan Westrup were extremely important. We consulted Martin O’Donoghue and Donal de Buitleir at certain stages of the project and their wisdom and experience were invaluable. None of the above is responsible for, or necessarily agrees with, the views expressed in this study. The views expressed are solely those of the authors alone. Shane Fitzgerald, from the staff of the IIEA, as well as contributing the second report, was an able and diligent co-ordinator and reference point for the project. Naturally, responsibility for reports 1 and 3 rests with William Scally and for report 2 with Shane Fitzgerald. These reports are not to be taken as representing the views of the IIEA. Dermot McAleese has contributed the Foreword. Dermot McAleese Project Chairman William Scally Project Leader 4 June 2010

CONTENTS

• Introduction

• Political Context of EU Reforms

• The Reform of Financial Supervision in Europe

• The Reform of Financial Regulation in Europe

• Final Remarks and Conclusions

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Introduction Financial regulation and supervision share the ultimate aims of ensuring financial stability, deterring malpractice and protecting consumers. Whereas regulation refers to actual rules, supervision describes the monitoring of the application of those rules. As a 2009 report into financial supervision in the European Union made clear, supervision and regulation are interdependent: “competent supervision cannot make good failures in financial regulatory policy; but without competent and well designed supervision good regulatory policies will be ineffective”.1 In responding to the global financial crisis, the EU has proposed both new regulations and new supervisory arrangements. It is also reviewing and amending an existing suite of financial services legislation.2 The Chartered Financial Analysts Institute (CFAI) estimates that during the next five years Europe will see at least 72 major rule-making initiatives affecting financial services. The head of the CFAI believes that 50 or so will affect the broader capital markets.3 This report first puts these reforms into political context by identifying certain institutions, events, and trends that will influence their evolution and implementation. It then goes into more detail about the reforms themselves, dealing first with the supervisory innovations before analysing developments in the area of regulation. Political Context of EU Reforms Introduction The policy response to the financial crisis is beginning to shift from one of short-term crisis management to one of long-term and strategic implementation of reforms. This transition takes place against the background of significant political shifts, which will impact on decisions made at national, regional and international levels. Among these are rapid changes in the global political economy and in the architecture of global governance, rising levels of public debt, a dangerous moment in the evolutionary paths of the European single market and the Eurozone, the commencement of a new European Commission, and the ever-present and ever-important variable of elections and domestic political considerations. Changes in the architecture of global governance An effect of the financial crisis has been to heighten debate within the architecture of global economic governance about a shift of power away from states (and financial institutions) and towards certain multilateral and international organisations. We can anticipate a growing relevance for international bodies such as the G20, the Financial Stability Board, the International Monetary Fund, the International Accountancy Standards Board, the Basel Committee for Banking Supervision and the International

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Organization of Securities Commissions. It is worth therefore briefly mapping these organisations, their recent evolution, and their contribution to the policy debate so far. Group of 20 (G20)  The Group of 20 is an informal grouping of the world's most powerful countries that together represent 85% of the world's economy. It was set up after the Asian financial crisis in 1999 to foster international consultation and co-operation among finance ministers and central bankers. The G20 membership consists of Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, the US and the EU. Since 2008, it has taken an increasingly leading role in global economic and financial policy coordination. Its leaders met in Washington D.C. in November 2008, London in April 2009 and Pittsburgh in September 2009. The next summit will take place in Huntsville, Ontario in June 2010, followed by a summit in Seoul in November 2010. At the November 2008 Washington Summit, the G20 members declared their intention “to work together to restore global growth and achieve needed reforms in the world's financial systems”4 and agreed an Action Plan designed to strengthen transparency and accountability, enhance sound regulation, promote integrity in financial markets, reinforce international cooperation and reform international financial institutions. This plan has since acted as a reference point for policy-makers across the world. Specific policy goals designated to the G20 finance ministers included: the mitigation of pro-cyclicality in regulatory policy; the review and alignment of global accounting standards; the strengthening of the resilience and transparency of credit derivative markets (including by improving the infrastructure of over-the-counter markets); the review of compensation practices as they relate to incentives for risk taking and innovation; the review of the mandates, governance, and resource requirements of the international financial institutions; the definition of the scope of systemically important institutions and the determination of their appropriate regulation or oversight. At the April 2009 London Summit, the G20 members agreed to:

• implement the Action Plan agreed in Washington; • reconstitute the Financial Stability Forum (FSF) as a Financial Stability Board

(FSB) to include all G20 countries, FSF members, Spain and the EU Commission; • endorse FSB and IMF collaboration on early warning procedures for

macroeconomic and financial risks; • reshape regulatory systems to take account of macro-prudential risks; • extend regulation and oversight to all systemically important financial

institutions; • support sustainable compensation schemes and corporate social responsibility;

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• reform capital requirements, especially to mitigate procyclicality; • take action against ‘non-cooperative jurisdictions’; • call on accounting standard setters to achieve a single set of high-quality global

standards; • extend regulatory oversight to CRAs, especially with regard to conflicts of

interest; • recommend “supervisory colleges” for all major cross-border financial

institutions; • return to the Doha development round; • refrain from raising new barriers to investment and trade, and to rectify any such

existing measures; • submit to monitoring in order to avoid protectionism; • strengthen global financial institutions (especially the IMF); and • support discussion on a charter for sustainable economic activity based on a

global consensus of key values and principles5 Since then, governments have been active in policy-making to achieve these goals, though recent months have seen a rise in the type of unilateral measures that the G20 was designed to avoid. Complex and welcome reforms have been attempted at national level, some significant developments at the regional level, especially in the EU, but not much has yet happened at the global level. Though governments have struggled to come up with coordinated policy responses, there have been significant instances of effective cooperation among central banks. For example, as far back as December 2007, the Eurosystem and the US Federal Reserve reached an agreement to grant loans in US dollars to euro area counterparties in connection with the Fed’s Term Auction Facility. The announcement of a coordinated interest rate cut by the ECB and five other major central banks (the Bank of Canada, the Bank of England, the Federal Reserve, Sveriges Riksbank and the Swiss National Bank) in October 2008 was another important and symbolic instance of international policy coordination. Central banks remain in close consultation about coordinating exit strategies from the crisis. Financial Stability Board (FSB)  The FSB was set up by the G20 to oversee stability of the global financial system and to ensure that agreed regulatory principles are applied consistently in each country. It brings together national authorities responsible for financial stability, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. The FSB is chaired by Mario Draghi, Governor of the Bank of Italy. Its Secretariat is located in Basel, Switzerland, and is hosted by the Bank for International Settlements. The FSB replaces the Financial Stability Forum, an informal G7 body. The FSB has recently issued a framework through which it intends to “foster a race to the top, wherein encouragement from peers motivates all countries and jurisdictions to raise

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their level of adherence to international financial standards.”6 In an effort to lead by example, FSB member jurisdictions have committed to:

• implementing international financial standards; • undergoing an assessment under the IMF-World Bank Financial Sector

Assessment Program (FSAP) every five years; • disclosing their degree of adherence of international standards, notably by

publishing the detailed assessments prepared by the IMF and World Bank as a basis for the Reports on the Observance of Standards and Codes (ROSCs); and

• undergoing periodic peer reviews using, among other evidence, reports prepared as part of the FSAP.7

The International Monetary Fund  The mandate of the International Monetary Fund is to “foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.”8 At the 2009 G20 summit in Pittsburgh, leaders asked the IMF to prepare a report for their next summit (taking place in Toronto in June 2010) on how the financial sector could make a fair and substantial contribution toward paying for the costs of future bank rescue packages. The report proposes two forms of contribution from the financial sector, serving two distinct purposes:

• A Financial Stability Contribution (FSC) to “pay for the fiscal cost of any future government support to the sector". It would be paid by all financial institutions, not just banks, initially at a flat rate but “refined over time to reflect institutions’ riskiness and contributions to systemic risk”. The revenue could either accumulate in a bail-out fund or be returned to general government revenues.

• A "Financial Activities Tax" (FAT), which would cover any further contribution

“that is desired” by governments. This would be levied on the sum of the profits and remuneration of financial institutions and paid into general revenues. This nicely-acronymed levy would hit hardest those companies which generate the highest profits and pay the largest bonuses. 9

The report notes that a number of countries have already begun to impose levies on financial institutions but argues that such unilateral actions risk being undermined by tax and regulatory arbitrage. Effective cooperation should not require full uniformity, but does demand broad agreement on principles, including the bases and minimum rates of new levies. The IMF proposals have the virtue of relying only on a base level of cooperation, beyond which jurisdictions can choose to rise if they so wish. It is emphasised that any levy must be linked to an effective resolution regime to avoid the perception that the receipts would be used to prop up failing institutions.

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At a time when banks are trying to rebuild their capital bases, these new costs will be firmly resisted. Those financial institutions not directly responsible for the crisis are particularly aggrieved and we can anticipate that many institutions will try to pass on the costs to their customers. Nor will these proposals get an easy ride from IMF member states. Many countries who survived the crisis relatively unscathed are resisting the idea. Canada is strongly opposed while Australian and Indian officials are also said to be cool on the idea. Nonetheless, Dominique Strauss-Kahn, Managing Director of a resurgent and increasingly assertive IMF, argues forcefully for the need to reject ad hoc, national reforms. In proposing a tax on bank liabilities (the FSC) and profits and pay (the FAT) his organisation also explicitly rejects the notion of a so-called “Tobin Tax” on financial transactions, which has been proposed by the UK and Germany amongst others. This was dismissed as unworkable because unless every single financial jurisdiction signed up, the potential for international arbitrage would be too great. The IMF’s proposals are nonetheless a timely reminder of the benefits of international cooperation. Despite its ambivalent reception, this report is likely to frame the imminent and important global debate on this issue. The IMF is increasingly visible in two other major debates. The first is the looming threat of a first world debt crisis, exemplified by the case of Greece, in whose rescue the IMF is taking a leading role. The second is the argument over representation in the IFIs. In Pittsburgh, the G20 leaders asked that the imbalance in voting power between leading and emerging economies in these institutions begin to be addressed. The World Bank and the IMF are both revising their voting structures this year so as to give developing countries a voting weight more commensurate with their economic clout. The transfer of voting quotas at the World Bank is already underway while the IMF is committed to completing governance and quota reforms before January 2011.10 The International Accounting Standards Board (IASB) and The Financial Accounting Standards Board (FASB) In Pittsburgh, the G20 also called on “international accounting bodies to redouble their efforts to achieve a single set of high quality, global accounting standards within the context of their independent standard setting process, and complete their convergence project by June 2011.”11 The IASB is responsible for formulating International Financial Reporting Standards (IFRS). Along with the FASB, a US agency, it is the most important player in this process. The IASB recently published an overhaul of rules on “fair value” accounting in response to concerns that this practice forced banks to book unnecessary write-downs during the crisis. These new rules are already in use by many jurisdictions but the European Commission delayed their introduction within the EU over fears that they could prove detrimental to some French, German and Italian banks with large investment portfolios.12 The decision was symptomatic of an increasingly politicised

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debate over how to measure financial assets, where tensions between the IASB and the FASB are central. The Commission has said that it will not adopt the changes until it has carried out an in-depth analysis. It is likely to reconsider adoption in late 2010. After a meeting in October 2009, the IASB and FASB Chairmen announced that their organisations have agreed to meet monthly, starting in January 2010, to achieve the goal of converging IFRS and US rules to the greatest extent possible by June 2011.13 Hopes of a rapid convergence were however dashed in February 2010 when the IASB announced that it would no longer pursue convergence with its US peer as "an objective in itself,” but rather insofar as the strategy served to promote and facilitate the adoption of IFRS internationally. The US is concerned about the technical implications of shifting from its existing rules-based system to the principles-based system embodied in the IFRS, but also about the loss of sovereignty that such a move would entail.14 The debate over accounting standards will be lent extra pungency as investigations into improprieties at financial institutions continue. The report15 of Anton Valukas, court-appointed examiner to Lehman Brothers, raised a number of serious issues relating to accounting and auditing practices at the firm, which are likely to crop up elsewhere as other investigations publish their findings. The controversy over hidden loans and other accounting practices at Anglo Irish Bank is only one immediate example. The Basel Committee on Banking Supervision (BCBS) The Basel Committee on Banking Supervision is an institution set up by the Central Bank governors of the G10. It usually meets at the Bank of International Settlements in Basel, Switzerland. The Committee formulates supervisory standards and guidelines and issues statements of best practice in banking supervision. The Committee is an informal forum and as such cannot issue binding regulation. However, national authorities take its recommendations seriously. For example, the Basel II Accord of 2004 created an international standard for capital requirements that national authorities use when determining how much capital banks should reserve to mitigate operational and financial risks and to safeguard their solvency. By making the process of capital allocation more sensitive to risk, by differentiating and quantifying operational and credit risk, and by aligning economic and regulatory capital more closely, ‘Basel II’ aimed to reduce moral hazard, lessen the scope for regulatory arbitrage, and strengthen the integrity of institutions and the broader financial system in which they operate. Basel II uses a "three pillars" concept: The first pillar demands the maintenance of regulatory capital linked to three major components of risk that banks face: credit risk, operational risk and market risk.

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The second pillar is concerned with all the other risks that banks may face, such as systemic, reputational, liquidity and legal risks. These ‘residual’ risks are harder to quantify but this ‘supervisory’ pillar gives more tools, both to banks and regulators, to try to capture these risks. The third pillar is supposed to improve transparency by increasing the disclosures that banks must make, thus allowing the market to view the overall risk position of a bank more clearly. Even before the crisis, Basel II was much criticised by commentators, some of whom went as far as to say that “the world at large would have been better off without the work of the Basel Committee.”16 The Committee was accused of choosing poor quality measures of risk, of exacerbating pro-cyclicality, and of relying too much on credit ratings agencies for determining credit risk.17 These criticisms have been borne out in the wake of the crisis. The Committee is now considering, as a supplementary measure to the risk-based framework, the introduction of a leverage ratio. The idea here is simply to reduce banks’ use of external debt finance to finance investment. This would have a major impact on European banks, some of which had until recently debt to capital ratios of thirty to one. It is also developing proposals on a revised definition of capital and considering the introduction of a counter-cyclical buffer mechanism to reduce the pro-cyclical effects of Basel II. The Committee’s Cross-Border Bank Resolution Group has also developed a set of recommendations intended to strengthen national resolution powers and their cross-border implementation. They also provide guidance for firm-specific contingency planning.18 The cumulative effect and interaction of all these proposed reforms will be analysed in an impact assessment study that is due to be published before the end of 2010.19 In the European context, these proposals will inform a review of the Capital Requirements Directive, referred to later. The International Organization of Securities Commissions (IOSCO) Although essentially a talking shop for securities regulators, IOSCO has positioned itself carefully for a bigger role in regulating markets in the wake of the crisis. The primary way in which it aims to make its presence felt is by facilitating information exchange. The IOSCO Multilateral Memorandum of Understanding (MOU) is the first global information-sharing arrangement among securities regulators. By helping to coordinate the fight against market abuse and fraud in increasingly connected global markets, it is “reshaping international enforcement.”20 A recently issued IOSCO template requires hedge funds to tell regulators more about their holdings, trading and borrowing in order to enable better assessment of systemic risk in the sector. While the template is advisory, similar proposals being worked on by

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major regulators such as the FSA and the SEC mean that it is likely to be adopted by all the main financial centres.21 The EU’s legislative proposals in this area will also adhere to the IOSCO template. Shifts in the Global Economy Underlying all these developments are general trends in the distribution of capital, power and momentum within the global political economy, many of which were accelerated by the financial crisis. The most important of these are shifts in in the dynamics of the world economy from West to East and from developed to emerging economies. While the West is expected to manage only low levels of growth over the next few years, IMF analysts expect India and China to keep growing at 8.8 and 10 percent respectively and Asia to continue to lead the global recovery.22 Newly-troubled Western states are highly dependent on such a global recovery to revive their fortunes but the crisis has exposed severe structural problems underlying many of their economies that global growth may not be enough to overcome. Compounding concerns over sovereign debt levels is a potentially chronic lack of competitiveness when compared to more dynamic emerging economies. The fiscal, demographic and competitiveness challenges facing countries in the European Union are perhaps especially stark. Many will look for guidance to EU2020, the European Commission’s successor to the Lisbon Strategy For Growth and Jobs. This has three key themes: creating value by basing growth on knowledge; empowering people in inclusive societies; and creating a competitive, connected and greener economy. The Barosso II Commission and the appointment of Michel Barnier An early focus of journalists and analysts in 2010 was the appointment of a Frenchman, Michel Barnier, to the position of Commissioner for Internal Markets and Services. In what Nicolas Sarkozy billed as a ‘defeat for Anglo-Saxon capitalism’, Barnier replaced Charlie McCreevy as arguably the most powerful man in European finance. Fearful British bankers were reassured by Barnier’s conciliatory attitude in his hearing before the European Parliament on January 13, and also by the fact that his Chef de Cabinet is Jonathan Faull, a long-serving and respected Commission staff member from England. Barnier’s hearing was light on the big ticket financial supervisory and regulatory reforms due in 2010 but more detail was provided in a written response to MEPs’ questions submitted before his hearing.23 In this he gave his three priorities as:

• Reinforcing the single market; • Moving out of the crisis and ensuring the stability of a financial system where

savers are protected; and • Developing a knowledge-based economy.

Barnier also detailed specific legislative and non-legislative initiatives that he intends to put forward. These include:

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• Completing the reform of EU financial supervision; • Creating a legal framework for crisis management and resolution; • Examining the implementation of European deposit guarantee funds and

resolution funds; • Revising of the Capital Requirements Directive in order to incorporate the G20

agenda and the work of the Basel Committee into the Community Agenda; • Adopting application measures under Solvency II; • Reforming of the IORP Directive (relating to the activities and supervision of

institutions for occupational retirement provision); • Reviewing the 'market abuse' and MiFID directives; • Proposing a coherent legislative framework to the Commission for over-the-

counter (OTC) derivatives; • Setting one or more deadlines for migration to Single Euro Payments Area

(SEPA) products for direct debits and credit transfers, as well as an initiative to improve governance; and

• Putting forward a coherent legislative framework to ensure that savers are better informed and better advised.

The most important of these proposals are discussed later in this report. In February, Commissioner Barnier announced that he would seek a more coherent way to address the issue of regulation of gambling across the Single Market, following conflicting rulings from the European Court of Justice on the issue.24 He is also committed to modernising and reinforcing the EU’s system of intellectual property rights. Taken altogether, this is a hugely ambitious programme and is bound to be controversial. Barnier is keen to allay fears that he will pursue a policy of dirigisme. He went on peace-making missions to London and continues to emphasise his commitment to following the path towards a new regulatory architecture laid out at the Pittsburgh summit.25 Replacements at the ECB In February 2010, Eurozone finance ministers nominated Vitor Constancio to succeed Lucas Papademos as the Vice-president of the European Central Bank. This appointment takes on extra significance as it is likely to influence the decision on who will replace Jean Claude Trichet as ECB president in 2011. France, Germany and Italy have not publicly backed any vice-presidential candidate but German officials have begun quietly lobbying for the President of the Bundesbank, Axel Weber, to succeed Trichet. Italy favours the Governor of the Banco d’Italia, Mario Draghi. The identity of Trichet’s successor could have implications for the economic prospects of Ireland and other Eurozone countries, particularly insofar as the new President is determined to make inflation-fighting a priority. It also has implications for international financial supervision, as the ECB President is set to chair the new European Systemic Risk Board when it gets up and running (more on which later).

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Mario Monti’s Special Report Delivering effective reform of the financial services sector is a gargantuan task. There is a risk that by concentrating on this agenda-setting issue, it will prove impossible to ensure full implementation of the Services Directive, and to deliver a much needed review of the Single Market as a whole. Perhaps anticipating this, and realising the extent to which the EU’s long-term economic future depends on an a robust Single Market, in October 2009, President Barroso tasked Mario Monti, who was Internal Market Commissioner 1995-99 and Competition Commissioner 1999-2004, with preparing a report on how to “relaunch” work on the EU’s single market. Monti says there is a need for a “new deal” between countries with a “social market” mentality and those with an “Anglo-Saxon” outlook. He also says that there were signs prior to the crisis of “a growing rejection” of the single market and that this was “particularly” true of France and Germany. His report will examine both gaps in the single market and how to ensure stronger enforcement of the laws underpinning it. Sensitive issues such as economic surveillance of member states and coordination of tax policy will also be addressed. His report was presented to Barroso at the beginning of May 2010.26 The European Parliament Special Committee on the Financial, Economic and Social Crisis During its October 2008 plenary meeting, the European Parliament decided to create a special committee on the financial and economic crisis (CRIS). This committee first met on 15 October 2009. It has a 12-month mandate, consists of 45 members, and is non-legislative in nature. Its focus is on “establishing a roadmap for the future, discussing possible new structures for financial markets and its participants, evaluating the application of relevant Community legislation and the coordination of action by Member States.”27 The committee will hear from industry members, governments, national parliamentarians and economic experts, and will contribute opinions to the legislative work of Parliament’s standing committees.28 The solutions it proposes are likely to underline the need for concerted global action. Its findings will be presented in two reports: a mid-term report and a final report containing recommendations on measures to be taken. The UK Given that the United Kingdom remains a global leader in the financial services industry and must be a main player in any effective European reform, the domestic debate there over the reform of financial supervision and regulation is of particular relevance to policymakers in Europe, and of course in Ireland. The new Chancellor, George Osborne, has been proposing to do away with the FSA altogether and to grant the Bank of England more powers with which to fulfill its mandate of ensuring financial stability. By giving the BoE the power to set counter-

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cyclical capital requirements and force systemically risky banks to restructure, he wanted to effectively abolish the tripartite system. Osborne also proposed a stronger consumer watchdog that would protect consumer interests and cut bank charges. The relationship between the EU and the UK’s new coalition government will be addressed in a forthcoming IIEA report. Financial, economic and regulatory issues will be a primary focus. Ireland In the wake of a devastating financial collapse, Ireland is in the midst of a painful bout of introspection. Reforming the domestic architecture of financial regulation and supervision is a key priority. The light touch regulatory approach of former Commissioner McCreevy and successive Irish governments may now be discredited, but financial services remain an important part of the Irish economy (see: IIEA Fixing Finance Report Three: The Irish Experience). Looking forward, decisions on the future of the sector need to be taken in close consultation with our European partners and with the institutions that are in the process of drafting and updating a whole host of financial services regulations, not to mention an overhaul of the European system of financial supervision. It it to these processes that we now turn. The Reform of Financial Supervision in Europe29 Introduction The focus of this section is the European Commission’s proposals in the area of supervisory reform. It begins with a discussion of the supervision function and the status quo before the financial crisis, before proceeding with a short summary of a report that effectively laid the basis for the EU’s supervisory and regulatory response to the crisis. It then tracks the policymaking process as it unfolded in 2009 and evaluates the package of draft legislation as it stands now, in late 2009, adopted by the Commission and being negotiated under the co-decision procedure between the European Parliament, Council and Commission. Finally, it considers some issues relating to the establishment and operation of the bodies proposed in the draft legislation and offers some preliminary observations. Macro-Prudential Supervision and Systemic Risk Analysis Macro-level supervision seeks to identify those large-scale trends and imbalances that are not susceptible to direct regulation or supervision by those national or sectoral authorities which are mandated only to focus on particular firms in specific sectors. In contrast, macro-prudential supervision concerns itself with the aggregate effect of individual firms’ actions, seeking to generate an overall picture of the functioning of the financial system.30 While certain national authorities carry out a macro-prudential function on their own,

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policy responses to the financial crisis have in many cases focused on ways in which countries and regions can pool their resources so as to create a degree of supranational supervision. The newly mandated Financial Stability Board is the leading example of this trend. Systemic risk can be defined as the risk that the distress or failure of a significant part of the financial sector will reduce the availability of credit and so adversely affect the real economy.31 Analysis of such risk is nothing new to macro-economists and the central banking community. For example, the G10’s Committee on the Global Financial System, made up of central bank representatives from the Group of Ten central banks and others, is mandated to “identify and assess potential sources of stress in the global financial environment through a regular and systematic monitoring of developments in financial markets and systems”.32 It issued a number of risk warnings ahead of the 2008/2009 crisis, as did other organisations such as the FSF, the IMF, the BIS and the ECB. In retrospect it is clear that these analyses were not adequately incorporated into the macro-prudential supervisory arrangements that existed at the time, and that these arrangements were not strong enough, nor their scope wide enough, to act as effective early warning systems to the financial and policymaking communities. Politically, the concept of supranational supervision of financial markets is a sensitive one as, if it is to be effective, it will inevitably clash with national interests and agendas. It also creates an asymmetry whereby the responsibility and power to prevent banking crises is passed upwards to a supranational agency, but it is the national fiscal authorities which will ultimately have to provide the resources to deal with any crisis. Supranational macro-prudential boards will therefore always struggle to exert influence over national economic policies, which are after all some of the most fundamental attributes of state sovereignty. Yet, as the financial crisis has made clear, national policies can often in themselves pose systemic risks. Though this dilemma is softened somewhat in the pooled sovereignty of the European Union, stubbornly insoluble elements remain. The idea of establishing a body to monitor and assess systemic risk at the European level was first suggested in the late 1990s, but it has taken over a decade to implement it.33 Events have since exposed serious weaknesses in the EU's macro-supervisory framework, which remains fragmented along national lines despite the longstanding establishment of a single market and the ever-increasing importance of cross-border transactions and institutions. The ECB pursued from the outset a research agenda on financial stability and systemic risk.34 In 2004, it began to publish a Financial Stability Review twice yearly, noting signs of systemic risk in several subsequent publications in 2006 and 2007.35 The IMF also continues to publish a Global Financial Stability Report twice yearly, though chapter two of its April 2006 report provides a cautionary tale for anyone thinking that simply undertaking a programme of macro-prudential analysis and reportage will prevent future shocks. Entitled “The Influence of Credit Derivative and Structured Credit Markets on Financial Stability,” it begins:

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There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient. Over the last decade, new investors have entered the credit markets, including the credit risk transfer markets. These new participants, with differing risk management and investment objectives (including other banks seeking portfolio diversification), help to mitigate and absorb shocks to the financial system, which in the past affected primarily a few systemically important financial intermediaries. The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently, the commercial banks, a core segment of the financial system, may be less vulnerable today to credit or economic shocks.36

As the Director of the UK’s Financial Services Authority, Adair Turner, noted on the occasion of the launch of The Turner Review: A Regulatory Response to the Financial Crisis,37 this assertion wasn’t just wrong, but:

180° wrong. So how do we ensure that we don’t in ten years’ time get it wrong again, going along with a dominant conventional wisdom? Market prices are subject to self-reinforcing herd effects: policymakers and policy intellectuals can be subject to intellectual herd effects; and there is no failsafe way to offset this human tendency to collective error. But we need as best possible to embed challenge into our institutions.38

Even where macro-prudential analysis was not technically incorrect, it was often of little use to policymakers. As ECB President, Jean-Claude Trichet, has said: “We knew that a storm was brewing but, admittedly, we did not know exactly where. Neither did we know what would trigger it, or when it would come”.39 And even where, with hindsight, advice was right on the money, it was often ignored. A significant cadre of economists and market analysts, including William White and Claudio Borio of the Bank for International Settlements, continually voiced prescient concerns about dangerous liquidity profiles giving rise to systemic risks, both in policy papers40 and in various international fora.41 Their arguments failed to penetrate the prevailing consensus. In the absence of an authoritative and coherent system of supervision and regulation that effectively combined micro- and macro-prudential functions, it is little surprise that warnings were ineffective, or misjudged, or ignored. Yet in retrospect it is clear that even the gloomier scenarios laid out in those risk warning documents relied on a “massive undervaluation”42 of risk, deriving from two main sources: misjudging or ignoring the probability of certain ‘outlier’ events occurring, and neglecting to properly conceptualise the effects of an increase in uncertainty at the systemic level.43 Appropriately accounting for these phenomena will be vital for the success of any new macro-prudential system. Such appropriate accounting will in turn depend on accurate risk data, which can only be

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provided by constant communication with thorough and well-connected systems of micro-supervision. Micro-Prudential Supervision and the Lamfalussy Process Micro-level supervision monitors individual firms’ compliance with financial regulation. It involves the collection and analysis of information about firms’ systems, their personnel, and their risk profiles.44 Presently in Europe, national supervisors co-operate within colleges of supervisors, but there are a number of gaps and points of conflict within this arrangement. Many technical rules are determined at member state level but there is considerable variation between member states’ approaches. Even where the rules are harmonised, application can be inconsistent. This incoherent system of micro-supervision ultimately undermines the single market, increases disputes and costs and makes effective oversight much more difficult. In 1999, the European Commission launched its Financial Services Action Plan (FSAP) as a key component of the EU's attempt to create a single market for financial services. Containing 42 proposals related to the harmonisation of the financial services markets within the European Union, its three core objectives were to provide a single wholesale market, an open and secure retail market, and state-of-the-art prudential rules and supervision. The Financial Conglomerates Directive of December 2002 formed an important part of the FSAP. It determined how the lead supervisor of a financial conglomerate should be decided and aimed to ensure that gaps in existing supervisory arrangements were filled. This represented the first transposition in the world of the international recommendations on the supervision of conglomerates that were adopted by the G10 and the Bank of International Settlements in 1999.45 The directive also provided for closer coordination and better exchange of information between the different sectoral supervisory authorities.46 The FSAP called for the creation of a Securities Advisory Committee to improve cross-sectoral discussion and cooperation between authorities. In responding to this call, an entirely new committee structure was established under what would become known as the Lamfalussy process. At the European Council in Lisbon in March 2000, an independent ‘Committee of Wise Men on the Regulation of European Securities Markets’ was set up, chaired by Alexandre Lamfalussy. Its aim was to reduce the backlog in securities market regulation so as to complete the integration of the financial single market by 2005. It recommended a novel approach to the development and adoption of EU financial services legislation, comprising a four-level procedure designed to speed up and streamline the legislative process by dividing legislation into high-level framework provisions and implementing measures. The new arrangements also featured open consultation procedures and greater

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transparency, and made provision for legislation to be modified as required to keep pace with market and supervisory developments.47 The new regulatory and institutional framework in securities that arose out of this process was endorsed by the EU institutions and the experience was considered a model for the transformation of governance in other policy areas.48 A number of FSAP measures have since been adopted using this new framework, including the Market Abuse Directive, the Prospectus Directive, MiFID, the Transparency Directive and the Solvency II review of the capital adequacy regime for the European insurance industry. The four ‘Lamfalussy levels’ are:

• Level One - framework legislation, proposed by Commission and voted on through co-decision by the Council and Parliament;

• Level Two - implementing measures for the Level One legislation, led by the Commission;

• Level Three - supervisory committees facilitating the convergence of regulatory outcomes; and

• Level Four - enforcement of all EU measures, led by the Commission.

In the case of banking, securities and insurance supervision, Level Two legislation was to be prepared by the Commission on the basis of advice provided by representatives of national supervisory authorities, acting through the so-called 'Level Three Committees’ (CESR, CEBS and CEIOPS).49 These committees were also mandated to foster supervisory convergence and best practice, principally by issuing (non- legally binding) guidance. In 2007, a review of the Lamfalussy supervisory system took place, with all interested parties submitting papers to the ECOFIN Council. ECOFIN concluded that the system was working well but recommended a number of changes. The Level Three Committees were in the process of responding to these conclusions when they became the subject of much more far-reaching reform proposals, based on the influential ‘de Larosière Report’. The de Larosière Report In October 2008, a high-level group on financial supervision, chaired by Mr. Jacques de Larosière, was mandated to investigate a number of issues arising out of the financial crisis. These included: how best to organise the supervision of international financial institutions (IFIs) and markets in the EU; how to strengthen European cooperation on financial stability oversight, early warning and crisis mechanisms; and how EU supervisors should cooperate globally. It issued its final report (hereafter the de Larosière Report)50 in February 2009. The de Larosière Report was structured into four parts: causes of the financial crisis; policy and regulatory repair; EU supervisory repair; and global repair. In section one, it identified the following key causes of the financial crisis:

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Macroeconomic: Excess liquidity, low rates, loose monetary policy,

mispricing of risk, and too much leverage. Risk Management: Lack of transparency, non-oversight of the shadow banking

system, the cumulative effects of the ‘originate to distribute’ model, and the difficulty of modelling for extreme complexity.

Credit Ratings Agencies: Dramatic failures fueled by major conflicts of interest. Corporate Governance: Weak shareholders and management, improper incentive

structures. Regulatory/Supervisory: Encouraged procyclicacity, problems with mark to market

system, unregulated OTC derivatives market, and bad readings of macro-prudential risk.

Institutional Weaknesses: Failures at the IMF, FSF, BIS and G20, plus an overall lack of coordination.

In section two, it identified the following general areas in need of policy and regulatory repair: Macroeconomic policy and macro-prudential analysis; capital requirements and the Basel II regime; credit rating agencies; international accounting standards; insurance; sanctions; oversight of the ‘shadow’ or ‘parallel’ banking system; securitized products and derivatives; and investment funds. It also advised that there should be a single set of core regulatory rules and supervisory standards in the EU.

In section three, the report set out its recommendations in the area of EU supervisory repair. The innovations discussed here have their roots in this section. There were two main proposals:

• The creation of a European Systemic Risk Council (ESRC) responsible for analysing trends, imbalances and systemic risks in the financial system as a whole (macro-prudential supervision).

• The formation of a European System of Financial Supervisors (ESFS)

responsible for the day-to-day supervision of individual banks and financial institutions (micro-prudential supervision). This would upgrade the existing ‘L3’ Committees into three new EU Authorities: the European Banking Authority; the European Securities Authority; and the European Insurance Authority.

Finally, in section four, the report made some recommendations with regard to repair at the global level, emphasising in particular how important it is to organise coherent EU representation in the new global economic and financial architecture. In all, the group made thirty key recommendations, which are useful as a ‘check list’ for policy makers and analysts.51

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The Legislative Process Building on the recommendations of the de Larosière report, the European Commission put forward proposals52 for a new supervisory framework in May 2009. These were fully endorsed at the June EU Council Summit,53 which published a communication calling for the rapid adoption of the necessary legislative texts. The Commission responded by adopting a package of draft legislation54 which has since been submitted to the European Parliament and Council. If approved, the Commission hopes that the rules can be in place by the end of 2010. The main recommendations of the de Larosière Report have survived the policymaking process thus far, though the title of the ESRC has been amended to become the European Systemic Risk Board (ESRB). The following sections consider the ESRB and the ESFS in more detail.55 The European Systemic Risk Board The ESRB is the centrepiece of the EU’s proposed new institutional arrangements. Building on the suggestions of the de Larosière Report that a systemic risk council be convened with the aim of scanning the horizon for potential systemic threats, the ESRB looks set to wield considerable moral and political authority, even though it will be established as a purely consultative body and will not be able to impose measures or sanctions on member states or financial institutions. In its role as an ‘early warning system’ for macro-level shocks, the ESRB will be able to request data from national authorities, central banks and the new European Supervisory Authorities, as well as issue warnings when it considers it prudent to do so. Its formal functions are to:

• define, identify and prioritise all macro-financial risks; • issue risk warnings and give recommendations to policy makers, supervisors and

eventually to the public; • monitor the follow-up of the risk warnings; • liaise with international and third country counterparts; and • report at least bi-annually to the EU Council and European Parliament.56

Members of a General Board will elect the chair of the ESRB for a renewable period of five years. The General Board will be the main decision-making body of the ESRB and will be composed of all EU central bank governors, the president and the vice-president of the ECB, a representative of the European Commission and the chairpersons of the three European Supervisory Authorities. National supervisors and the president of the Economic and Financial Committee will also be board members, but without voting rights. The ESRB’s operations will be steered by a committee consisting of the ESRB chairperson and vice-chairperson, five additional central bank representatives, the

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chairpersons of the new European Supervisory Authorities, the president of the Economic and Financial Committee and the Commission representative. The ESRB will be based at the ECB’s Frankfurt headquarters and ECOFIN has asked the ECB to provide analytical, statistical, administrative and logistical support to the operation, as well as to pass on technical advice from the national central banks and supervisors. The board will issue recommendations and risk warnings to member states and the European Supervisory Authorities. Recipients will be obliged to comply or else explain why they have not done so. In general, recommendations will also be sent to the Council. Decisions over whether or not to publish ESRB warnings publicly will be made on a case-by-case basis.

Specific follow-up procedures are also foreseen. For instance, when a national supervisory authority intends to deviate from an ESRB recommendation, it must first discuss and justify it with the competent European authority and will have to take into account its views before answering the ESRB. And if the ESRB feels that the explanations are not convincing, it shall inform the Council. 57

The European System of Financial Supervisors The proposed European System of Financial Supervisors (ESFS) seeks to create a robust network out of national financial supervisors working in tandem with three new functional authorities, the European Supervisory Authorities. These new authorities effectively upgrade the existing ‘L3’ advisory committees – CEBS becomes the European Banking Authority (EBA), CEIOPS becomes the European Insurance and Occupational Pensions Authority (EIOPA) and CESR becomes the European Securities and Markets Authority (ESMA). The new agencies will operate with substantially increased authority and workloads and will be related to the macro-supervisory initiative insofar as they will be obliged to respond to recommendations from the ESRB. They will also feed micro-prudential information upwards to the ESRB and benefit from any early risk warnings it issues. In addition to performing the functions of the existing committees, they will have the following competences:

• Developing proposals for technical standards and working towards a common rulebook by helping to ensure more consistent rules within the EU;

• Ensuring national supervisors take a more coordinated approach by facilitating the exchange of information and resolving cases of disagreement, where legislation requires them to co-operate or to agree;

• Monitoring consistent application of technical Community rules (including through peer reviews) to ensure incorrect or inconsistent application is dealt with quickly and effectively; and

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• Adopting a role as coordinator and fulfilling some decision-making functions in emergency situations.

• The European Securities and Markets Authority will exercise direct supervisory powers over Credit Rating Agencies.58

The new authorities will work towards a common rulebook by developing technical standards in areas to be defined by legislation and by drawing up interpretative guidelines to assist national supervisors in taking individual decisions. The total costs of the new authorities have been estimated at about EUR 37 million in the first full year of operation (2011), rising to about EUR 68 million after three years (2014) due to increases in activity and staff levels. It is proposed that this cost should be split between member states and the Community budget at a ratio of 60 : 40. (It is envisaged that the ESRB will not present any extra cost for the Community budget as it will build, to the extent possible, on existing staff and resources of the European System of Central Banks, with a secretariat provided by the ECB.) Observations on the European Systemic Risk Board As the financial crisis made clear, supervising individual institutions in isolation is not enough. It is essential to address the broader risks that are presented by particular business models, sectors, and the wider markets and economic conditions in which firms operate.59 A key issue is ensuring that close and strong links are forged between the realms of micro- and macro-supervision so that day-to-day supervisory tasks are undertaken in the context of a good understanding of the broader systemic risks. The creation of the ESRB is in line with several other multilateral and international initiatives, including the reinforcement of the IMF’s economic surveillance function and the creation of a Financial Stability Board by the G20. A primary and crucial function of the ESRB will be to liaise with these institutions. Though the conceptual framework has achieved broad consensus, doubts remain over operational aspects of the plan, including whether or not sufficient resources have been allocated to ensure that the new agencies are effective. Meanwhile, the Association of British Insurers has expressed their concern that “the ESRB is dominated by bankers and does not have enough insurance expertise”.60 Given the failure of supervisors to prevent or even predict the last crisis, concerns exist about the ambition of the new plans. In an October 2009 speech, Lorenzo Bini-Smaghi, Member of the ECB Executive Board, noted that the ability of the ESRB to perform its tasks “will depend on its understanding of systemic risk, the amount of relevant information at its disposal, the analytical tools that are available to assess the risks, and the framework used to distil the most important results from all these elements”.61

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Lacking powers of enforcement, the ESRB will essentially be trading on its reputation. There is a worry that any failure by the board to fulfill its duties could seriously undermine both its own credibility and that of the ECB, with which it will be closely intertwined. Mr Bini Smaghi makes the point:

In particular regarding the issuance of risk warnings, the credibility of the ESRB will rest upon the minimisation and balancing of so-called type I errors and type II errors. Type I errors entail the possibility of identifying those risks that subsequently do not materialise, while type II errors relate to the possibility of failing to identify risks that subsequently do materialise. Identifying a long list of potential systemic risks to financial stability could minimise the probability of making type II errors but may lead to accusations of “crying wolf”. The opposite could lead to an important risk to the EU financial system being overlooked, which if it materialised, could harm the ESRB’s reputation. 62

Central banks are to play a significant role in the ESRB because “they are well placed to contribute to the analysis of the impact on financial stability of the inter-linkages between the financial sector and the broader macroeconomic environment”.63 With regard to the crucial issue of appointments, the ECB president, Jean Claude-Trichet, will almost certainly be elected as chairman and it is very likely that Mervyn King, governor of the Bank of England, will be offered the position of vice-chair. A potentially serious difficulty which has surfaced in the debate over the ESRB arises out of the disjuncture between the Eurozone, the EU and the EEA. This makes any perceived transfer of authority to the ECB controversial as states outside the Eurozone are reluctant to cede control to an institution that does not speak for them. Plotting the structure and hierarchy of the ESRB has thus been very sensitive but it seems that a workable solution has been reached in the organisation and division of responsibility described. The ESRB looks set to go ahead and, if it can work in tandem with the newly empowered Financial Stability Board, may succeed in its mission to provide an effective early warning system that might deflect future threats. In actual fact, though the ESRB is the ‘headline’ element in this proposal, member states and analysts have much more serious reservations about the ESFS. Observations on The European System of Financial Supervisors The ESFS is designed to coordinate actions by national supervisors and the ESAs, and to resolve possible cross-border disputes. However, the proposals do not guarantee the effective resolution of such disputes. As it stands now, the draft legislation proposes the introduction of an appeal mechanism, which member states could turn to should they disagree with decisions taken by the new authorities. This means that it would ultimately be up to the EU Council to mediate conflicts by qualified majority vote. This is a potentially cumbersome procedure, and one in which national interests are likely to prevail against the common good.64

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The Commission is urging early adoption of the entire package so that the new authorities can be up and running before the end of 2010. However, Sharon Bowles the head of the Parliament's Economic and Monetary Affairs (ECON) Committee, says that her committee had no intention of being rushed to approve the legislation and that it will take the time to carefully assess the "cumulative effect" of the Commission’s plans.65 European Parliament’s Proposed Amendments In February 2010, Parliament rapporteurs unveiled a host of proposed amendments that would give greater powers to the new agencies. All four rapporteurs questioned the compromise that emerged from the December ECOFIN meeting. A major bone of contention was the safeguard clause, introduced at the insistence of the UK, which ringfences member states’ sovereignty over fiscal policy. This effectively offers a quasi-veto to member states over decisions made by the authorities. The rapporteurs propose that opportunities to invoke such a veto be limited and that stricter conditions be applied to its deployment. 66 Another issue which arose was that of the geographic fragmentation of the system. Current plans envisage each of the new authorities, and the ESRB, being hosted in a different city. The rapporteurs argue that bringing all the organisations together (in Frankfurt perhaps) would reduce operating costs and assist coordination in case of a crisis.67 The reports would strengthen the position of the ESFS in a number of ways, such as by tasking the authorities with preventing regulatory arbitrage, granting them the power of initiative to undertake stress tests, and empowering them to represent the EU during international dialogues of supervisors. They also include a greater oversight role for the European Parliament.68 José Manuel Garcia-Margallo y Marfil, the Spanish MEP who is steering the banking authority legislation, proposes that the authority be given a binding mediation role in the case of conflicts between national supervisors. He also proposes the introduction of a European Financial Protection Fund and specific burden-sharing arrangements between countries in the event of a crisis. 69 Sylvie Goulard, the French rapporteur on the ESRB legislation, meanwhile wants to diversify the governance of the ESRB by adding academics, consumer, business, and trade union representatives, academics and others to the existing mix of central bank governors, regulators and EU institution representatives.70 Her report also proposes formalising that the President of the ECB will be the President of the ESRB and suggests greater oversight by the Parliament of the Board’s operation. It also proposes that the Board whould be able to request information from undertakings not directly covered by the banking, markets or insurance supervisory regimes.

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The depth and range of proposed amendments and the delicacy of the compromised reached by the Council in December mean that the stage is set for a showdown between the Parliament and Council on this issue. All reports are expected to be put to the vote in committee in May; a plenary vote is likely to follow in July.71 Conclusions Where supervision is uneven and uncoordinated, the EU now seeks to make it robust and coherent. But even with a robust European supervisory system in place, the fact will remain that markets are global, but supervision is not. For this reason, coordination and cooperation with other supervisors will be a vital function of any new European system. Such a system will also need to be built upon a solid foundation of regulatory laws and practices. The Reform of Financial Regulation in the European Union

Introduction The drafting of new and updated regulations for the financial sector has been a high priority for the EU institutions and national governments in 2009 and 2010. The process has become intensely politicised as angry, recession-hit electorates demand blood from the bankers while leaders vie to reposition themselves, and their countries, in a transformed economy. Weaknesses in the single market and in the European system of surveillance have been laid bare, and an old argument over anglo-saxon versus continental economic models revived. In a complex narrative, much of the controversy has coalesced around a few particular points of conflict. Hedge funds, bonuses, and transnational transactions have come in for the most scrutiny (and spleen), but there are a number of elements to the policy response with potentially serious implications. Draft Alternative Investment Funds Managers (AIFM) Directive Purpose AIFs typically are hedge funds or private equity funds, but the label also covers commodity funds, real estate funds, feeder funds and infrastructure funds. (For the purposes of this legislation, AIFs are defined as as all investment vehicles not covered under existing UCITS rules.) This sector managed around €2 trillion in assets at the end of 2008. The purpose of this proposal is to establish a secure and harmonized framework for supervising risks that AIFMs pose to investors, counterparties, other market agents and overall financial stability; and to permit, subject to compliance, AIFM to provide services and market their products across the internal market.

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Status Talks were recently postponed due to strong resistance to the draft legislation from the UK and elsewhere. It was widely acknowledged that the original draft was unworkable but this has since been extensively rewritten and reports are that the UK and continental positions are not so far apart. In addition, the UK is far from the only critical voice. Michel Barnier received a letter from US Treasury Secretary Timothy Geithner on 1 March warning that the draft directive was “protectionist” and not only discriminated against US funds but would lead to an Anglo-American drift from the EU.72 The issue now looks set for debate at the next G20 summit in Huntsville, Ontario in June. Under the co-decision procedure, both parliament and the council need to agree a final version before the law can be passed to member states to implement. Issues The AIF Management sector in the EU is substantial, diverse and disproportionately based in a small number of member states (preeminently the UK but also Ireland), so proposals to regulate it were always bound to be politically contested. This directive, drafted by Commissioner Mc Creevy in early 2009, has proven highly controversial. Industry associations complain that the draft directive was published hastily with little consultation and could impose significant costs on sectors that were not directly responsible for the financial crisis. They are supported in their campaign to dilute the new rules by British politicians and diplomats worried about the potential impact on City tax revenues. Advocacy of ‘principles-based’ rather than ‘rules-based’ regulation for the sector has been strong in Ireland as well as the UK. The Irish Funds Industry Association (IFIA) “is alarmed by a number of proposals in [the] draft legislation”.73 According to IFIA statistics, there are 42 fund administration companies and 19 trustee and custodians operating in Ireland, employing 12,500 people. Most of the IFSC's customers are based in London. If managers there were to move their business to a non-EU location it could have a significant impact on revenues and employment in Dublin’s financial services sector. The UK would appear to have an influential champion in Sharon Bowles, the British Liberal MEP who is the new chair of the European Parliament’s Economic and Monetary Affairs (ECON) Committee. Questioned recently on the need for the directive, the holder of one of the most important committee positions in the Parliament said, “Personally, I think I could have lived without it”.74 A French MEP, Jean-Paul Gauzès, has been appointed by the EPP-ED as Rapporteur. Mr. Gauzès not only seems set to firmly resist British efforts to dilute its contents but is also determined to strengthen its provisions in a number of areas. On 17 March, ECON reached a compromise during its deliberations on Gauzès’ report that could allow non EU-domiciled funds to be marketed in Europe. Nonetheless, over 1400 amendments to this report have been tabled and the final shape of the report remains uncertain.75

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Discussion between UK Prime Minister Gordon Brown and French President Nicolas Sarkozy was thought to have brought the two countries closer to agreement. However, deep difference still exist at Council level between member state positions. There are also industry concerns that the debate about the shorting of sovereign credit default swaps could "contaminate" the EU discussions on AIFM. Some EU politicians have been calling for a ban on certain derivatives trading synonymous with “excessive trading”.76 Amendments to the Capital Requirements Directive (2006/48/EC and 2006/49/EC) Purpose The European Union’s Capital Requirements Directive (CRD) (2006/48/EC and 2006/49/EC) aims to promote financial stability and ensure the financial soundness of banks and other financial institutions. It is also intended to promote a stronger culture of risk management and to ensure the international competitiveness of the European banking sector. The 2006 CRD (actually a pair of related directives) effectively transposed the Basel II Accord on capital measurement and standards into European law, stipulating how much of their own financial resources banks and investment firms must hold in order to cover their risks and protect their depositors. It allowed banks to choose among various methods of fulfilling the requirements but contained a strong preference for risk analysis and risk management over the blunter tool of leverage ratios. The CRD forms the basis of an evolving legal framework that is being continually updated. Building on recommendations of the Financial Stability Forum, some technical amendments were adopted in the first half of 2009. They included new rules on securitisation (banks will now be required to retain five percent of the securitised products they originate and sell), large exposures, home-host relationships, ‘hybrid’ capital and liquidity risk management, and are expected to be implemented by December 2010. Status and Issues The Commission proposed to further amend the CRD in July 2009. These proposals include increased capital requirements for trading books and re-securitisations; increased disclosure demands for securitisation exposures; and restrictions on remuneration policies. This so-called CRD3 would, in effect, implement new principles proposed in 2009 by the Basel Committee on Banking Supervision. These new principles would equate to an 11.5 per cent average increase in overall capital levels, equivalent to €216bn of more equity for eurozone banks alone. Europe’s banks are lobbying hard against the proposals and they still await adoption by the European Parliament and Council. Assuming adoption, implementation can be expected by 2011.77 Arlene McCarthy, the British Labour MEP

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and Rapporteur to the legislation in the Parliament, wants tougher rules on bonuses and to increase the amount of capital that banks are required to hold in respect of certain trading book assets and resecuritisations.78 On 26 February 2010, the Commission launched a public consultation inviting views regarding further possible changes to the CRD. Proposed amendments relate to liquidity standards, definition of capital, leverage ratios, counterparty credit risk, counter-cyclical measures, specific measures for systemically important financial institutions and the consideration of a single rule book for banking. Responses are requested by mid-April 2010.79 The Commission’s proposals on ‘CRD4’ are likely to be published in late 2010. Commission Communications on Enhancing the Resilience of OTC Derivatives Markets Purpose Derivatives are financial instruments, often extremely complex and opaque, whose values are based on the values of other investments. They played an important role in the US sub-prime mortgage fiasco that triggered the recent crisis and are now firmly in the sights of regulators on both sides of the Atlantic. From the European Commission’s website:

Derivatives play an important role in the economy but are associated with certain risks. The crisis has highlighted that these risks are not sufficiently mitigated in the over-the-counter (OTC) part of the market, especially as regards credit default swaps (CDS). Since the beginning of the financial crisis, the Commission has been working to address the most urgent of these risks. In October 2008 Commissioner McCreevy called a meeting with the industry and European regulators to discuss two sets of objectives:

• to have concrete proposals as to how the risks from credit derivatives can be mitigated; in particular, he asked for ambitious plans for moving CDS on to central clearing facilities;

• more generally, to have a systematic look at derivatives markets in the aftermath of the lessons learned from the crisis.80

Status The Commission adopted two Communications in 2009 on derivatives. The first was an analysis of the benefits and risks of derivatives markets.81 The second set out future policy actions that the Commission intended to pursue in order to increase transparency, reduce counterparty and operational risk in trading and enhance market integrity and oversight. 82

The G20 has agreed to try to move large portions of the huge over-the-counter (OTC) or privately-traded derivatives sector into central clearing houses and the Commission is set to propose a draft European Market Infrastructure Directive to this end by June 2010.83 It wants the new law to take effect from the end of 2012, a remarkably short time frame for what is a law of potentially huge significance.

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Issues The murkiness of the privately-traded derivatives market became strikingly clear after undetected CDS exposure at AIG led to its near-collapse and subsequent bail-out.84 Fresh controversy was stirred when the role that credit derivatives trades played in hiding Greece’s debt problems emerged. The Greek saga led to the organisation in charge of collecting global data for credit derivatives – the DTCC Trade Information Warehouse – being forced to issue more information to international regulators. New guidelines promise that it will give regulators “unfettered access” to information, including the identity of trading counterparties. Previously, the DTCC revealed this information only with the prior consent of counterparties.85 Corporate treasurers are alarmed that this measure, aimed at discouraging risky speculation, could have a serious impact on companies trying to limit their financial and market risk exposure by employing over-the-counter derivatives products. Companies regularly use these products to hedge the risk of movements in currency, commodity, interest rate and other prices. According the the European Association of Corporate Treasurers, moving these products to central clearing houses will “increase liquidity risk and funding costs,” impeding investment and job creation.86 A bill currently before the United States Senate proposes strict rules on derivatives trading, including their introduction onto regulated exchanges and clearing houses. The proposals have met with firm opposition from Wall Street but President Obama has said that he is prepared to veto a bill that does not include such regulation.87 The Commission is reported to have reached agreement in principle with the US administration on the issue. Timothy Geithner, the US Treasury Secretary, has written to Michel Barnier setting out a reform plan and calling for transatlantic co-operation, which he said was essential to address the systemic risks posed by OTC derivatives. His letter also says that the EU and US should co-ordinate how they regulate non-financial firms that use the derivatives markets to hedge risk, supporting a lighter regulatory regime for these companies in order to address the concerns outlines above. 88 The UCITS IV Directive Purpose/Background The original Undertakings for Collective Investment in Transferable Securities (UCITS) Directive was implemented by Member States by 1 October 1989. It was designed to introduce a harmonised legal framework to facilitate the cross-border offering of investment funds to retail investors and to develop an integrated and competitive European single market for investment funds. In addition, it aimed to establish a defined level of investor protection through strict investment limits and capital, organisational and disclosure requirements. In the early 1990s, proposals were developed to amend the original Directive so as to better harmonise laws throughout Europe. These discussions, although leading to a draft UCITS II directive, were eventually abandoned when the Council of Ministers could not reach a common position.

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In July 1998 the EU Commission published two new proposals, which were finally adopted in December 2001 (UCITS III). UCITS III consists of Directive 2001/107/EC of (the ‘Management Directive’) and Directive 2001/108/EC (the ‘Product Directive’). All Member States implemented these by 13 February 2004. They expanded the set of eligible assets, allowed for new investment techniques, simplified prospectuses for investors and introduced new rules for management companies. A key attraction of UCITS, as consolidated by the Management Directive, is their ability to “passport” throughout the EU. This means that a UCITS authorised in Ireland can be sold in any of the other 27 EU member states without further regulatory authorisation. UCITS have grown to be hugely successful products, seen by investors as representing a ‘gold-standard’ in terms of investor protection, regulation and disclosure. Latest figures from the European Fund and Asset Management Association (EFAMA) show that the net assets under management at UCITS funds as of March 2009 were almost $6 trillion.89 UCITS are becoming more and more popular outside the EU, as foreign investors and regulators in those countries become more familiar with UCITS’ built-in safeguards. Status In January 2009 the European Parliament formally adopted UCITS IV, the latest stage of the UCITS project, which continues the push for a pan-European single market for investment funds. The Directive adds six key enhancements, which EU member states will be required to implement by July 1, 2011.

First, the notification procedure has been simplified and accelerated, reducing administrative requirements for funds distributed across borders. Second, a procedure for Ucits mergers has been established to facilitate cross-border mergers. Third, master-feeder structures can now be created, with feeder funds, usually based in the same country as an investor, feeding assets into a master fund that can be based elsewhere. Fourth, a new standardised Key Investor Information (KII) document has been introduced to provide more detailed information for investors. Fifth, existing regulatory requirements have been strengthened. Finally, the concept of a Management Company Passport (MCP) has become a reality, meaning companies can manage funds cross-border and will not have to appoint service providers in a fund’s domicile, apart from the custodian bank.90

Issues This last provision has proven especially controversial in Ireland and other member states such as Luxembourg which have managed to capitalise on the existing situation by specialising in service provision to UCITS funds. However, fears of an exodus from Dublin and Luxembourg appear to be overstated as, aside from costs, a key reason that funds are domiciled in these locations will continue to be the expertise and infrastructure that have built up around the sector.

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UCITS IV is due to be implemented in 2011. It should cut costs and improve efficiencies, thus making the EU funds market less bureaucratic and less expensive. But it will also lead to consolidation of the number of funds in the EU, which could in turn affect the stable position and reputation of UCITS products in markets across the world.91 Solvency II Purpose Solvency II is the name given to a package of legislation which aims to modernise the EU’s regulation of insurance and reinsurance sectors. A solvency margin is the amount of regulatory capital an insurance undertaking is obliged to hold in reserve. Solvency margin requirements have been in place since the 1970s, though there has been little change to the regulatory regime since then. Following a Commission review of arrangements in the 1990s, the European Parliament and the Council agreed a limited reform of these requirements in 2002. This reform is now known as Solvency I. It became clear during the Solvency I process that a more fundamental and wider ranging review of financial positions in the insurance industry was necessary, taking into account developments in finance techniques, risk management, international financial reporting and prudential standards, etc. This project became known as Solvency II.92 Solvency II therefore aims to establish a revised set of EU-wide capital requirements and risk management standards to replace the current Solvency I rules. This strengthened regime should reduce the likelihood of insurers failing, thus preventing consumer loss or market disruption. Status The Directive text was adopted by the European Parliament on 22 April 2009 and endorsed by the Council of Ministers on 5 May 2009, thus concluding the legislative process for adoption. The new regime should be fully implemented by 31 October 2012.93 Central elements of the new regime include:

• Demonstration of adequate Financial Resources (Pillar 1): This applies to all firms under the regime’s remit and relates to key quantitative requirements, including own funds, technical provisions and the calculation of the Solvency II capital requirements (the Solvency Capital Requirement - SCR, and Minimum Capital Requirement - MCR) through either an approved internal model or the European standard formula approach.

• Demonstration of an adequate System of Governance (Pillar 2): Firms must devise an effective risk management system and demonstrate prospective risk identification through the Own Risk and Solvency Assessment (ORSA).

• Public Disclosure and Regulatory Reporting Requirements (Pillar 3). • Supervisory Review Process: This refers to the overall process conducted by the

supervisory authority in reviewing insurance and reinsurance undertakings, ensuring compliance with the Directive requirements and identifying those

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institutions with financial and / or organisational weaknesses that might produce higher risks to policyholders.94

Issues The main advantage of the new framework should be better consumer protection. Policyholders should have less cause to fear their insurer failing because it will have a better understanding of the risks it faces and be better protected against these. Solvency II also aims to increase competition and transparency across the sector, which should in turn improve efficiency and lead to lower premiums for consumers, as well as facilitating a Single Market for insurance across the Union. The new rules will apply to all insurance and reinsurance firms with gross premium income exceeding EUR5m or gross technical provisions in excess of EUR25m. Critics of the Solvency II provisions point to the failure of sophisticated risk management systems to predict or mitigate the financial crisis. They ask how embedding such flawed systems at the heart of Europe’s regulatory system can be promoted as a prudent development. Remuneration Purpose Banks’ compensation practices are ultimately a matter for corporate governance, and in money terms are probably the least important of the areas being targeted for reform. Nonetheless, the combination of popular moral sentiment and severely degraded risk profiles means that the issue is now being taken seriously by regulators and supervisors in determining capital and liquidity requirements. However, while dealing sternly with institutions receiving public support is possible, reining in remuneration in the broader financial sector is proving more difficult. Status At the April 2009 G20 summit in London, leaders agreed to give banking supervisors powers to intervene if they thought remuneration practices were encouraging too much risk-taking. This was a key issue for European countries going into the September 2009 Pittsburgh Summit. French President Nicolas Sarkozy unveiled tough new rules for his country's bankers (spreading bonuses over three years and penalising traders whose investments lost money in the longer term) and wanted to push for limits and taxes on bonuses at Pittsburgh. He was unable, however, to convince enough of his European colleagues to form a common EU position that would not be rejected by the US out of hand. In the end, the G20 endorsed implementation standards put forward by the Financial Stability Board aimed at aligning compensation with long-term value creation by:

(i) avoiding multi-year guaranteed bonuses; (ii) requiring a significant portion of

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variable compensation to be deferred, tied to performance and subject to appropriate clawback and to be vested in the form of stock or stock-like instruments, as long as these create incentives aligned with long-term value creation and the time horizon of risk; (iii) ensuring that compensation for senior executives and other employees having a material impact on the firm’s risk exposure align with performance and risk; (iv) making firms’ compensation policies and structures transparent through disclosure requirements; (v) limiting variable compensation as a percentage of total net revenues when it is inconsistent with the maintenance of a sound capital base; and (vi) ensuring that compensation committees overseeing compensation policies are able to act independently. Supervisors should have the responsibility to review firms’ compensation policies and structures with institutional and systemic risk in mind and, if necessary to offset additional risks, apply corrective measures, such as higher capital requirements, to those firms that fail to implement sound compensation policies and practices. Supervisors should have the ability to modify compensation structures in the case of firms that fail or require extraordinary public intervention. We call on firms to implement these sound compensation practices immediately. We task the FSB to monitor the implementation of FSB standards and propose additional measures as required by March 2010.

Issues A peer review report published by the FSB in March 2010 found that progress on remuneration issues internationally had been impressive but inconsistent. It called for work to be progressed on a rapid timetable so that results could be reflected in 2010’s end-of-year compensation reviews. It is to conduct a follow-up review in early 2011.95 Markets in Financial Instruments Directive 2004/39/EC (MiFID) Purpose MiFID was the cornerstone of the European Commission's Financial Services Action Plan, which was designed to create a single market in financial services MiFID was a 'maximum harmonisation' directive designed to achieve a level playing field for firms across the European Union and EEA countries by requiring the same rules to be implemented in each state. It extended the coverage of the previous Investment Services Directive (ISD) regime and introduced new and more extensive requirements for firms, in particular in relation to their conduct of business and internal organisation. MiFID applies to all firms which conduct investment business, regardless of their legal form. Thus it applies equally to banks and non-banks, providing a level playing field where the conduct rules and capital requirements are determined by activity undertaken, not by regulatory status.96

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Status MiFID comprised two levels of European legislation. ‘Level 1’, the Directive itself, was adopted in April 2004. It was implemented by November 2007. The Directive made provision for its requirements to be supplemented by ‘technical implementing measures’, so-called ‘Level 2’ legislation. Under the 'Lamfalussy Process’, this Level 2 mechanism enables MiFID to be kept relevant in changing circumstances by tweaking its implementation with new legislation. MiFID is undergoing its first review this year. Issues According to Jeremy Grant of the Financial Times, “[t]hree years after Mifid was enacted, the criticisms of it are starting to drown out the positives.”97 Commissioner McCreevy, speaking in Dublin in September 2009, said that although the Directive had stimulated greater competition in some areas, it had led to significant migration of share trading transactions from the MiFID regulated venues to unregulated OTC broker-dealer venues where substantial unregulated dark pools of liquidity have built up. He raised the questions of whether this meant that these operators were enjoying unfair commercial advantages and whether the trend served to undermine price discovery and market integrity and efficiency.98 The review of MiFID aims to answer these and other questions. Final Remarks and Conclusions

The policy response to the financial crisis that is now well underway takes place against a transformed international landscape. This report began by referring to certain changes in the global political economy and in the architecture of global governance that are empowering some economies and institutions even as they mark a decline in others. In particular, the growing role for international institutions such as the G20, the IMF and the Financial Stability Board – in framing the terms of debate, formulating new principles and guiding policy decisions by governments – was emphasised. So was the fact that the crisis has triggered the start of an overdue realignment of voting weight within such bodies in line with the changing distribution of global economic power. In the European context, important political and economic considerations that will weigh on the reform process – such as the formation of a new Commission, ongoing intergovernmental tensions, a crisis in the Eurozone, and continuing concerns about the bloc’s international competitiveness – were discussed. There followed a detailed analysis of the supervisory and regulatory reforms now underway at EU level. What can be drawn from this is that the single market in financial services was always a blind spot in Europe’s vision of a truly open market for people, goods and services. Fundamental issues of accountability, transparency, responsibility and sovereignty were for too long addressed by remedies that were piecemeal and iterative where they should have been muscular and comprehensive. The financial crisis has exposed these weaknesses in glaring clarity, just as the unfolding European sovereign debt crisis is exposing the

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unwieldy mechanics of a monetary union that was always as much a political project as a product of purely sensible economics. The political, even ideological nature of certain assumptions underlying the policy goal of an open market in financial services was not adequately questioned, and the implications of such a market, superimposed as it was on a network of overlapping and sometimes opposed national supervisory and regulatory regimes, were not adequately thought through. The European Union now seeks to fill in the gaps in this framework, or in some areas to revise the infrastructure altogether. The fact remains that Europe does not yet have a single market in financial services and that effective surveillance of the complex and evolving matrix which does exist will require much more robust supervision than has existed to date. Proposals for a pan-European body charged with identifying and mitigating systemic risk are bold, but no less bold than the situation demands. The European Economics and Monetary Affairs Commissioner, Olli Rehn, recently suggested that Eurozone nations should go much further in coordinating economic policy so as to tighten their fiscal discipline, redress macroeconomic imbalances and improve crisis management. Such moves may be necessary but they would also deeply transform the Union. In comparison, the pooling of sovereignty which a European macro-prudential function would demand seems relatively shallow. In the area of regulation, the EU is generally adhering to internationally-agreed principles such as those emanating from the G20 and related institutions. Early expectations of a set of comprehensive international agreements have been lowered as particular jurisdictions retrench. In Europe, the flashpoints arise out of certain idiosyncracies of the European banking system as well as conflicts between member states over some issues. While these may prevent the optimum level of, for example, EU-US cooperation, recent signals on the scope for international cooperation have been encouraging. The task of tracking the development of international regulatory policies is both urgent and ongoing. This report represents one small contribution to this effort. Although its findings will almost certainly have been superseded by events by the time it is published, it is hoped that it will provide a useful reference for analysts trying to understand the evolving process of international financial supervisory and regulatory reform.

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Endnotes                                                         1 de Larosière, Jacques et al. 2009. Report of the High Level Group on Financial Supervision in the EU, p. 38. Accessed on November 18 2009 at: http://www.ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf 3 Woolfe, Jeremy. 2010. “EU Plans Governance Advances for 2010”. Accessed on January 20 2010 at: http://www.complianceweek.com/article/5738/eu-plans-governance-advances-for-2010 4 Group of Twenty. 2008. “Declaration Summit on Financial Markets and the World Economy”. Accessed on May 27, 2010 at: www.g20.org/Documents/g20_summit_declaration.pdf 5 Group of Twenty. 2009. “G-20 Communique: Full Text of the London Summit”. Accessed on May 27, 2010 at: http://www.forbes.com/2009/04/02/communique-g20-text-markets-equity-economy.html 6 Financial Stability Board. 2010. “FSB Framework for Strengthening Adherence to International Standards”. Accessed on May 27, 2010 at: http://www.financialstabilityboard.org/publications/r_100109a.pdf 7 Ibid. 8 See for example the IMF Website at: http://www.imf.org/external/index.htm 9 International Monetary Fund. 2010. “A Fair and Substantial Contribution by the Financial Sector: Interim Report for the G-20”. Accessed on May 27, 2010 at: http://news.bbc.co.uk/1/shared/bsp/hi/pdfs/2010_04_20_imf_g20_interim_report.pdf 10 The Economic Times. 2010. “World’s growth engine India seeks more voice”. April 25. Accessed on May 27, 2010 at: http://economictimes.indiatimes.com/news/international-business/Worlds-growth-engine-India-seeks-more-voice/articleshow/5856984.cms 11 Group of Twenty. 2009. “Leaders’ Statement: The Pittsburgh Summit”. Accessed on May 27, 2010 at: http://www.pittsburghsummit.gov/mediacenter/129639.htm 12 Tait, Nikki and Rachel Sanerson. 2009. “EU delays adoption of accounting rule changes”. Financial Times. November 12. Accessed on May 27, 2010 at: http://www.ft.com/cms/s/0/25434302-cfcf-11de-a36d-00144feabdc0.html 13 Financial Stability Board. 2010. “Report of the Financial Stability Board to G20 Finance Ministers and Governors on Financial Stability”. Accessed on May 27, 2010 at: http://www.financialstabilityboard.org/publications/r_100419.pdf

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                                                        14 Sanderson, Rachel. 2010. “IASB softens stance on accounting convergence.” Financial Times. February 16. Accessed on May 27, 2010 at: http://www.ft.com/cms/s/0/9c4c9780-1a9a-11df-bef7-00144feab49a.html 15 Valukas, Anton R. 2010. “Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s Report”. Accessed on May 27, 2010 at :http://lehmanreport.jenner.com/ 16 Kurowski, Per. 2009. “The world at large would have been better of without any Basel regulations”. Accessed on May 27, 2010 at :http://www.voxeu.org/index.php?q=node/3022 17 Daníelsson, Jón et al. 2001. “An Academic Response to Basel II”. Accessed on May 27, 2010 at: http://www.bis.org/bcbs/ca/fmg.pdf. Page 3. 18 Basel Committee. 2009. “Report and recommendations of the Cross-border Bank Resolution Group”. Accessed on May 27, 2010 at: http://www.bis.org/publ/bcbs169.htm 19 Financial Stability Board. 2010. “Report of the Financial Stability Board to G20 Finance Ministers and Governors on Financial Stability”. Accessed on May 27, 2010 at: http://www.financialstabilityboard.org/publications/r_100419.pdf 20 Masters, Brooke. 2010. “Iosco pact reshapes market enforcement.” Financial Times. January 8. Accessed May 27, 2010 at: http://www.ft.com/cms/s/0/b843b8f0-ee45-11de-a274-00144feab49a.html 21 Masters, Brooke. 2010. “Hedge funds to become more transparent”. Financial Times. February 25. Accessed May 27, 2010 at: http://www.ft.com/cms/s/0/3feba9c4-222c-11df-9a72-00144feab49a.html 22 The Economic Times, op. cit. 23 Barnier, Michel. 2010. “Written Answers to the European Parliament Questionnaire to the Commissioner-Designate”. Accessed May 27, 2010 at: http://www.europarl.europa.eu/hearings/static/commissioners/answers/barnier_replies_en.pdf 24 EurActiv. 2010. “Barnier to seek coherent EU rules on gambling”. 12 February. Accessed on March 22, 2010 at: http://www.euractiv.com/en/sports/online-gambling-debate 25 EurActiv. 2010. “Barnier: ‘I don’t believe in self-regulation’”. March 19, updated March 27. Accessed on May 27, 2010 at: http://www.euractiv.com/en/financial-services/barnier-i-don-t-believe-self-regulation-news-358458

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                                                        26 Brunsden, Jim. 2009. “Monti calls for new deal on EU’s single market”. European Voice. December 10. Accessed on January 20, 2010 at: http://www.europeanvoice.com/page/policies-economics-management-all-articles/528.aspx 27 Klinz, Wolf. “On the European Parliament’s Special Committee to Tackle the Financial Crisis”. Accessed on May 27, 2010 at: http://www.europarl.europa.eu/news/public/story_page/042-61775-292-10-43-907-20091002STO61738-2009-19-10-2009/default_en.htm 28 European Public Health Alliance. “Parliament creates Special Committee on Financial Crisis”. Accessed on May 27, 2010 at: http://www.epha.org/a/3670 29 This section builds upon the 2009 IIEA paper, “The Reform of Financial Supervision and Regulation in Europe”. 30 House of Lords Select Committee on Economic Affairs. 2009. “Banking Supervision and Regulation”, p. 10. Accessed on November 18 2009 at: http://www.publications.parliament.uk/pa/ld200809/ldselect/ldeconaf/101/101i.pdf 31 Group of Ten. 2001. “Report on Consolidation in the Financial Sector”, Basel. Quoted in: Bini Smaghi, Lorenzo. 2009 “Financial Supervision in an Uncertain World”. Speech Delivered at the CEPR/ESI 13th Annual Conference, Venice International University. Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2009/html/sp090925.en.html 32 Group of Ten. 1999. “Committee on the Global Financial System: Mandate”. Accessed on November 18 2009 at: http://www.bis.org/cgfs/mandate.htm 33 Lorenzo Bini Smaghi notes that in 1998 the European Shadow Financial Regulatory Committee proposed a ‘European Observatory of Systemic Risk’ as an initial step towards a European-wide supervisory structure. See: Bini Smaghi, Lorenzo. 2009 “Financial Supervision in an Uncertain World”. Speech Delivered at the CEPR/ESI 13th Annual Conference, Venice International University. Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2009/html/sp090925.en.html 34 Bini Smaghi, Lorenzo. 2009 “Financial Supervision in an Uncertain World”. Speech delivered at the CEPR/ESI 13th Annual Conference, Venice International University. Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2009/html/sp090925.en.html 35 Trichet, Jean Claude. 2008. “Undervalued Risk and Uncertainty: Some Thoughts on the Market Turmoil”. Speech delivered at the Fifth ECB Central Banking Conference, Frankfurt am Main. Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2008/html/sp081113_1.en.html

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                                                         36 International Monetary Fund. 2006. “Chapter Two: The Influence of Credit Derivative and Structured Credit Markets on Financial Stability” in Global Financial Stability Report – April 2006. Accessed on November 18 2009 at: http://www.imf.org/external/pubs/ft/gfsr/2009/01/pdf/text.pdf 37 The Financial Services Authority. 2009. The Turner Review: A Regulatory Response to the Banking Crisis. Accessed on November 18 2009 at: http://www.fsa.gov.uk/pubs/other/turner_review.pdf 38 Turner, Adair. 2009. Speech at Press Conference for The Turner Review. Accessed on November 18 2009 at: http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0318_at.shtml 39 Trichet, Jean Claude. 2008. “Undervalued Risk and Uncertainty: Some Thoughts on the Market Turmoil”. Speech delivered at the Fifth ECB Central Banking Conference, Frankfurt am Main. Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2008/html/sp081113_1.en.html 40 See for example: Borio, Claudio. 2004. “Market distress and vanishing liquidity: anatomy and policy options”. Bank of International Settlements Working Paper. Accessed on November 18 2009 at: http://www.bis.org/publ/work158.htm 41 Cassidy, John. 2008. “Anatomy of a Meltdown – Ben Bernanke and the Financial Crisis”. The New Yorker, December 1. Accessed on November 18 2009 at: http://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy?printable=true 42 Trichet, Jean Claude. 2008. “Undervalued Risk and Uncertainty: Some Thoughts on the Market Turmoil”. Speech delivered at the Fifth ECB Central Banking Conference, Frankfurt am Main. Accessed on November 18 2009 at: Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2008/html/sp081113_1.en.html 43 Trichet, Jean Claude. 2008. “Undervalued Risk and Uncertainty: Some Thoughts on the Market Turmoil”. Speech delivered at the Fifth ECB Central Banking Conference, Frankfurt am Main. Accessed on November 18 2009 at: Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2008/html/sp081113_1.en.html 44 House of Lords Select Committee on Economic Affairs. 2009. Banking Supervision and Regulation, p. 10. Accessed on November 18 2009 at: http://www.publications.parliament.uk/pa/ld200809/ldselect/ldeconaf/101/101i.pdf 45 Basel Committee on Banking Supervision. 2008. “Supervision of Financial Conglomerates”. Accessed on November 18 2009 at: http://riskinstitute.ch/145720.htm

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                                                        46 IASPlus. 2009. “Financial Services Action Plan Evolution Chart”. Accessed on November 18 2009 at: www.iasplus.com/europe/0609fsapsummary.pdf 47 Financial Services Authority. 2008. “Lamfalussy Guide”. Accessed on November 18 2009 at: http://www.fsa.gov.uk/Pages/About/What/International/european/lamfalussy/index.shtml 48 Bouwen, Pieter. 2009. “New Modes of Governance in Europe – The Impact of the “Lamfalussy Committee’ on European Governance”. Accessed on November 18 2009 at: http://www.coll.mpg.de/?q=text/new-modes-governance-europe-%E2%80%93-impact-%E2%80%9Clamfalussy-committee%E2%80%9D-european-governance 49 The acronyms CESR, CEBS and CEIOPS respectively stand for Committee of European Securities Regulators, Committee of European Banking Supervisors, and Committee of European Insurance and Occupational Pensions Supervisors. 50 de Larosière, op. cit., p. 38. 51 See appendix 2. 52 European Commission. 2009. “Communication in European Financial Supervision”. Brussels, 27 May. Accessed on November 18 2009 at: http://ec.europa.eu/internal_market/finances/docs/committees/supervision/communication_may2009/C-2009_715_en.pdf 53 Council of the European Union. 2009. “Council Conclusions on Strengthening EU Financial Supervision – 2948th Economic and Financial Affairs Council”. Luxembourg, 9 June. Accessed on November 18 2009 at: www.eu2009.cz/scripts/file.php?id=56595&down=yes 54 European Commission. 2009. Financial Services Supervision and Committee Architecture Web Archive. Accessed on November 18 2009 at: http://ec.europa.eu/internal_market/finances/committees/index_en.htm#package 55 For a graph detailing the relationship between the new supervisory institutions, please see Appendix 3. 56 Lannoo, Karel. 2009. “The road ahead after de Larosière”. Brussels. Foundation for European Progressive Studies. Accessed on November 18 2009 at: http://www.feps-europe.eu/fileadmin/downloads/political_economy/090626_FEPS_Lannoo.pdf 57 Europa.eu. 2009. “Press Release: New Financial Supervision Architecture”. Accessed on November 18 2009 at:http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/09/405&format=HTML&aged=0&language=EN&guiLanguage=en

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                                                         58 European Commission. 2009. “Press Release – Financial Services: Commission adopts additional legislative proposals to strengthen financial supervision in Europe”. Accessed on November 18 2009 at: http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/1582 59 Verena, Ross. 2009. “Speech delivered to the European Banking Roundtable”. 14 June. Accessed on November 18 2009 at:http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/1014_vr.shtml 60 Tait, Nikki & Masters, Brooke. 2009. “Big promises fail to dispel prosaic doubts”. Financial Times. September 24. Accessed on November 18 2009 at: http://www.ft.com/cms/s/0/31076fa4-a8a3-11de-9242-00144feabdc0.html 61 Bini Smaghi, Lorenzo. 2009 “Financial Supervision in an Uncertain World”. Speech delivered at the CEPR/ESI 13th Annual Conference, Venice International University. Accessed on November 18 2009 at: http://www.ecb.int/press/key/date/2009/html/sp090925.en.html 62 Ibid. 63 European Commission, DG Internal Markets and Services. 2009. “Commission Adopts Financial Supervision Proposals” in Single Market News No. 54. Accessed on November 18 2009 at: http://ec.europa.eu/internal_market/smn/smn54/index_en.htm 64 EurActiv. 2009. “EU Brings Financial Supervision Reform to the G20” http://www.euractiv.com/en/financial-services/eu-brings-financial-supervision-reform-g20/article-185713# 65 Willis, Andrew. 2009. “Commission adopts further legislation on financial regulation”. Euobserver.com, 26 October. Accessed on November 18 2009 at: http://euobserver.com/9/28887 66 European Parliament Press Release. 2010. “More powerful EU financial supervisory bodies and less national interest, demand MEPs”. Accessed on May 27, 2010 at: http://www.europarl.europa.eu/news/expert/infopress_page/042-69356-054-02-09-907-20100223IPR69355-23-02-2010-2010-false/default_nl.htm 67 Ibid. 68 Ibid. 69 Tait, Nikki. 2010. “MEPs want more financial watchdog powers”. Financial Times. February 10. Accessed May 27, 2010 at: http://www.ft.com/cms/s/0/ffd06f82-166e-11df-bf44-00144feab49a.html

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                                                        70 Ibid. 71European Parliament Press Release. Op. cit. 72 EurActiv. 2010. “EU rejects US claim of hedge funds regulation rift.” March 12. Accessed on May 27, 2010 at: http://www.euractiv.com/en/financial-services/eu-rejects-geithner-s-claims-regulation-rift-news-330649 73 O’Hara, Ailish. 2009. “Fund managers warn new rules will cost €1.9bn”. The Irish Independent. September 28. Accessed on May 27, 2010 at:http://www.independent.ie/business/irish/fund-managers-warn-new-rules-will-cost-836419bn-1898151.html 74 Brunsden, Jim. 2009. “Legislation ‘could drive firms away’”. Europeanvoice.com. September 3. Accessed on May 28, 2010 at: http://www.europeanvoice.com/article/imported/legislation-%E2%80%98could-drive-firms-away%E2%80%99/65755.aspx 75 Black, Edward & Cornish, Martin. 2010. “Presidency Withdraws AIFM Directive Compromise Draft”.March 19. Accessed on May 27, 2010 at: http://www.lexology.com/library/detail.aspx?g=d73b8c6d-a0f8-44b3-b152-6c08315f73e7 76 Reuters. 2010. “Germany asks EU to ban certain derivatives trading”. April 24. Accessed on May 28, 2010 at: http://uk.reuters.com/article/idUKTRE63N0KD20100424 77 Jenkins, Patrick. 2009. “Capital reforms spark lobbying”. Financial Times. November 10. Accessed on May 28, 2010 at: http://www.ft.com/cms/s/0/48c8aa7e-cd9a-11de-8162-00144feabdc0.html 78 Tait, Nikki. 2010. “MEPs seek tougher curbs on bankers’ bonuses”. Financial Times. March 8. Accessed on May 28, 2010 at: http://www.ft.com/cms/s/0/0f560e42-2a94-11df-b7d7-00144feabdc0.html 79 Relevant documentation can be found on the European Commission Webpage devoted to Regulatory Capital. Accessed on May 27, 2010 at: http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm 80 Relevant documentation can be found on the European Commission Webpage devoted to Derivatives. Accessed on May 27, 2010 at: http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm 81 Ibid. 82 Ibid.

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                                                         83 EurActiv. 2009. “Draft EU derivatives law set for July 2010”. November 24. Accessed on May 28, 2010 at: http://www.euractiv.com/en/financial-services/draft-eu-derivatives-law-set-july-2010/article-187604 84 van Duyn, Aline. 2010. “Tighter OTC derivaties rules loom”. Financial Times. March 25. Accessed May 28, 2010 at: http://www.ft.com/cms/s/0/f1787bca-37af-11df-88c6-00144feabdc0.html 85 Ibid. 86 Bulletin Quotidien Europe 10053. 12 January 2010, pp. 10. 87 Rabkin, Job. 2010. “Darling: ‘Urgent’ need to reform derivatives market”. Channel4.com. April 23. Accessed May 28, 2010 at: http://www.channel4.com/news/articles/politics/domestic_politics/darling+quoturgentquot+need+to+reform+derivatives+market/3623692 88 Brunsden, Jim. 2010. “EU-US move closer to deal on derivatives regulation”. Europeanvoice.com. April 22. Accessed May 28, 2010 at: http://www.europeanvoice.com/article/imported/eu-us-move-closer-to-deal-on-derivatives-regulation/67759.aspx 89 O’Kelly, Grellan. 2009. “UCITS Funds Gain Popularity, Increasingly Employ Hedge Fund Strategies”. Final Alternatives. September 1. Accessed May 28, 2010 at: http://www.finalternatives.com/node/8961 90 Adams, David. 2009. “Ucits IV – the next stage”. ICFA Magazine. September 24. Accessed May 28, 2010 at: http://icfamagazine.com/public/showPage.html?page=icfa_display_feature&tempPageId=869229 91 Ibid. 92 http://ec.europa.eu/internal_market/insurance/solvency/background_en.htm 93 Solvency II will be adopted under the Lamfalussy process, with the Level 1 Framework Directive setting out the key principles of the new system. Following adoption of the Directive, detailed implementing measures will be introduced at Level 2. The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), a Level 3 Lamfalussy committee, will then give advice to the Commission on the implementing measures. 94 Financial Services Authority. 2008. “Insurance Risk Management: The Path To Solvency II”. Accessed May 28, 2010 at: www.abioric.com/media/1462/dp08_04.pdf

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                                                         95 Reuters. 2010. “FSB says application of remuneration code patchy”. March 30. Accessed on May 27, 2010 at: http://uk.reuters.com/article/idUKTRE62T2G420100330 96 See for example: Mifid.ie. Accessed on May 27, 2010 at: http://www.mifid.ie/aboutmifid.html 97 Grant, Jeremy. 2010. “Quick View: Mystified by Mifid”. Financial Times. March 23. Accessed May 28, 2010 at: http://www.ft.com/cms/s/0/17cdb06a-36b1-11df-b810-00144feabdc0.html 98 McCreevy, Charlie. 2009. “Towards an Integrated Approach to Regulation Across the EU”. Accessed on May 27, 2010 at: http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/09/398&format=PDF&aged=0&language=EN&guiLanguage=en