The Case for a European Banking Charter

WP/07/173



The Case for a European Banking Charter

Martin ih̃k and JCrg Decressin

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ւ 2007 International Monetary Fund
WP/07/173



IMF Working Paper


European
Department

The Case for a European Banking Charter

Prepared by Martin Ʉih̃k and JCrg Decressin1

Authorized for distribution by Michael Deppler

July 2007

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

Most financial institutions in the European Union (EU) are still based in one country, but a
number of large financial institutions (LCFI) have systemic cross-border exposures. The
paper explains how, despite much progress, nationally-segmented supervisory frameworks
and national accountability for financial stability hinder optimization across borders of
banks֢ operations and efficient and effective LCFI supervision. A full-fledged EU-level
prudential regime that operates along-side national regimes––a European Banking Charter
(EBC)––could harness market forces to establish a level playing field for financial sector
competition, while plugging some significant gaps in Europe’s financial stability framework
without concentrating excessive powers.

JEL Classification Numbers: G21, G28

Keywords: European Union, Financial System, Financial Stability, Banking Charter

Authors’ E-Mail Addresses: mcihak@imf.org, jdecressin@imf.org


1 We would like thank, without implicating, Wim Fonteyne, Daniel Hardy, Nico Valckx, Jan-Willem van der
Vossen, Steven Seelig, and participants of a seminar at the IMF and informal seminars at the DG-ECFIN and at
the Dutch Ministry of Finance for many useful comments and discussions. All remaining errors are our own.

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Contents Page
I. Introduction ............................................................................................................................3
II. The Current Financial System and Framework.....................................................................5
A. The European Financial System ...............................................................................5
B. What Is Already in Place?.........................................................................................5
C. What Are the Fundamental Problems?......................................................................7
III. The Proposal: A European Banking Charter .....................................................................12
A. Features ...................................................................................................................13
B. Attractions ...............................................................................................................15
C. Issues .......................................................................................................................16
D. Alternatives .............................................................................................................22
IV. Conclusion .........................................................................................................................24
References................................................................................................................................30

Figures
1. Adjustments in Prudential Practices Through Institution-Specific MOUs..........................24

Boxes
1. Impossibility of Implementing Ex-Post Efficient Dominant Strategies ..............................11

Appendixes
I. Nordics: Institution-Specific MoUs On Supervisory Cooperation.......................................26
II. The European Company Statute..........................................................................................28
III. Bank Insolvency in Europe................................................................................................29

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I. INTRODUCTION
This paper explains how establishing a specific EU-level prudential regime––a European
Banking Charter (EBC)––could foster European financial integration and stability. Much
work is underway to achieve this, notably in the context of the EU Financial Services Action
Plan (EU FSAP) and the Lamfalussy framework.2 The charter is an alternative route that
could be pursued and, like national charters, would come with a full-fledged EU-wide
prudential framework. All banks would be free to choose under which charter and supporting
prudential framework––EBC or national––to operate, affording market forces a greater role
in balancing EU-wide against national regulation and supervision.
The charter could achieve a prudential level playing field for European banks, while helping
to remedy more rapidly problems presented by the national segmentation of Europe’s
financial stability framework. This segmentation stands in the way of better supervision and
optimization across borders of banks’ operations. The EBC therefore aims at leveling the
playing field for cross-border banking business––which is essential to boost competition and
productivity in Europe’s financial services sector3––and improving the cross-border
supervision of large, complex cross-border financial institutions (LCFI).4
The key point is that creating an EU-level prudential regime need not imply taking a one-
size-fits-all approach and creating a single European regulator/supervisor. The need for a
streamlined and harmonized EU-level prudential regime is most urgent for those financial
institutions that have cross-border ambitions, notably the LCFI, not for the vast majority of
Europe’s 8,000 banks that cater mainly to national markets. This raises two considerations:
•
First, it is difficult for policymakers to determine exactly how much prudential
convergence is required and what prudential issues are the most critical to quickly
level the playing field for banking business. Financial markets are extremely complex
and thus the “marginal product” of regulatory action is very difficult to assess.
Prudential convergence therefore becomes, to some extent, a lengthy process of trial
and error. The EBC directly involves market players in establishing the right mixture
of centralized versus decentralized prudential policies and practices and therefore
reduces the potential for errors along a key dimension of the integration process.

2 For details, see http://ec.europa.eu/internal_market/finances/actionplan/index_en.htm and
http://ec.europa.eu/internal_market/securities/lamfalussy/index_en.htm.
3 Empirical estimates suggest that about a half of the productivity growth gap between the United States and the
Euro Area in 1995–2005 can be traced to the financial sector (excluding insurance) (IMF, 2006).
4 Some of the literature uses the abbreviation LCFIs for all large complex financial institutions. In this paper, we
focus on those large and complex institutions that also have a substantial presence in more than one country.

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•
Second, a harmonized EU-level prudential regime is crucial to improving the
supervision of LCFIs, which are rapidly changing the banking landscape in Europe.
Introducing an EBC would allow faster progress on this front, complementing
national banking charters with an alternative that is tailored to these LCFIs. To that
effect, the EBC’s supporting EU-wide prudential (regulatory and supervisory)
framework would have to build on joint responsibility and joint accountability of
national prudential authorities. This would ensure that national supervisors would pay
due attention to the external spillovers of their domestic actions on cross-border EBC
banks, which can be very large, particularly in crisis situations.
More fundamentally, the single prudential framework is essential to overcome the basic
dilemma facing national policymakers between allowing cross-border market integration
while retaining accountability for national financial stability.5 This is a specific challenge for
the EU for two reasons. First, under the EU’s supervisory set-up foreign branches of banking
groups are subject to home rather than host-country supervision. These branches can be of
systemic importance in host countries, leaving host-country financial stability exposed to
home-country actions.6 Second, the EU’s aim is to create a single financial market, which
entails allowing financial institutions to structure their business freely, without regard to
national borders.
Building on previous IMF work on Europe’s financial stability framework (e.g., Decressin,
Faruqee, and Fonteyne, 2007; Čihák and Tieman, 2006), the paper identifies the problems
with the existing financial stability framework, and discusses the major principles of the
proposed charter. The structure of the paper is as follows. Section II overviews the European
financial system and the existing framework, and outlines the fundamental problems. Section
III spells out the European Banking Charter, presenting its features and attractions. It also
discusses implementation issues relating to the charter, as well as the charter’s alternatives.
Section IV concludes.


5 The focus here is on banks, but the EBC can be extended to apply also to financial conglomerates. Throughout
the paper, we refer to banking for simplicity, because banks dominate the European financial sector, and it is
banking supervision where most of the policy discussion has concentrated so far. However, the arguments apply
to various extents also to non-bank financial institutions. Given the presence of financial conglomerates in
Europe, it may be useful to extend to coverage of the charter accordingly, into a European Financial
Institutions Charter (incidentally, in Canada, there are federal and provincial financial institutions charters).
Nonetheless, for simplicity of exposition, the focus here is on banking.
6 The issue is similar with respect to host-country subsidiaries of groups with home-country centralized treasury
and risk management. Some supervisors are therefore arguing that independently operating subsidiaries must
have adequate core functions and not be “quasi” branches with limited or no core functions (e.g., see Bednarski
and Bielicki, 2006).

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II. THE CURRENT FINANCIAL SYSTEM AND FRAMEWORK
A. The European Financial System
The vast majority of Europe’s approximately 8,000 banks are mainly doing national business
and are likely to continue to do so over the foreseeable future. For retail (customer) business,
the cross-border component does not exceed 5 percent and has not shown any marked
increase over time (see, e.g., Dierick, Freund, and Valckx, 2007). As a result, banking is still
the least “Europeanized” sector of the economy according to some measures (Véron, 2006).
This partly reflects the continued importance of proximity to the customer and of local
market knowledge as well as other factors, but can also be attributed to the fragmentation of
the European regulatory framework.
Nonetheless, large cross-border banks are emerging in Europe, and have a substantial market
share. European banking integration is gaining momentum in terms of cross-border flows,
market share of foreign banks in several domestic markets, and cross-border mergers and
acquisitions of significant size (e.g., Schoenmaker and Oosterloo, 2005; and Dermine, 2005).
There is a rapidly growing number of LCFI that engage significantly in cross-border
business. The bulk of this business is in wholesale markets, which are now relatively well-
integrated, notably interbank and corporate bond markets (in contrast, there is considerable
scope for further integration in equity, securitization markets, and arms-length financing). A
mapping exercise of EU banking groups with significant cross-border activity carried out by
the Banking Supervision Committee of the European System of Central Banks revealed that
some 46 LCFIs hold about 68 percent of EU banking assets; of these, 16 key cross-border
players account for about one third of EU banking assets, hold an average of 38 percent of
their EU banking assets outside their home countries, and operate in just under half of the
other EU countries (Trichet, 2007).7 The legal, regulatory, and supervisory framework has
not been able to keep up with this rapidly growing cross-border presence, notably the
centralization of treasury and risk management functions of the LCFIs.
B. What Is Already in Place?
Prudential policies and practices are partly fostering the trend toward pan-European players,
partly hindering it, and, in significant ways, playing catch up with it. The Second Banking
Directive of 1993 accelerated the move toward a level-playing field with respect to
prudential policies and practices. To that end, it introduced home-country control and mutual
recognition, resulting in a “single passport” for branching across the EU: any bank licensed
in any EU country was subsequently free to open branches in other EU countries provided it
met some common, minimum standards. In principle, the freedom to branch could over time
lead to something akin to a “single rules book” covering prudential policies and practices,

7 Further information on the mapping exercise can be found for example at ECB (2005, 2006).

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provided that good regulatory competition is fully embraced by national authorities. For the
national authorities, however, this entails a loss of control over domestic financial stability,
for which they remain accountable. For financial institutions, market entry via branching is
often less attractive than via establishing subsidiaries.8 Thus, the “single rules book” and
level playing field have not materialized, although considerable progress has been made.
Regulation
Regulatory convergence has been a priority. Much progress has been made through the broad
common framework of financial sector directives under the EU FSAP and the work of the
Lamfalussy committees (such as the Committee of European Banking Supervisors, CEBS),
which focus on the development and implementation of legislation. There has been much
legislative and regulatory convergence, pushed forward in particular by the 2006 Capital
Requirements Directive (CRD) for banks and investment firms, the forthcoming Solvency II
Directive for insurance companies, and the Markets in Financial Instruments Directive for
financial markets (e.g., De Rato, 2007).
Nonetheless, the existing framework stops short of delivering a level playing field for banks
across the EU. Considerable cross-country differences persist in the legal and regulatory
framework for bank operation. Implementation of the EU directives has not leveled the
playing field for business, mainly because of remaining national discretion. Even for the
CRD, for example, there are roughly one hundred national specificities (Kager, 2006),
leading some LCFIs to consider limiting the adoption of the advanced approach to their
headquarters. The practice of “goldplating” by national authorities adds further national
requirements over and above those allowed for under EU directives. Aside from stability
concerns, the lack of convergence implies a high regulatory burden for cross-border financial
institutions, which runs counter to the objective of a unified financial market.
Supervision
On the supervisory front, the framework for cooperation has been strengthened, to some
extent reacting to increased merger and acquisition activity among large European banks.
Memoranda of Understanding (MoUs) have become a common device for collaboration and
information exchange among various regulators. At the EU level, several directives and
MoUs specify a general framework for cross-border supervision and general principles for
cooperation and information sharing.
However, the MoUs are rather general and by their nature nonbinding. Hence, they do not
resolve fundamental tensions between supervisors that are likely to emerge in times of crisis

8 Subsidiaries accounted for 56 percent of cross border presence in the EU (70 percent for the euro area) in 2005
(Dierick, Freund, and Valckx, 2007). Centralization of business functions makes the distinction between
branches and subsidiaries less relevant from an operational point of view.

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(see next section), do not make clear who has the final authority to make the key decisions in
a stressful situation, and stop short of ensuring that all necessary information is accessible in
real time to the relevant supervisors. This, to varying degrees, also holds for institution-
specific MoUs (e.g., for the Nordea and Sampo groups—see Appendix I).
Crisis Management and Resolution
There has been partial progress in the area of crisis handling. The MoUs of 2003 and 2005,
the CRD, and the Conglomerates Directive, have established some basic principles of crisis
management, in particular with respect to information sharing during a crisis. Additionally,
countries have signed financial institution-specific MoUs and several crisis-management
exercises have helped establish channels of communication and provide insight into how
cross-border crises could be handled within the current institutional framework. Moreover,
the Winding-Up Directive has allocated responsibilities and introduced some basic principles
for failing banks but left most decision-making power at the national level.
However, there are many important weaknesses. There is a lack of fully effective pre-crisis
sanctions and tools in many countries, partly because of EU shareholder rights legislation
(Hüpkes, 2005). As regards deposit insurance, EU law mandates that depositors in foreign
branches be as well covered as home depositors. Other than that, however, there are large
differences in country deposit insurance schemes. Also, many countries do not have bank-
specific insolvency regimes, meaning that LCFI-crisis resolution would likely be a drawn out
judicial process, where national-level decision making and LCFI cross-border business
structures entail that systemic issues are unlikely to be addressed satisfactorily (Hüpkes,
2005).
C. What Are the Fundamental Problems?
The existing framework has problems with respect to rapidly increasing the contestability of
national financial services markets while safeguarding their stability. Financial institutions
face 27 different prudential regimes and this limits the contestability of national markets. The
financial stability concerns can be summarized into several basic economic concepts. These
include the external spillovers of domestic actions that are likely to arise during LCFI crises;
the diverse incentives of national supervisory agencies, who are accountable only to their
domestic authorities; the dispersed and asymmetric information among the supervisory
bodies both at the macroeconomic (e.g., regarding the optimal response to housing market
booms) and the microeconomic (e.g., concerning cross-border transfers of assets by large
groups as well as cross-border business and deposit insurance) level; and the resulting
collective action problems and moral hazard in the large institutions.

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Level playing field issues
Despite progress, the existing framework does not deliver a level playing field for banks
across the EU. Accordingly, European financial institutions have been calling for a
streamlined and more coherent, consistent, and cost efficient EU prudential framework.9
Ensuring uniform implementation of the directives by national prudential authorities is the
responsibility of Level 3 (committees of supervisors) and 4 (enforcement by the
Commission) of the Lamfalussy framework; however, progress on this front has been mixed.
Fundamentally, the Lamfalussy committees do not have a clear and strong mandate for
action. On the one hand, they have been charged by the European Commission and European
Parliament with helping design and delivering convergent prudential policies and practices.
On the other hand, they are staffed with representatives from national prudential agencies
that operate by consensus and are ultimately accountable to their national authorities. This
makes for a slow process of integration and numerous implementation options that cater to
national interests. The result is, to some extent, a collection of national rather than a single
set of best prudential policies and practices. As a result, policymakers now increasingly
emphasize “convergence” over “harmonization,” together with mechanisms for “mediation”
among national authorities. More ambitious proposals call for qualified majority voting in
these committees, supported by the introduction of specific EU-related references in mission
statements of the national prudential authorities (e.g., Trichet, 2007).
From theoretical perspective, the lack of level playing field can also be explained by models
of public good provision by local communities (Tiebout, 1956). Using this approach, Hardy
(2004) presents a model of “regulatory capture” in banking, finding that if banks are able to
influence regulators to favor their interests, differences in regulatory regimes across
jurisdictions are likely to persist. The reason is that captured regulators may differentiate
their regulatory “product” to discriminate in favor of the dominant incumbent institutions.
The reasons why regulators can become fully or partly captured include budget constraints
and managerial and bureaucratic interests (as discussed in detail, e.g., by Kane, 2001).10
Cross-border financial stability issues
The need for more EU-wide intervention is also justified by the potential for market failures
associated with the presence of LCFI. While a cross-border LCFI crisis may have a low
probability, the need for effective coordinated arrangements to deal with it is pressing

9 See, for example, European Financial Services Round Table, July 28, 2006, letter to EC President Barroso, EU
finance ministers, Lamfalussy bodies, and others at www.efr.be.
10 For example, some supervisory agencies have their income tied to the asset size of the locally incorporated
financial institutions that they supervise (meaning that, e.g., a switch of a foreign bank subsidiary into a branch
may have an impact on the supervisory income). In some cases, industry representatives have an even more
direct say on the determination of the income side of the supervisory budget.

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