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EU Financial Market Reform: Status and Prospects

Case study by Dullien, Sebastian; Herr, Hansjörg/ HTW, 2010

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The financial and economic crisis has made it clear that the financial markets are in need of far-reaching reform and more effective regulation. Since the most pressing dangers have been averted and the economy in most industrialised countries is clear of recession, however, the topic of financial market regulation has largely disappeared from the public gaze. Having said that, a great deal is happening in the background with regard to financial market regulation, including at the EU level. Against this background, economists Sebastian Dullien and Hansjörg Herr present the current state of the debate in some of the most important areas of EU financial market regulation and ongoing legislative processes and evaluate the most important plans. The authors come to the conclusion that, although the current deliberations on reform are going in the right direction, they are insufficient to ensure the long-term stability of the EU financial system.

INTERNATIONAL POLICY ANALYSIS


EU Financial Market Reform
Status and Prospects, Spring 2010


SEBASTIAN DULLIEN AND HANSJÖRG HERR
May 2010


The financial and economic crisis has made it clear that the financial markets are in
need of far-reaching reform and more effective regulation. Since the most pressing
dangers have been averted and the economy in most industrialised countries is clear
of recession, however, the topic of financial market regulation has largely disap-
peared from the public gaze.


Having said that, a great deal is happening in the background with regard to finan-
cial market regulation, including at the EU level. Against this background, econo-
mists Sebastian Dullien and Hansjörg Herr present the current state of the debate in
some of the most important areas of EU financial market regulation and ongoing
legislative processes and evaluate the most important plans.


The authors come to the conclusion that, although the current deliberations on re-
form are going in the right direction, they are insufficient to ensure the long-term
stability of the EU financial system. For example, the European Commission’s initia-
tives and even more so the ideas of the Council amount to an unacceptable dilution
of the demands of the De Larosière expert group. Dullien and Herr demonstrate
these defects and develop alternative proposals by means of which the European
Parliament could implement substantial EU financial market reforms.






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SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


Content


1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3


2 Requirements of Well-Functioning Financial Market Regulation at the EU Level . 3
2.1 Comprehensive, Uniform Oversight of All Products and Institutions . . . . . . . . . . . . . 3


2.2 Capital Adequacy Requirements and Rating Agencies . . . . . . . . . . . . . . . . . . . . . . . 4


2.3 New Rules for Derivatives Trading and Securitisation . . . . . . . . . . . . . . . . . . . . . . . . 6


3 Current Reform Progress at the EU Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.1 Financial Supervision Package . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7


3.2 Changes in Capital Adequacy Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10


3.3 Stricter Regulation of Rating Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11


3.4 Initiatives on Derivatives Trading and Securitisation . . . . . . . . . . . . . . . . . . . . . . . . . 12


4 What Next? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13


Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16






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SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


1 Introduction


Since the outbreak of the current financial and economic


crisis in 2007 and its intensification after the collapse of


US investment bank Lehman Brothers in September 2008


there has been no shortage of grandiloquent words as


politicians have sought to describe what is to be done


differently in the financial sector in future. »Making


banking boring« was suddenly the phrase on everyone’s


lips. As late as September 2009, at the G20 summit in


Pittsburgh, the Leaders’ Statement declared: »Today we


agreed: … To make sure our regulatory system for banks


and other financial firms reins in the excesses that led to


the crisis. Where reckless behavior and a lack of respon-


sibility led to crisis, we will not allow a return to banking


as usual«. However, since for the time being critical


threats have been averted and the economies of most


industrialised countries have come out of recession, fi-


nancial market regulation has faded from public view.


This applies in particular to Europe where, traditionally,


legislation at the European level – where decisions on


financial market regulation are made, as a result of the


Single Market – has figured far less prominently in the


predominantly national media than the reporting of


national legislation.


In fact, however, a great deal is happening in the back-


ground with regard to financial market regulation. The


European Commission has already presented a number


of draft directives which are now slowly making their way


through the European decision-making bodies.


The aim of this paper is to present and evaluate the cur-


rent status of the debates and legislative procedures with


regard to some of the most important areas of financial


market regulation. We shall limit ourselves to financial


market supervision and financial market regulation in the


narrow sense. Although the authors are convinced that


macroeconomic imbalances played a significant role in


the origins and outbreak of the global financial and eco-


nomic crisis of 2008–2009, for reasons of space they


must largely be left to one side.1


In what follows, we shall scrutinise three areas of finan-


cial market regulation which have particular significance


for the EU. First, financial market supervision at the EU


level – that is, banking, securities and insurance; second,


1. Those interested might consult Dullien et al. (2009).


the banks’ capital requirements; and third, the regulation


of derivatives markets in the EU, including the rating


agencies.2


2 Requirements of Well-Functioning Financial
Market Regulation at the EU Level


Before attempting to assess current developments in


financial market regulation it is worth taking one more


look at where problems emerged in the latest crisis and


what is required for a better system of financial market


supervision.


2.1 Comprehensive, Uniform Oversight of All Products
and Institutions


A fundamental problem not only with the latest, but also


previous financial and banking crises was often not so


much that the banks were not regulated at home, but


that other financial institutions or other jurisdictions were


less strictly regulated than the native banks and that the


commercial banks took advantage of this by transferring


particularly risky transactions to less regulated parts of


the financial system (regulatory arbitrage). Before the lat-


est crisis, for example, many banks externalised their


transactions involving US subprime securities in the form


of so-called special purpose vehicles, often located in less


regulated financial centres, making it possible, among


other things, to circumvent capital requirements. The risk


remained for the commercial banks through their credit


and ownership links with the so-called »shadow banks«


(Brunnermeier et al. 2009). In the event, this behaviour,


together with the regulatory differences in different parts


of the financial sector, led not only to a more risky, but


also to a more opaque financial system.


The development of the US subprime crisis cannot be


understood without taking a look at the still extremely


fragmented state of financial supervision in the USA. For


example, most subprime mortgages were issued not by


banks, but by mortgage companies which were subject


only to state-level regulation (Gramlich 2007). Many


2. The matters that will not be dealt with explicitly include the control
of hedge funds and other high-risk funds, a European deposit guarantee,
a European bankruptcy law and unregulated – or only lightly – offshore
centres in Europe itself, the purpose of which is to take advantage of
regulatory arbitrage and tax evasion.




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SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


states exercised their regulatory powers so loosely that in


fact there was no regulation at all. The securities of in-


vestment banks were securitised and in any case such


banks were not subject to the same strict rules as normal


commercial banks.


Most authors are therefore in agreement that a central


requirement of a well-functioning and powerful financial


supervision is that it is as complete and comprehensive as


possible. It is crucial that all financial institutions – regard-


less of their legal nature – and all financial products are


included. Regulation should be directed towards what a


product’s function is and what kind of transactions an


institution is involved in, not the legal character of the


product or institution. Only in this way can regulatory ar-


bitrage be effectively prevented (Dullien et al. 2009:


154ff).


At the European level, there are further arguments for


the harmonisation and – at least partial – centralisation


of regulation and oversight in the financial system. On


the one hand, the shifting of transactions to countries


with lower regulatory standards is particularly easy due


to the Single Market. On the other hand, there is a sig-


nificant danger that the consequences of inadequate fi-


nancial market regulation will spill over to the other


countries. First of all, the financial institutions in Europe


are very closely intertwined and second, the current crisis


and the debate on financial assistance for the heavily in-


debted Greece have shown that there is an implicit obli-


gation of liability among the partners for the debts of an


individual country.3 This implies an enormous moral


hazard problem in the absence of a uniform financial


supervision: individual countries always have the incen-


tive to regulate financial institutions more loosely than


other countries do in order to attract them. Potential


costs in the event of a crisis are at least partially exter-


nalised. Even basically uniform rules at the EU level are of


no help against this problem unless there is a uniform


supervision, because national authorities have an incen-


tive to interpret the rules as loosely as possible.


The most sensible option would be a supervisory system


whose structure resembled the European system of cen-


tral banks, with a centralised authority which takes im-


portant decisions and subordinate national authorities


3. The explicit no-bail-out clause has thus in the meantime become an
implicit bail-out guarantee (cf. Dullien / Schwarzer 2009).


which implement these decisions. This would mean su-


pervisory authorities with large staffs on the ground in


the respective countries which, among other things,


would undertake the on-site supervision of financial in-


stitutions – just as, at present, the national central banks


in their day-to-day dealings with the commercial banks


implement the European Central Bank’s (ECB) monetary


policy.


2.2 Capital Adequacy Requirements and
Rating Agencies


Another problem responsible for the current crisis was the


banks’ gluttonous appetite for risk. In all major industri-


alised countries, in recent years, the banks’ capital buffer


has been systematically reduced, causing the debt-equity


ratio – so-called gearing or leverage – to rise rapidly. For


example, equity at institutions such as Deutsche Bank or


the Swiss bank UBS was reduced from almost ten per cent


at the beginning of the 1990s to two to three per cent


before the outbreak of the latest financial market crisis


(Hellwig 2008: 44).


One reason for this development may well have been the


reform of the rules on capital adequacy (the so-called


Basel II standards). The earlier, relatively simple equity


capital guidelines were replaced by new, more complex


guidelines, under which each investment by a bank had


to be backed by equity capital in accordance with its spe-


cific risk. The risk of an investment in each instance was


determined by an internal or external rating.


There were three problems with this. First, using internal


risk models, the dangers arising from certain investments


were likely to be assessed as low as a matter of course.


Although individual risk models had to be approved by


the banking supervision, there was an incentive to adopt


models which evaluated the risks as low and entailed low


capital adequacy. Second, a strong pro-cyclical element


was introduced into the banks’ lending. Ratings tend to


improve systematically in an upswing and to be down-


graded in a downturn. In connection with Basel II, the


problem arose that, in good times, the banks did not


have to hold so much capital and thus could expand their


credit portfolio. This is likely to have further fuelled the


boom, for example, in mortgage allocation. In the down-


turn, in contrast, more equity capital was abruptly re-


quired, so that the banks, in the very period in which the




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SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


economy needed more expansive lending, were forced to


curtail it. Third, the close links between financial institu-


tions and rating agencies became problematic: because,


in particular, the evaluation of structured financial prod-


ucts was very profitable for the rating agencies and, at


the same time, such evaluations were commissioned and


paid for by the issuing financial institutions, there was an


incentive to provide even dubious products with good


ratings. Furthermore, for smaller financial institutions,


which do not use their own risk models, rating agencies


took over risk evaluation.


Commercial banks traditionally pursued a business model


which concentrated, first and foremost, on lending to


non-financial institutions, that is, to companies, private


households and public authorities. In addition, banks


traded on capital markets, currency markets and other


speculative markets on behalf of others. In particular,


banks operating internationally in recent years have dra-


matically increased the volume of proprietary trading.


This means that they carried out speculative bond, for-


eign currency, precious metals and, not least, derivatives


transactions on their own account.


These risky transactions on the part of the commercial


banks should be strictly limited in order to prevent them


from using their privileged access to central banks (to re-


finance their lending) to engage in highly speculative ac-


tivities. One option would be to impose particularly high


capital requirements – up to 100 per cent – on proprie-


tary trading. Alternatively, a far-reaching ban on specula-


tive transactions in the proprietary trading of commercial


banks should be contemplated. US President Barack


Obama, based on the recommendations of former Chair-


man of the Federal Reserve Paul Volcker, has proposed


reforms along these lines.4 Both options would also lead


to a limitation or even reduction of the size of financial


institutions, which in any case is desirable on regulatory


grounds. To be sure, in both instances it must be ensured


that commercial bank loans to other highly speculative


actors in the financial sector – hedge funds, private equity


funds and so on – are limited. Likewise, in this case par-


ticularly high capital requirements and an outright ban


are equally worthy of consideration.


The commercial banks not only engaged in risky trans-


actions in proprietary trading, but also financed other fi-


4. Cf. Financial Times Deutschland, 21 January 2010.


nancial institutions, such as investment banks, hedge


funds and private equity funds, whose business models


are, as a rule, highly risk oriented and speculative. As a


result, a direct channel emerged between the creation of


money by central banks, the commercial banks’ credit


expansion and the credit financed speculation of risk-


taking financial market actors. The central banks had no


instrument at their disposal to promote credit expansion


in productive branches or to impede the financing of


speculative activities, which led to asset market bubbles.


For risk capital – for example, in the form of venture


capital – more than enough funds are still available, be-


cause non-commercial banks can attract investments, for


example, from risk-seeking private households.


The revision of equity capital rules is therefore key to


effective reform of financial market regulations. The fol-


lowing points are of particular importance in this regard:


1. Capital requirements should, by and large, be higher


than they are now.


2. Banks should be compelled to back transactions


externalised in special purpose vehicles or similar institu-


tions with equity capital.


3. The hitherto pro-cyclical effects of equity capital rules


should be eliminated, for example, by introducing obliga-


tions on banks, in good times, to build up capital reserves


or by means of capital requirements which vary counter-


cyclically over the economic cycle.


4. The rating agencies’ role in the process should be


reduced; furthermore, rating agencies’ payment model


should be changed so that they no longer have an incen-


tive to evaluate securities in the interests of their issuers.


The establishment of a European rating agency could


break the monopoly of the private rating agencies, which


have failed.


5. Commercial banks’ proprietary trading must be sub-


ject to very high capital requirements. The same applies


to commercial banks’ lending to non-banks in the finan-


cial sector. Alternatively, proprietary trading could be


banned and strict limits considered on commercial banks’


loans to non-bank financial institutions.




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SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


2.3 New Rules for Derivatives Trading and
Securitisation


Another problem which has attracted renewed attention


in the current crisis is the growing significance of unregu-


lated bilateral trading – over the counter or OTC – of fi-


nancial derivatives. A particular focus is the market for


credit default swaps (CDS) which, according to current


estimates, is now worth more than 60 trillion US dollars.


Many have predicted that problems on the CDS market


could usher in a new round of bank failures.5 This funda-


mental problem of the CDS market also applies to many


other derivatives and financial innovations.


One of the main difficulties of the derivatives market is


that, because of its bilateral nature, it is unclear which


market participants hold what positions and whether


there is a concentration of risk or not. In the event of


more dramatic price movements or the insolvency of a


firm the purchaser of a derivative – for example, a CDS –


can find itself in financial difficulties. Furthermore, if an


OTC counterparty goes bankrupt, the other also comes


under threat. In the past, market participants just blindly


assumed that OTC counterparties could always step into


the breach. In this way, business strategies were classed,


from a microeconomic perspective, as safeguarded, al-


though from a macroeconomic perspective it ought to


have been clear that this was not the case. As a result,


financial institutions signalled solvency and liquidity posi-


tions from the microeconomic level which rapidly proved


to be illusory in the crisis.


Precisely these dangers manifested themselves in the


course of the nationalisation of US insurance group AIG


and the bankruptcy of Lehman Brothers. AIG had enor-


mous sums outstanding in CDSs, so that the US govern-


ment feared a domino effect of bank failures if the com-


pany went bankrupt. There was a similar fear in the case


of the investment bank Lehman Brothers, which ulti-


mately led to the state more or less doing whatever it


took to rescue the situation after its collapse. The fact


was, however, that the supervisory authorities simply


could not foresee the consequences of insolvencies.


One solution to the problem of risky OTC derivatives


markets would be to transfer all such transactions to cen-


tral clearing houses on a compulsory basis. A central


5. See, for example, Münchau (2009).


clearing house would have a number of advantages.


First, regulators would be provided with summary infor-


mation on current risks, as all transactions would go


through it. Regulators could see at a glance who had


taken what positions and counterpositions, so that the


net risk of a bank failure could be more easily assessed.


Second, a central clearing house would provide some


sort of protection in the selection of counterparties in de-


rivatives trading: depending on the development of lia-


bilities from derivatives contracts counterparties would


have to deposit a certain proportion of these liabilities at


the clearing house in the form of bank deposits or highly


liquid government bonds. Although it would not be ab-


solutely guaranteed that the counterparties could even-


tually fulfil their commitments, the accumulation of ex-


tremely risky positions almost without the use of own


funds would be prevented. Third, the obligation to de-


posit liquid securities automatically limits the amount of


derivatives that individual financial institutions can issue.


In this way, in turn, the risk and volume of the derivatives


market, if desired, can be reduced relatively simply by in-


creasing the deposit obligation and ensuring that deriva-


tives trades involve a higher proportion of investors’ own


funds. A higher deposit obligation functions like a fee


which makes hedging transactions moderately more ex-


pensive and counteracts an excessively high inclination


towards risk on the markets.


With the securitisation of credit instruments the original


lender sells his claims arising from lending to a third party.


A large number of loans can, as frequently happened be-


fore the subprime crisis, be pooled and divided into


tranches, allowing the process to be repeated a number


of times. The distance between the original lender and


the final holder of the loan, who bears the default risk,


thereby becomes greater. The risk of moral hazard also


emerges because the original lender, in granting credit,


no longer applies strict standards, since he can sell the


risks and de facto operates as a credit broker. Rating


agencies, as the subprime crisis has shown, were not in a


position to evaluate sometimes very complex securitisa-


tions adequately. In order to solve this problem we pro-


pose that the original lender should be obliged to hold


an appropriate portion of the granted credit until the


term of the loan is reached.6 It must be taken into ac-


count that the original lender holds a large portion of the


6. The SPD party executive’s project group »More Transparency and
Stability on the Financial Markets« in October 2008 called for the reten-
tion of 20 per cent. This seems appropriate to us.




7


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


»first loss« part, that is, the tranche which suffers first in


the event of default.


The question arises, in the face of the seemingly relent-


less emergence of financial innovations – which overall


make financial markets increasingly opaque, even for ex-


perts and supervisory authorities – of how to deal with


new financial products. A large number of these prod-


ucts are not financial innovations at all, but rather the


result of regulatory arbitrage. In Dullien et al. (2009), the


introduction of a financial »MOT« (in German: TÜV or


Technischer Überwachungs-Verein [Technical Inspection


Association]) is proposed as a solution. In contrast to


what is usually put forward when this matter is raised in


the public debate, it would not, in the first instance, be


the task of a financial MOT to bar access to certain risky


forms of investment to small investors. The point would


rather be to subject all products – that is, also those in


use only in inter-bank trading – to strict examination be-


fore they are introduced on the market.


The approach taken to the licensing of drugs should


serve as the model here: a financial institution which


wants to introduce a new product or a new type of con-


tract must first prove that the individual or national eco-


nomic use of the new product is proportionate to the risk


and to any increase in market opacity on account of the


product. Products which represent no discernible im-


provement over existing contracts should be rejected in


this process, as should innovations with excessive risk.


Good innovations, in contrast, may continue to be devel-


oped and find their way into the market.


3 Current Reform Progress at the EU Level


Many of the elements proposed above are reflected in


the proposals being discussed at the EU level. Of central


importance for the EU debate is the report by the so-


called De Larosière Group, which was ordered by the


European Commission and presented in February 2009,


which more or less serves as the basis for the proposals


for a Directive which the Commission got under way in


the course of 2009.


3.1 Financial Supervision Package


A key element of the Commission proposals is the cre-


ation of a European System for Financial Supervision


(ESFS). Basically, the idea of a unified supervisory struc-


ture goes back to the outline presented by the De


Larosière Group (De Larosière Report 2009: p. 48ff), the


proposed structure of which was adopted virtually unal-


tered in the draft directive presented by the European


Commission in September 2009 (European Commission


2009).


This system is intended to form a network of European


financial supervisory authorities (see Figure 1). The three


previously existing so-called »Level 3 committees« for the


regulation of banks, insurance companies and securities


supervision – the Committee of European Banking Super-


visors (CEBS), the Committee of European Insurance and


Occupational Pensions (CEIOPS) and the Committee of


European Securities Regulators (CESR) – are to be up-


graded to authorities with offices in Frankfurt, Paris and


London. At the same time, national supervisory authori-


ties would continue to be concerned mainly with the su-


pervision of financial institutions and markets, while the


newly established European Supervisory Authorities (ESA)


are to adopt a coordination function and, among other


things, »coordinate the application of common high level


supervisory standards«, as well as directly monitoring in-


dividual cross-border institutions.


A European Systemic Risk Board (ESRB) is to be set up


alongside these Supervisory Authorities, to assess macro-


economic risks and make recommendations when things


take a wrong turn. The plan is that the ESRB’s Taxation


Committee should have 33 voting members, namely the


27 national central bank heads, the ECB President and


vice-president, a representative of the European Commis-


sion and the heads of the three ESAs. The main task of


this committee would be to issue warnings and recom-


mendations. The ESRB’s secretariat is to be located at the


ECB in Frankfurt.


Apart from the basic structure, the powers envisaged for


the Authorities in the legislative process represent a


marked dilution in comparison to the De Larosière pro-


posal. In the De Larosière Report, ESA experts were


granted relatively substantial »break-through rights« in


the form of mandatory instructions to national supervi-


sory authorities. For example, it had been recommended




8


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


that the new authorities could challenge »the perfor-


mance by any national supervisor of its supervisory re-


sponsibilities … and to issue rulings aimed at ensuring


that national supervisors correct the weaknesses that


have been identified. In the event of the national supervi-


sor failing to respond to this ruling, a series of graduated


sanctions could be applied …« (De Larosière Report


2009: 60f).


In the draft presented by the European Commission


(2009a; 2009b; 2009c) in September this idea no longer


had the clarity of the first draft. It is true that the Euro-


pean Commission was given the right, when weaknesses


in the implementation of EU financial market regulations


by national financial supervisions came to the notice of


the new EU authorities, to force them to change their


policies. Furthermore, the direct practical powers of the


new European authorities in relation to financial institu-


tions such as rating agencies, central counterparties, in-


cluding clearing houses, and similar European institutions


were limited. This means that break-through rights with


regard to »normal« financial institutions which operate


predominantly at the cross-border level were dropped.


In comparison to the Commission’s draft, the draft dis-


cussed in the Council of Ministers in December 2009


(Council of the European Union 2009) represented even


thinner gruel. For example, the direct »breakthrough


rights« of the planned European authorities with regard


to financial institutions were further restricted and explic-


itly limited to rating agencies. What is more important,


however, is that in this draft the European Commission’s


Figure 1 A new European framework for safeguarding financial market stability


M
ac


ro
-p


ru
de


nt
ia


l s
up


er
vi


si
on »European Systemic Risk Council« (ESRC)


[Chaired by President ECB] Main tasks of the European Systemic Risk Council:
decide on macro-prudential policy, provide early risk
warning to EU supervisors, compare observations on
macro-economic and prudential developments and
give direction on these issues.Members of ECB/ESCB


General Council
(with alternates where


necessary)


+
Chairs of


EBA, EIA&ESA
+


European
Commission


Information on
micro-prudential
developments


Early risk warning


M
ic


ro
-p


ru
de


nt
ia


l s
up


er
vi


si
on


»European System of Financial Supervision« (ESFS)
Main tasks of the Authorities: in addition to the
competences of the existing level 3 committees, the
Authorities would have the following key-competenc-
es: (i) legally binding mediation between national su-
pervisors, (ii) adoption of binding supervisory standards,
(iii) adoption of binding technical decisions applicable
to individual institutions, (iv) oversight and coordination
of colleges of supervisors, (v) licensing and supervi-
sion of specific EU-wide institutions (e.g., Credit Rating
Agencies and posttrading infrastructures), (vi) binding
cooperation with the ESRC to ensure adequate macro-
prudential supervision, and (vii) strong coordinating role
in crisis situations.


Main tasks of national supervisors: continue to be
fully responsible for day-to-day supervision of firms.


»European Banking
Authority« (EBA)


»European Insurance
Authority« (EIA)


»European Securities
Authority« (ESA)


National Banking
Supervisors


National Insurance
Supervisors


National Securities
Supervisors


Source: De Larosière Report (2009), p. 65.




9


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


authority to issue instructions to national supervisory au-


thorities is deleted and downgraded to a mere recom-


mendation. Furthermore, the European authorities’ deci-


sion-making competence in an emergency is withdrawn.


Finally, the draft envisages the possibility of member


states exercising a veto against decisions of the European


financial market supervision if they threaten their bud-


getary sovereignty. A critical feature of this provision is


that, according to the Council draft, no justification is re-


quired with regard to why an individual member state


considers its budgetary sovereignty to have been jeop-


ardised and that such a veto automatically has a suspen-


sive effect on the European authority’s decision.


The package is currently being debated in the European


Parliament and its first reading is due in May or June 2010.


The question is, whether the Parliament will go along


with the Council’s desired changes or risk a conciliation


procedure. The problem with such a conciliation proce-


dure may be that the supervision directives are unlikely to


be adopted in 2010.


The current state of reform with regard to financial mar-


ket supervision represents an improvement in relation to


the status quo, but it has grave defects which may hinder


the emergence of a truly powerful and efficient EU finan-


cial market supervision through the planned directive.7


It is generally to be welcomed that further competences


are being transferred to the financial supervision at the


European level. This is a step which can prevent geo-


graphical regulatory arbitrage. Also generally positive is


the fact that a special committee will be devoted at the


European level to the topic of systemic risk and macro-


economic risks.


It is difficult to understand the planned structure of the


supervisory authority, however. The division into three


authorities, separated both geographically and in terms


of subject-matter, is problematic. It is becoming increas-


ingly difficult to assign modern financial institutions to a


certain segment of the financial sector. The division of


supervisory competence to three authorities brings with


it the danger of divergent application of regulations and


of transitions which lead to regulatory gaps. The recent


crisis furnishes a vivid illustration of this: the US insurance


7. This section is based on Sebastian Dullien’s testimony before the Eu-
ropean Parliament’s ECON Committee in January 2010 (Dullien 2010).


group AIG was not forced onto the ropes on account of


its insurance business, but because it gambled in the


credit derivatives market, more precisely with credit de-


fault swaps (CDS). The US government took the view


that it had no choice but to stage a rescue because AIG


had engaged in such transactions with a multitude of


banks and its bankruptcy would also have dragged these


institutions under. The danger is that a fragmented su-


pervision, like the one planned by the EU, would fail to


see such connections.


The same applies to the geographical division of supervi-


sory competence and the location of the authorities in


three different cities and countries. Recognising the risks


emerging at the interfaces between individual financial


institutions requires the active exchange of views by su-


pervisory personnel at all levels. The danger of geograph-


ical separation is that, although there will be regular


meetings at the top level, those working at the coalface


will be too isolated from one another to identify every


threat in time.


Turning to the ESRB, its close linkage to the European


Central Bank is a matter of concern. Although central


banks have privileged access to information on financial


stability, and the ECB has regularly published its Financial


Stability Review since 2004, central banks tend to think


and act by strict consensus. Most European central bank-


ers are trained on the basis of similar models and modes


of thinking, while many years of cooperation lead to fur-


ther convergence of worldviews. As the US subprime cri-


sis illustrated, it is often outsiders who identify risks. For


example, the US Federal Reserve long ignored the risks


attendant on the house price bubble, while economists


such as Raghuram Rajan and Robert Shiller sounded the


alarm. Experience of earlier financial crises shows that


they generally do not arise where financial crises arose


before, and that the dominant economic interpretation


often underestimates developing threats. It would there-


fore be important to integrate maverick opinions in the


evaluation of macroeconomic and systemic risks. This is


ruled out by the overwhelming majority of 29 out of 33


votes for central bankers in the ESRB.


A further problem is the question of how central bankers


in the committee react when ECB policy becomes a sys-


temic risk. The question is whether, for example, the cen-


tral bankers in the ESRB would agree to issue a warning


about an over-hasty series of interest rate hikes by the




10


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


ECB, if they jeopardised macroeconomic stability in Eu-


rope.


Finally, it has to be said that, so far, the ECB has not ex-


actly covered itself with glory in its crisis assessments. For


example, in July 2008 – that is, almost one year after the


first appearance of turbulence on the money markets


(and when Europe’s economy, as we now know, was al-


ready in recession) – the ECB raised interest rates once


more. This, albeit small, interest rate increase is likely to


have further aggravated the situation in the European


banking sector. The ECB’s decision can be explained only


by the fact that it failed to perceive the seriousness of the


situation at that time. There is no reason to believe that


the ECB will do better in the future than it has so far.


To sum up, a better solution to the problems of financial


sector supervision would be to create a single supervisory


authority for the whole financial sector in one city (and


best of all, in one building), which is responsible for the


banks, insurance companies and the securities markets


alike.


3.2 Changes in Capital Adequacy Requirements


The De Larosière Report regards the reduction of the eq-


uity capital of financial institutions as one of the reasons


for the subprime crisis, and proposes a »fundamental re-


view« of the Basel II framework (De Larosière Report


2009: 22). In detail, it is proposed to gradually increase


the minimum capital requirements, to reduce the procy-


clical effect of Basel II, to introduce stricter rules for off-


balance sheet positions, to tighten up liquidity manage-


ment and to reinforce the provisions on internal control


and risk management of banks. The Basel Committee of


Banking Supervisors is called on to make the appropriate


changes speedily. The Report also proposes the establish-


ment of a common definition of regulatory capital, which


should be confirmed by the Basel Committee. With refer-


ence to the mechanical application of banks’ internal risk


models there is also an explicit demand for management


personnel and board members to make greater use of


their own judgement and to possess high personal integ-


rity and technical knowledge (De Larosière Report 2009:


22).


Concerning the shadow banking system, the Report calls


for all firms of potential significance for the financial sys-


tem to be subject to appropriate regulation. Particularly


in the case of systemically important hedge funds a


worldwide obligation to register and to provide informa-


tion on strategies, methods and leverage, also in global


transactions, is called for. For banks which conduct pro-


prietary trading, an appropriate capital requirement


should be set. This also applies to banks which are own-


ers or operators of hedge funds (De Larosière Report


2009: 28f).


Although the proposals of the De Larosière Report do not


include quantitative stipulations, their overall thrust is


relatively far-reaching. The sole relevant difference with


regard to our approach concerns whether proprietary


trading should be permitted for commercial banks and


how commercial bank lending to hedge funds and other


non-bank financial intermediaries should be dealt with.


On this the Group proposes that, in the case of banks


which conduct proprietary trading and are owners or op-


erators of hedge funds, an appropriate capital require-


ment should be enforced. In our view, such a proposal is


certainly a step in the right direction. However, clear pro-


posals are lacking on how commercial banks’ lending


relationships to the shadow banking system can be pre-


vented or at least so strictly limited that the spread of


problems from the shadow banking system to the normal


banking system can be avoided.


On 6 May 2009, the European Parliament approved a


tightening up of banks’ capitalisation, which is supposed


to be adopted in the member states by 31 October 2010


and come into force by the end of the year (European


Parliament 2009; Stichele 2009). More specifically, it was


laid down that banks may allocate no more than 25 per


cent of their capital to one client or group of clients.8 It


was also agreed that, in the case of securitisations, a re-


tention of at least 5 per cent should apply. Criteria were


also more clearly defined for the »duty of care« in the


valuation of securitisations.


In July 2009, the European Commission presented pro-


posals for the further tightening up of financial institu-


tions’ capital holdings (Europa Press Releases 2009a). A


consultation process then commenced on the proposals,


which was concluded in September 2009. The key ele-


ments of the Commission proposals are as follows:


8. In future, balance sheet capitalisation can only include up to a max-
imum of 35 per cent of capital subject to withdrawal.




11


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


1. In the case of re-securitisations, banks should be sub-


ject to higher capital requirements.


2. The new provisions are to tighten up disclosure re-


quirements with regard to securitisation risks. Accord-


ingly, banks must clearly identify and publish risks related


to securitisations.


3. Capital requirements for the trading book are to be


modified in such a way that the banks take full account


of potential losses which could occur as a result of un-


favourable market developments in stress situations,


such as those encountered in 2008 and 2009. The trad-


ing book includes all financial instruments held by a bank


in order to resell them in the short term or in order to


cover other instruments in the trading book, that is, es-


sentially the bank’s proprietary trading.


4. Banks’ remuneration policy and practice are to be de-


signed in such a way that an excessive willingness to take


risks is neither encouraged nor rewarded. Banking super-


visors can sanction banks which do not comply with the


new provisions.


The European Commission’s proposals are disappointing


with regard to bank capitalisation. Although higher cap-


italisation is implicitly proposed in the case of banks’ pro-


prietary trading, including re-securitisations, it is not suf-


ficient. It would be much better to tightly restrict banks’


proprietary trading. The banks’ banking book, which


should include longer-term planned investments, such as


receivables from loans or securities and thus the banks’


core business, is not even discussed with regard to capital


adequacy. No general increase in bank capitalisation is


provided for, nor the introduction of countercyclical ele-


ments with regard to capitalisation, in particular includ-


ing banks’ banking book. Commercial relationships with


non-bank financial intermediaries, such as hedge funds


and commercial banks, are not addressed and play no


role with regard to capital adequacy obligations. The


European Commission’s proposals with regard to capi-


talisation fall far short of the ideas contained in the De


Larosière Report. As things stand at the moment, no far-


reaching reform measures are to be expected from the


European Commission with regard to bank capitalisation.


Having said that, it can be seen that the subprime crisis


and its consequences have kick-started a Basel III. The


defects of Basel II are so deep that even its developers are


discussing reform. The Basel Committee will give its opin-


ion on a Basel III in April 2010. The European Commission


will then make its own comments.


There can be no objection to disclosure obligations with


regard to securitisation risks and the supervision of banks’


remuneration policy and practice, but these are »soft«


areas of regulation which, although important, are not


sufficient.


3.3 Stricter Regulation of Rating Agencies


With regard to rating agencies, the De Larosière Report


demands that their licensing and supervision be trans-


ferred to a reinforced European supervisory institution,


the Committee of European Securities Regulators (CESR).


Rating agencies’ business models and financing, as well


as their combination of valuation and consultation ac-


tivities are to be subjected to fundamental examination.


Specific provisions must be introduced for the rating of


structured products. Finally, the use of ratings in financial


provisions should be severely restricted (De Larosière Re-


port 2009: 23).


With regard to the regulation of rating agencies, reform


measures were instigated at the EU level. In November


2009, a Regulation on the subject was issued (Official


Journal of the European Union 2009; European Parlia-


ment 2009a). The key points of the Regulation are that


rating agencies headquartered in the Community will


have to register with the European supervisory authority,


the CESR. The rating agencies are regulated by the com-


petent authority of the respective member state of origin,


in cooperation with other member states. It is under con-


sideration to include the CESR in this system. Further-


more, under the new Regulation, rating agencies are for-


bidden to issue ratings for a given company or involved


third parties if they are also providing it with consulting


services. The rating of financial instruments may only


take place on the basis of well-founded information.


There must be annual transparency reports on the rating


agencies’ fundamental assumptions, models and meth-


ods. Structured products must be specifically designated


by rating agencies. With regard to the internal control of


rating agencies, there must be at least two independent


members on the administrative or supervisory board of


agencies, who are remunerated independently, serve a


one-off maximum term of five years and may be dis-


missed only on the grounds of professional impropriety.




12


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


At least one member must be an expert on securitisation


and structured financial instruments.


The EU Regulation falls short of the De Larosière Report


on one important point. In the latter, the supervision of


rating agencies by a reinforced European supervisory in-


stitution was envisaged. In the Regulation, supervision


remains a matter of national regulation. The financing of


rating agencies by the company issuing the securities to


be rated was not changed, either. As a result, a key ele-


ment of the dependency of rating agencies remains,


which is a clear instance of moral hazard, affecting their


rating activities.


3.4 Initiatives on Derivatives Trading and Securitisation


The De Larosière Report proposes with regard to deriva-


tives markets that OTC derivatives be simplified and stan-


dardised (De Larosière Report 2009: 29). It remains an


open question, however, how this is to be done. For


CDSs, which are regarded as particularly dangerous, the


Report proposes a well-capitalised central clearing house


for the whole EU. The clearing house should be super-


vised by the European supervisory authorities, including


the ECB. With regard to securitisation, it is proposed that


all issuers of securitised products must retain a significant


portion of the underlying risk, which is not insured by


hedging, for the entire lifetime of the instrument (De


Larosière Report 2009: 29). As in the case of capital ad-


equacy, the proposals of the De Larosière Report are fairly


far-reaching. It would have been more consistent, how-


ever, if the Report had called for a state-supervised clear-


ing house for all derivatives transactions. One defect of


the Report is that it did not propose the introduction of


a financial MOT.


After the first draft in July 2009 and consultations


(Stichele 2009), in October 2009 the European Commis-


sion presented proposals on the regulation of derivatives


markets based on the De Larosière Report and consulta-


tions with interest groups (Europa Press Releases 2009).


The proposals are in line with the G20 declaration in Pitts-


burgh. In order to rule out regulatory arbitrage and to


ensure globally coherent policy approaches the Commis-


sion is willing to cooperate with authorities from all over


the world, before finalising its legislative proposals. Draft


bills should be presented in the course of 2010. The key


points of the Commission proposals are as follows:


1. Risk of default is to be prevented. For that purpose,


legal provisions should be put forward to establish com-


mon safety, regulatory and operating standards for cen-


tral clearing houses (central counterparties). The collater-


alisation of OTC transactions is to be improved. Capital


requirements with regard to OTC transactions are to be


significantly increased in comparison to transactions car-


ried out through a central clearing house. For stan-


dardised contracts, clearing through a central counter-


party is to be made mandatory.


2. Operational risk is to be reduced. For that purpose,


the standardisation of contract conditions and contract


management is to be actively pursued.


3. Transparency is to be increased. Market participants


are to be obliged to enter positions and transactions


which are not carried out through central clearing houses


in transaction registers, which are to be regulated and


supervised. Transparency will also be enhanced by the


fact that standardised derivatives transactions may only


be carried out via organised trading centres. All deriva-


tives markets are to be covered, including commodity


derivatives.


4. Market integrity and supervision are to be improved.


Existing regulations against market manipulation and so


on are to be extended to derivatives. Regulatory authori-


ties are to be given the possibility to set position limits.


The intentions of the Commission, which were character-


ised by Charlie McCreevy as »a paradigm shift away from


the traditional view that derivatives are financial instru-


ments for professional use and thus require only light-


handed regulation« (Europa Press Releases 2009), are


largely identical to the proposals of the De Larosière Re-


port.


However, it would have been better if the Commission


had proposed that all derivatives transactions be carried


out through organised clearing houses. The idea of a fi-


nancial MOT was also left out, as it was from the De


Larosière Report. However, only a financial MOT can end


the pursuit of a succession of new structured products


which in many areas are intransparent and of no benefit


for economic development.




13


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


4 What Next?


Taking the De Larosière Group’s Report as a starting


point, it is fair to say that, while the proposals with regard


to a European financial market supervision, the capitali-


sation of banks and the regulation of derivatives markets


are a step in the right direction, they fall far short of en-


suring the long-lasting stability of the financial system. In


particular, the segmentation of financial market super-


vision in the EU and the design of the committee that is


to supervise macroeconomic financial market stability are


unsatisfactory. As far as the banks are concerned, one


would have wished for tighter restrictions on banks’ pro-


prietary trading, the business relations of commercial


banks with the shadow banking system and a commit-


ment to a financial MOT.


Previous Regulations at the EU level and the European


Commission initiatives mentioned in this article represent


a marked and unacceptable dilution of the demands of


the De Larosière Report. Furthermore, the Council’s


stance again falls short of the Commission’s proposals.


Proposals which were a lot closer to those of the De


Larosière Report would have been much better, notwith-


standing the fact that the latter is hardly a radical docu-


ment itself (see overview in Table 1).


What next? First, it should be emphasised that even the


Commission proposals watered down by the Council rep-


resent an improvement of the status quo. There is not a


single area in which existing provisions are relaxed. The


planned new authorities have the sole purpose of pre-


venting the inadequate application of European regula-


tions at the national level. Further, stricter rules at the


national level, such as the »dynamic provisioning« – a


countercyclical loan provisioning measure – stipulated for


commercial banks in Spain before the crisis, remain pos-


sible. It is also conceivable in principle that the single-


currency states agree among themselves on separate,


stricter rules for their financial institutions.


However, strongly integrated financial systems are only


ever as stable as their weakest systemically important


element. Different degrees of regulatory stringency


within the single European market in effect encourage


regulatory arbitrage. Sustainable stabilisation of the


European financial system by means of nation-states


going it alone simply will not work.


The question for the European Parliament is whether it


accepts the proposals now on the table or insists on


stricter rules and a more coherent supervisory structure.


When this translation of this study was being completed


(beginning of May), it became apparent that the Parlia-


ment’s ECON Committee would suggest a large number


of changes to the present draft legislation. Since the re-


sults of the voting in the Committee are not yet available


and the concluding readings and votes have not yet hap-


pened in Parliament, there is no analysis in this study of


the Parliament’s proposals. It is clear, however, that a


large number of proposed changes, or changes that are


particularly far-reaching, could delay the whole legisla-


tion on a European supervisory architecture and stricter


regulations because, besides a second reading, a concili-


ation procedure could also be necessary. This would


make it difficult to get the regulations finally adopted by


the end of 2010. The danger here is that such a delay


might be a tough sell to the voters. Weighing up the pros


and cons of the various strategies, the best option would


probably be for the Parliament to take a tough line. First


of all, there is no need for undue haste, at present. A new


financial crisis is unlikely to unfold over the months or


year which would be needed to establish the new super-


visory structure. Second, there is the danger that the


adoption of new laws would result in the creation of per-


manent unsatisfactory structures which, not least on ac-


count of the particular interests of the new supervisory


personnel, will be almost impossible to change at a later


date. It is therefore important to design these structures


and regulations rationally from the outset and simply to


accept a certain delay in their implementation.




14


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


Table 1: Overview of the state of financial market reform in the EU


Regulatory area De Larosière Group proposal State of the debate with regard
to EU legislation*


Comment / assessment


Microprudential
Supervision


– Three EU supervisory authori-
ties: for banks, insurance
companies and securities


– Network of EU and national
authorities


– »Breakthrough rights« at the
EU level with regard to na-
tional authorities


– Supervision of pan-European
financial institutions by EU
authorities


Commission proposal:


Like the De Larosière-Group, but:


– limited breakthrough rights for
the EU authorities


– direct supervision only of clear-
ing houses, rating agencies, etc.


Council proposal:


Like the Commission, but:


– no authority to issue directives
for the European Commission in
relation to national authorities


– direct supervision only of Euro-
pean rating agencies


– implicit veto of member states
with regard to decisions of the
EU authorities


– An integrated supervisory
authority for all parts of the
financial sector would be
preferable


– Dilution of breakthrough
rights by the Commission and
Council proposals is unac-
ceptable


Macroprudential
Supervision


– Introduction of a European
Systemic Risk Board (ESRB) to
monitor macroeconomic sta-
bility


– Strong weighting of central
banks in the ESRB


Like the De Larosière Group – Weighting of central bankers
in the ESRB should be ur-
gently reduced


– Outsiders (academics etc.)
should be included in the
process


Capital require-
ments


– Increase in capital require-
ments


– More equity capital for securi-
tisations


– More equity capital for off-
balance sheet obligations


– Uniform definition of equity
capital


– More equity capital for pro-
prietary trading


– Prevention of procyclical ef-
fects of equity capital provi-
sions


– Equity capital requirements for
re-securitisations are increased


– Equity capital requirements for
proprietary trading increased


Improvements necessary:


– Capital requirements for pro-
prietary trading insufficient


– No adequate capital require-
ments for loans to the
shadow banking system


– So far, no solution for the
problem of procyclicality


Derivatives
trading


– OTC derivatives are to be sim-
plified and standardised


– There is to be a well-capital-
ised central clearing house
for CDSs


– Promotion of the standardisa-
tion of contract conditions and
contract management


– Promotion of a central clearing
house for standardised con-
tracts


– Transaction register for OTC
transactions


Improvements necessary:


– Central clearing house should
be made binding


– Derivatives should be stan-
dardised via a financial MOT




15


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


Regulatory area De Larosière Group proposal State of the debate with regard
to EU legislation*


Comment / assessment


Rating agencies – Supervision at the EU level


– Supervision of business and
financing models


– Prohibition of simultaneous
consultation and ratings for
the same client


– Binding provisions for the rat-
ing of structured products


– Restriction of the use of rat-
ings in financial provisions


– New transparency provisions


– Prohibition of simultaneous con-
sultation and ratings for the
same client


– Registration obligation with re-
gard to EU supervisory authori-
ties


Improvements necessary:


Adoption of the proposals of the
De Larosière Group


Financial MOT Not envisaged Like the De Larosière Group Introduction urgently recom-
mended; for guidance, refer to
the procedure for drug approval


* Unless noted otherwise, Commission proposal.




16


SEBASTIAN DULLIEN AND HANSJÖRG HERR | EU FINANCIAL MARKET REFORM


Literature


Official Gazette of the European Union (2009): Regulation (EC) No. 1060/2009 of the European Parliament and of the
Council of 16 September 2009 on credit rating agencies.


Brunnermeier, M., A. Crocket, C. Goodhart, A.D. Persaud and H. Shin (2009): The Fundamental Principles of Financial
Regulation. Geneva Reports on the World Economy 11: Geneva.


De Larosière Report (2009): Brussels.


Dullien, S. (2010): Testimony on the planned reform of macroprudential supervision in Europe in front of the ECON Com-
mittee of the European Parliament, 25 January 2010: Brussels. Available at: http://www.euro-area.org/blog/?p=252.


Dullien, S., H. Herr and C. Kellermann (2009): Der gute Kapitalismus. Bielefeld: Transcript Verlag.


Dullien, S. and D. Schwarzer (2009): Gerettet wird immer. Financial Times Deutschland, 13 February 2009, p. 26.


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markets. Reference: IP/09/1546, 20 October 2009.


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capital and on remuneration in the banking sector. Reference: IP/09/1120, 13 July 2009.


European Parliament (2009): New rules to avoid future financial crisis – Capital Requirements Directives. Press release of
6 May 2009.


Gramlich, E.M. (2007): Subprime Mortgages: America’s Latest Boom and Bust. Urban Institute Press.


Helwig, M. (2008): Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis. Max Planck
Institute for Research on Collective Goods, 2008/43.


Münchau, W. (2009): Die Zeitbombe tickt. Financial Times Deutschland, 18 March 2009, p. 24.


European Council (2009): Proposal for a regulation of the European parliament and the Council establishing a European
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Stichele, M.V. (2009): An Oversight of Selected Financial Reforms on the EU Agenda. Centre for Research on Multinational
Corporations. 22 September 2009 (updated version).




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About the authors


Prof. Dr. Sebastian Dullien teaches at the Hochschule für
Technik und Wirtschaft / University of Applied Sciences in Berlin.


Prof. Dr. Hansjörg Herr teaches at the Hochschule für
Wirtschaft und Recht in Berlin / Berlin School of Economics and
Law.


ISBN 978-3-86872-341-0




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