A partnership with academia

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.

1

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

3

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.

4

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

5

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.

6

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.

European Commission (2009a): Proposal for a Regulation of the European Parliament and of the Council establishing a
European Banking Authority. COM (2009) 499.

European Commission (2009b), Proposal for a Regulation of the European Parliament and of the Council establishing a
European Insurance and Occupational Pensions Authority. COM (2009) 502.

European Commission (2009c): Proposal for a Regulation of the European Parliament and of the Council establishing a
European Securities and Markets Authority. COM (2009) 503.

Europa Press Releases (2009): Financial services: Commission sets out future actions to strengthen the safety of derivatives
markets. Reference: IP/09/1546, 20 October 2009.

Europa Press Releases (2009a): Commission proposes further revision of banking regulation to strengthen rules on bank
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
Securities and Markets Authority (ESMA) – presidency compromise. Interinstitutional File: 2009/0144 (COD).

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).

Imprint

Friedrich-Ebert-Stiftung
International Policy Analysis
Hiroshimastraße 28 | 10785 Berlin | Germany

Responsible:
Dr. Gero Maaß, Head, International Policy Analysis

Tel.: ++49-30-269-35-7745 | Fax: ++49-30-269-35-9248
www.fes.de/ipa

To order publications:
info.ipa@fes.de

The views expressed in this publication are not necessarily
those of the Friedrich-Ebert-Stiftung or of the organization for
which the author works.

This publication is printed on paper from sustainable forestry.

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