European Monetary System

Principles of Banking Supervision.

The country-specific, non-harmonised, part of the platform is also

quite relevant and very diversified. It includes, among other things, the

different organisational arrangements for the conduct of banking

supervision (central bank, separate agency or a mixed arrangement); the

tools used by banking supervisors (e.g. supervisory reporting, on-site

inspections); provisions for the liquidation and restructuring of banks;

and the definition and legal protection of financial instruments and

contracts. Even the key notion of a regulated market is harmonised only to

a very limited extent.

15. Such "neutrality" and "incompleteness" on the part of the EU

legislator with respect to key aspects that are normally incorporated in

the regulatory framework is a unique feature of EU banking regulations and

is likely to trigger a deregulatory process, pushed by competition among

the national systems and the different financial centres in the euro area,

and beyond that in the EU. Against the background of the increasing

competition and other changes in the banking industry, one can expect that

the regulatory platform will evolve in the years to come. Additional EU

legislation may prove necessary to complete and strengthen the harmonised

part. One important part of common legislation, namely the draft Directive

on liquidation and re-organisation measures for credit institutions, has

not yet been adopted and, indeed, has been stalled for years. This

Directive is needed to bring legal certainty to the framework for banking

crisis management. In this regard, it would be useful for the Eurosystem,

if necessary, to be able to exclude counterparties from the single monetary

policy on prudential grounds. Also, the non-harmonised part of the platform

will come under pressure to converge, as I have just mentioned, through the

process of "regulatory competition". Like any other rapidly changing

industry, the banking sector will require careful attention by regulators.

As indicated earlier, the ECB will have the possibility of contributing to

the rule-making process through its advisory tasks under Article 105 (4) of

the Treaty and Article 25.1 of the Statute of the ESCB.

16. On the whole, and taking a euro area perspective, the legislative-

cum-regulatory platform of the banking industry, although rather unusual

and very diversified in comparison with those of most currency

jurisdictions, does not seem to present loopholes or inconsistencies that

may hamper the pursuit of systemic stability. Seen from the point of view

of the regulatory burden, it is a light system. It will become even more so

if competition among national banking systems and financial centres

encourages national regulators to free their banks from regulatory burdens

that are not required by the EU Directives. Conversely, seen from the point

of view of its flexibility, i.e. how quickly it can adapt to new

situations, it is, on the contrary, a heavy system. This is the case both

because the EU legislative process is slow (three years or even longer may

be needed to pass Directives) and, perhaps more importantly, because many

provisions are embodied in the Community primary legislation (i.e.

Directives) rather than in Community secondary legislation (amendable

through simpler comitology procedures).

The establishment of EMU does not seem to determine a need for

revising the pillars of the current legal framework. What seems to be

necessary, however, is a more flexible legislative procedure which allows

for a faster and more effective revision of Community legislation, whenever

needed in relation to market developments.

17. Let me now turn to the execution of banking supervision. It

should immediately be recalled that supervision, contrary to regulation, is

a national task, exercised by what the jargon of the Directives calls the

"competent authority". Since the euro area has adopted a separation

approach between supervisory and central banking functions, it is natural

to examine first the functioning of the "euro area supervisor" (i.e. the co-

operative system of national supervisors) and then turn to the tasks and

needs of the "euro area central banker" (i.e. the Eurosystem).

18. The euro area supervisor can be regarded as a rather peculiar

entity composed of national agencies working in three modes: stand-alone,

bilateral and multilateral. Let us briefly examine each of them.

The stand-alone mode is the one in which the supervisor exclusively

operates in the national (or even local) context. Today it is by far the

most predominant mode. In most cases, this approach is sufficient to

achieve the objectives of banking supervision because most banks in Europe

are operating in a context that does not even reach the nationwide market

of the country of origin. Such a decentralised model is even more effective

because it allows the efficient use of information that may not be

available far from the market in which the bank operates. That is why it is

actually applied even within countries. In Italy, for example, over 600 of

the 900 licensed credit institutions at end-1998 were entirely supervised

by the Banca d'Italia branch of the town in which the bank is licensed.

The bilateral mode involves co-operation between two supervisory

agencies. It is used for cross-border supervision of the same type of

financial institutions, such as credit institutions, or the supervision of

different types of financial institutions operating in the same market,

such as credit institutions and securities firms. The instrument that has

been devised to organise bilateral co-operation between banking supervisors

is the Memorandum of Understanding (MoU). With the implementation of the

2nd Banking Co-ordination Directive, the Member States began to negotiate

extensively MoUs in order to establish the necessary co-operation between

"home" and "host country" authorities to supervise efficiently institutions

that have cross-border activities or foreign country establishments.

By the end of 1997, 78 bilateral MoUs had been signed between the EEA

banking supervisory authorities. The key aims of MoUs are to establish a

regular exchange of information between national supervisory authorities.

While the "gateways" for the exchange of information have been laid down in

Community legislation, MoUs provide a practical framework for communication

to be carried out between supervisors. Moreover, MoUs define procedures and

reciprocal commitments between pairs of EU supervisors related to the

various parts of the supervisory process, such as establishment procedures

and on-site examinations.

Finally, the multilateral mode is the one in which a group of

supervisors works collectively as, say, a single consolidated supervisor.

Such a mode is required when the problems involved are area-wide. They may

be area-wide for a number of reasons with regard to the institutions, or

groups, involved: their dimension; their linkages with a number of

different markets in various countries; the role they play in the payment

system or in other "systemic" components of the market, etc. Multilateral

co-operation can also enhance the quality of supervision by examining

common macroeconomic influences on the banking system and common trends in

the financial system that may not be revealed from the national perspective

only.

Today, the Banking Supervision Committee is the key forum for

multilateral co-operation. It is composed of representatives of the banking

supervisory authorities of the EU countries, either forming part of the

respective NCB or separate bodies. The Banking Supervision Committee's main

functions are the promotion of a smooth exchange of information between the

Eurosystem and national supervisory authorities and co-operation among EU

supervisory authorities. Another forum for dealing with the requirements of

the multilateral mode is the Groupe de Contact, a group of EU banking

supervisory authorities which, for many years, has discussed individual

banking cases in a multilateral way, but at a lower organisational level

than the high-level Banking Supervision Committee.

19. So far, the need to develop the multilateral mode has been

relatively limited, as the emergence of a single banking market in the

European Union has been slow and the euro was not yet in place. Thus, the

fact that the multilateral mode has not gone, for the moment, beyond

periodic discussions among supervisors and occasional industry-wide

analyses should not be a cause for concern.

I am convinced, however, that in the future the needs will change and

the multilateral mode will have to deepen substantially. Over time such a

mode will have to be structured to the point of providing the banking

industry with a true and effective collective euro area supervisor. It will

have to be enhanced to the full extent required for banking supervision in

the euro area to be as prompt and effective as it is within a single

nation.

There are no legal impediments to that. The existing legislation,

whether Community or national, permits all the necessary steps to be made.

Information can be pooled; reporting requirements and examination practices

can be developed and standardised; common databases can be created; joint

teams can be formed; and analyses of developments across the whole banking

system can be conducted. The Community legislation providing for the

unconstrained exchange of confidential information between supervisors does

not distinguish between bilateral and multilateral co-operation, but the

common interpretation is that it covers both modes. It will be the task of

the Banking Supervision Committee, for its part, to develop the

multilateral mode among EU banking supervisors.

20. If the above concerns primarily the euro area supervisor, what

about the euro area central banker, i.e. the Eurosystem? The euro area

central banker has neither direct responsibility for supervising banks nor

for bank stability. It is, however, no stranger in this land. It has a

vital interest in a stable and efficient banking industry; it is,

therefore, keen to see its action complemented with an effective conduct of

the supervisory functions by the competent authorities; it needs a clear

and precise knowledge of the state of the euro area's banking industry as a

whole and of its major individual players; and it may have a role to play,

as we shall see, in the management of crises.

For the Eurosystem, natural reference models are provided by the

central banks of countries that apply the separation approach, for example:

Germany before the euro; the United Kingdom after the creation of the

Financial Services Authority; or Japan. In all these cases the central bank

has a well-developed expertise in the micro and macro-prudential field;

each distinctively plays a role in the macro-prudential field by addressing

threats to the stability of the banking system and analysing the soundness

of the structural features of the system. For their own purposes, these

central banks also have precise and comprehensive information about the

banks in their respective country. This is obtained either from performing

practical supervisory duties, as in the case of the Bank of Japan or the

Bundesbank; or from the national supervisory authority; or through direct

contacts with the banking industry, as in the case of the Bank of England.

The Banking Supervision Committee is in a good position to co-operate

with the Eurosystem in the collection of information. Indeed, the so-called

BCCI Directive has removed the legal obstacles to the transmission of

confidential information from competent supervisory authorities to "central

banks and other bodies with a similar function in their capacity as

monetary authorities". This includes national central banks and the ECB. Of

course, the provision of supervisory information is voluntary and its

development will have to be based on an agreed view of the central banking

requirements the Eurosystem will have in this field.

V. CRISIS MANAGEMENT

21. In normal circumstances central banking and prudential

supervision have an arm's length distance between them. In crisis

situations, however, they need to act closely together, often in co-

operation with other authorities as well. Charles Goodhart and Dirk

Schoenmaker have made here at the London School of Economics a valuable

contribution to analysing the handling of major banking problems in the

history of industrial countries. One of their conclusions is that, in most

instances, central banks have indeed been involved. Banking problems are so

close to monetary stability, payment system integrity and liquidity

management that this finding hardly comes as a surprise. The advent of the

euro will not, by itself, change this state of affairs.

22. When discussing crisis management, it should not be forgotten

that, while central banks have a direct and unique role to play when the

creation of central bank money is involved, this represents just one

category of emergency action. Another category refers to the injection - by

politically liable Finance Ministries - of taxpayers' money into ailing or

insolvent credit institutions. There is also a third, market-based,

category, consisting of the injection of private money by banks or other

market participants. These three typologies of emergency action all require

the involvement of policy-makers, but they must not be mixed up when

evaluating the existing arrangements. Therefore, before discussing the much

debated question of the lender-of-last-resort, let me briefly comment on

the two, probably less controversial cases where central bankers are not

the providers of extra funds.

23. First, the "private money solution". This market-based approach

is clearly the preferable option, not just to save public funds and avoid

imbalances in public finances, but also to reduce the moral hazard problem

generated by public assistance to ailing institutions. Indeed, policy-

makers are increasingly aware that the expectations of a helping hand can

increase financial institutions' risk appetite in the first place. However,

even when a market-based solution is possible, on the grounds of private

interest, private parties may not be able to reach a solution for lack of

information or co-ordination. Public authorities have therefore an active

role to play for the market solution to materialise. The recent rescue

package co-ordinated by the Federal Reserve Bank of New York to prevent the

LTCM hedge fund from collapsing is a good example of public intervention

being used to achieve a private solution.

Acting as a "midwife" in brokering a private sector deal is not the

only example of managing crises without injecting public funds. Banking

supervisors have at their disposal a number of tools to intervene at the

national level to limit losses and prevent insolvency when a bank faces

difficulties. These tools include special audits, business restrictions and

various reorganisation measures.

In the euro area, national supervisors and central banks will

continue to be the key actors in the pursuit of market-based solutions to

crises. The Eurosystem, or the Banking Supervision Committee, would become

naturally involved whenever the relevance of the crisis required it.

24. Second, the "taxpayers' money solution". Taxpayers have been

forced to shoulder banks' losses in the past, when public authorities felt

that otherwise the failure of a large portion of a country's banking system

or of a single significant institution would have disrupted financial

stability and caused negative macroeconomic consequences. In such instances

banks have been taken over by the state, or their bad assets have been

transferred to a separate public entity to attract new private investment

in the sound part of the otherwise failed banks. The US savings & loans

crisis of the 1980s, the banking crises in Scandinavia in the early 1990s

and the current banking crises in Japan and some East-Asian countries are

examples of system-wide insolvency problems that have triggered taxpayers'

support. Crйdit Lyonnais and Banco di Napoli are recent examples of public

support to individual insolvency problems.

The introduction of the euro leaves crisis management actions

involving taxpayers' money practically unaffected. The option of injecting

equity or other funds remains available for the Member States, since these

operations are not forbidden by the Treaty. Nevertheless, the European

Commission will be directly involved in scrutinising and authorising such

actions, since any state aid must be compatible with the Community's

competition legislation. This happened, for example, in the cases of Banco

di Napoli and ‚[pic]Crйdit Lyonnais.

The handling of solvency crises is not within the competence of the

national central banks nor that of the ECB, although national central banks

are likely to be consulted, as they have been in the past.

25. Third, the "central bank money solution". This is the lender-of-

last-resort issue that has brought the Eurosystem under vigorous criticism

by distinguished academics and the IMF's Capital Markets Division of the

Research Department. The criticism has been that the alleged absence of a

clear and transparent mechanism to act in an emergency raises doubts in the

markets about the ability of the Eurosystem to handle crisis situations. It

is said that the uncertainty generated by the present arrangements would

entail new risks, including the possibility of investors requiring an

additional risk premium at times of financial market volatility and,

ultimately, of the credibility of EMU being damaged. Two examples of these

concerns deserve an explicit mention. The IMF "Report on Capital Markets",

September 1998, stated that "it is unclear how a bank crisis would be

handled under the current institutional framework …which is not likely to

be sustainable". Similarly, the first report of the CEPR (Centre for

Economic Policy Research) on monitoring the ECB entitled "The ECB: Safe at

Any Speed?" expressly suggested that the Eurosystem lacks crisis management

capacity and is too rigid to pass the A-Class test to keep the vehicle on

the road at the first steep turn in financial market conditions in Europe.

26. My response to this criticism is threefold. To my mind, the

criticism reflects a notion of lender-of-last-resort operations that is

largely outdated; it underestimates the Eurosystem's capacity to act; and,

finally, it represents too mechanistic a view of how a crisis is, and

should be, managed in practice.

27. The notion of a central bank's lender-of-last-resort function

dates back more than 120 years, to the time of Bagehot. This notion refers

to emergency lending to institutions that, although solvent, suffer a rapid

liquidity outflow due to a sudden collapse in depositors' confidence, i.e.

a classic bank run. A bank could be exposed to depositors' panic even if

solvent because of the limited amount of bank liquidity and an information

asymmetry between the depositors and the bank concerning the quality of

bank's assets that do not have a secondary market value.

Nowadays and in our industrial economies, runs may occur mainly in

textbooks. They have little relevance in reality because, since Bagehot,

many antidotes have been adopted: deposit insurance, the regulation of

capital adequacy and large exposures, improved licensing and supervisory

standards all contribute to the preservation of depositors' confidence and

minimise the threat of a contagion from insolvent to solvent institutions.

A less unlikely case is a rapid outflow of uninsured interbank

liabilities. However, since interbank counterparties are much better

informed than depositors, this event would typically require the market to

have a strong suspicion that the bank is actually insolvent. If such a

suspicion were to be unfounded and not generalised, the width and depth of

today's interbank market is such that other institutions would probably

replace (possibly with the encouragement of the public authorities as

described above) those which withdraw their funds. It should be noted, in

this respect, that the emergence of the single euro money market lowers

banks' liquidity risk, because the number of possible sources of funds is

now considerably larger than in the past.

Given all of these contingencies, the probability that a modern bank

is solvent, but illiquid, and at the same time lacks sufficient collateral

to obtain regular central bank funding, is, in my view, quite small. The

textbook case for emergency liquidity assistance to individual solvent

institutions has, as a matter of fact, been a most rare event in industrial

countries over the past decades.

28. What if this rare event were nevertheless to occur and cause a

systemic threat? The clear answer is that the euro area authorities would

have the necessary capacity to act. This is not only my judgement, but also

that of the Eurosystem, whose decision-making bodies have, as you can

imagine, carefully discussed the matter. I am not saying that we are, or

shall be, infallible; no one can claim such a divine quality. I am saying

that there are neither legal-cum-institutional, nor organisational, nor

intellectual impediments to acting when needed. In stating this, I am aware

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