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2005-01-13 12:01:00
Consulate Frankfurt
Cable title:  

EU Financial Supervisory Framework: Standing on

Tags:   ECON  EFIN  EUN 
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E.O. 12958: N/A
SUBJECT: EU Financial Supervisory Framework: Standing on
the Edge of the Future

This cable is sensitive but unclassified. Not/not for
Internet distribution.





E.O. 12958: N/A
SUBJECT: EU Financial Supervisory Framework: Standing on
the Edge of the Future

This cable is sensitive but unclassified. Not/not for
Internet distribution.

1. (SBU) Summary: The EU-wide financial supervisory
framework created and made operational in less than three
years is about to come into its own. The three new
supervisory committees, the Committee of European Securities
Regulators (CESR), the Committee of European Banking
Supervisors (CEBS) and the Committee of European Insurance
and Occupational Insurance Supervisors (CEIOPS) will play a
central role in implementing recent legislation that has
basically retooled the EU financial services framework.
CESR, the oldest of the three, is leading the way. In one
paper CESR laid out its implementation activities and, in a
separate provocative think piece, asks the question, "What
if intensifying coordination among national supervisors is
not effective?" One possible answer: give "the Network" of
national supervisors legal and supervisory powers to deal
with trans-EU issues. This is like standing on the edge of
the future.

2. (SBU) The European financial industry has cut through
practical, legal and political niceties by calling for the
creation of a lead regulator. While this has attracted push
back from CEBS and the European Central Bank (ECB), the
recently approved Capital Adequacy Directive (CAD III)
incorporates the concept of "coordinating supervisor," a
possible step along the way to a lead supervisor. Ensuring
political accountability will be essential before the EU
progresses to a unified supervisor. The idea, however, is
irresistible to some. Deutsche Bank, for example, welcomes
the current trend and is dusting off its old piece: A
European Financial Supervisory Authority - A Matter of When,
Not If." End Summary

Committee Creation: Back Waters No Longer

3. (SBU) In a short three and a half years CESR, CEBS, and
CEIOPS, each composed of all relevant member state
supervisors, have been created and become operational. CESR
was the first. Created in June 2001, CESR was conceived
upon a recommendation by a group of wise men led by

Alexander Lamfalussy (the Lamfalussy Group). Lamfalussy,
who headed up the precursor to the ECB, reasoned that
knitting European financial markets closer together would
require a flexible regulatory process to respond to dynamic
markets and close cooperation among national supervisors to
ensure uniform implementation on a pan-EU scale. Finance
Ministers replicated this basic approach in agreeing at the
end of 2002 to create CEBS and CEIOPS. Like CESR, CEBS and
CEIOPS were matched by regulatory committees composed of
Finance Ministry representatives. The Financial Services
Committee, which reports to ECOFIN, takes an overview and
sets strategic directions. Details of CEBS and CEIOPS took
a while to resolve. Both opened their doors for business in
the fall of 2004.

4. (SBU) Granted, each of these committees had precursors.
What is different is that they all have a formal role in
providing advice to the Commission on Financial Legislation
and Regulation, and in ensuring consistent implementation of
EU legislation in member states. The European Council's
Stockholm Resolution that gave birth to CESR states that
"national regulators and CESR should also play an important
role in the transposition process by securing more effective
cooperation between supervisory authorities carrying out
peer reviews and promoting best practices, so as to ensure
more consistent and timely implementation of community
legislation in member states." Precursor supervisory
committees were largely voluntary, with no space or only a
small space in the formal EU regulatory framework. All this
is about to change.

Long "To Do List:" Implementation Begins

5. (SBU) Implementation of legislation now has become the
focal point for EU financial services activities. The
Financial Services Action Plan has retooled basic elements
of EU securities legislation and now will have to be
implemented. CESR is helping with the implementation of the
Market Abuse and Prospectus Directives, the Regulation on
International Accounting Standards, and amendments to the
Directive on Undertakings in Collective Investments in
Transferable Securities (UCITS). In the wings is
implementation for the more recently adopted Directives on
Markets in Financial Instruments (MiFID) and on

6. (SBU) Even though their legislative list is not as long
as CESR's, the other two committees will have responsibility
for implementing major new directives. CEBS is beginning
its implementation work for the Capital Adequacy Directive
(CAD III) that will fundamentally change risk capital
assessments for financial institutions. CAD III is being
finalized by the Council and is pending in the European
Parliament. CEBS is designing a common reporting framework
for capital requirements and the solvency ratio, has
published draft guidelines on the supervisory review
process, and introduced "prudential filters" aimed at
neutralizing the effects of new accounting standards on
regulatory capital. CEIOPS is gearing up to provide advice
for the Commission's major rewrite of capital adequacy rules
for insurance firms (Solvency II). The Commission is likely
to make a proposal in 2006 or early 2007.

Implementation: Where the Rubber Hits the Road
-------------- --

7. (SBU) The logic of an integrated financial market is that
all players to follow the same rules. This can help ensure
healthy competition and a relatively efficient allocation of
capital. In highly competitive and regulated financial
markets, this also implies that the rules be enforced in the
same way. Lax enforcement might be considered to gain a
competitive advantage, like an "off-shore" financial center.
Such an approach would put a quick end to "mutual
recognition" of one member state's supervisory surveillance
by another, the cornerstone of the internal market.

8. (SBU) CESR has done the most public thinking on this
topic. In a paper released at the end of October, CESR used
three groups to categorize its implementation functions (so-
called "Level 3" functions, Level 1 being the directives,
Level 2 being the implementing measures regulations or
follow up directives, and Level 3 being the nitty gritty of
issuing rule books and supervisory guidance explaining how
firms are expected to comply with the directives and
regulations). These are: (1) coordinated implementation of
EU law; (2) regulatory convergence; and (3) supervisory

9. (SBU) Coordinated implementation involves the legal
transposition of directives into national laws and their day-
to-day application. CESR has established a Review Panel to
carry out peer reviews using correspondence tables detailing
how directives are being implemented in each member state.
CESR members are to provide a self-assessment on their
implementation. The Review Panel will offer an opinion and
suggestions for common approaches to implementation. The
correspondence tables, assessments and opinions would be
made public. To ensure consistent enforcement in all member
states CESR has recommended that CESR members be granted
equivalent rulemaking and enforcement powers by their
respective national authorities.

10. (SBU) Regulatory convergence is defined by CESR as
creating common approaches. Each supervisor takes decisions
that create a body of jurisprudence in its jurisdiction.
Acting together, CESR notes that its members can decide on
common approaches that could be memorialized in meeting
minutes, indicative guidance, or regulatory recommendations.
These would not have the status of EU law, but be
implemented on a "voluntary basis" by all supervisors.
Areas that are subject to such regulatory convergence need
not be covered by EU law, in CESR's opinion. CESR's recent
standards on clearing and settlement developed together with
the ECB are an example. CESR also has worked on guidelines
on implementation of the Market Abuse and Prospectuses
Directive and has begun work on guidance for certain mutual
fund issues.

11. (SBU) Supervisory convergence relates to how supervisors
approach the practical operation of rules and legislation.
This means strengthened cooperation in practical ways. One
is to pull together provisions in directives that mandate
mutual recognition and cooperation into one consolidated
text. CESR thinks this would serve as the basis to handle
all situations requiring cooperation among supervisors. In
another practical implementation measure, CESR plans to set
up a "mediation mechanism by its peers" to provide an
acceptable solution where "home" and "host" supervisors
disagree. Joint supervisory visits and investigations by
CESR members and compiling "EU jurisprudence" in a database
of national decisions are other CESR initiatives to
strengthen cooperation and, thereby, supervisory

12. (SBU) CESR develops these ideas further in another,
provocative thought piece entitled "Preliminary Progress
Report: Which Supervisory Tools for the EU Securities
Markets?" This paper, referred to as the "Himalayas
Report," given its lofty perspectives, elaborates the three
categories of implementation functions cited above. CESR
sets the tone by proclaiming its "serious objective" is to
"enhance its role as the `supervisor of national
supervisors.'" In this regard CESR suggests that its
network of supervisors might consider more systematic peer
reviews on member state implementation with "mission teams"
making assessments and CESR publishing results where
implementation is inadequate.

13. (SBU) A more robust mediation mechanism could require
mediation where there are disagreements or lack of
cooperation among supervisors.

14. (SBU) In the Himalaya paper CESR ventures onto the area
of supervision of trans-European activities, such as
investment firms, raising questions as to whether
cooperation can be efficiently executed by many separate
authorities, particularly in a financial crisis situation.
Other areas demanding a possible pan-EU approach include
public offerings, standard mutual funds, the application of
accounting standards for listed companies, the regulation of
credit rating agencies, and trans-European market
infrastructures (exchanges and clearing and settlement
systems). CESR muses whether its network should take single
EU decisions on such matters. Backing up a bit from the
edge, CESR reflects that a "trans-national" option is risky
and should not be attempted unless the present system cannot
provide proper solutions to supervisory convergence.
Different local laws, regulatory powers and jurisdictions,
and political accountability at the EU level present real
obstacles to a pan-EU solution.

Industry: Leading the Way to the Lead Supervisor?
-------------- --------------

15. (SBU) The European Financial Services Roundtable (EFSR)
cuts through the worrisome details and recommends that the
trans-national option be exercised now, calling for a "lead
supervisor for prudential supervision of cross-border
financial institutions." The EFSR proposes that the lead
supervisor would be the single point of contact for the
financial institution within the prudential supervisory
framework, receiving all reports, validating and authorizing
internal models, approving capital and liquidity allocation,
and approving cross-border set up of specific functions.
Local supervisors would be involved in supervision based on
delegated authority from the lead supervisor. The lead and
local supervisors would set up "colleges" to advise the lead
supervisor, and the relevant supervisory committees, such as
CEBS, could mediate any disagreements. In the Roundtable's
opinion, the lead supervisory regime will not only improve
the quality of supervision at an acceptable cost, but also
be an important catalyst for convergence of supervision
towards best practices.

Dutch Nudge: Just Thinking Out Loud

16. (SBU) The Dutch Presidency gave the notion of lead
supervision a bit of a nudge. In a November seminar on
"Enhancing Supervisory Convergence," Dutch Finance Minister
Zalm raised questions as to whether present coordinating
mechanisms were effective, delivering as promised, and
efficient. He opined that different supervisory practices
in different member states can "cause market distortions."
Good supervisory arrangements, in his judgment, should
stimulate rather than hamper the integration of European
financial markets. Noting that national supervisors can
only operate under national mandates, he mused whether there
should be "thinking about more European solutions for
supervision of truly European financial groups. Although we
should not try to cause a revolution here, we are likely to
see an evolution towards more European supervisory

CAD III Coordinating Supervisor: Planting the Seed
-------------- --------------

17. (SBU) The proposed CAD III contains a potential seed for
a lead supervisor. According to the Commission's proposal
draft, the coordinating supervisor is the member state
authority that has responsibility for supervision of a
financial institution on a consolidated basis. This
supervisor needs to work with other relevant authorities of
jurisdictions in which the institution is present to
validate technical aspects of CAD III. Such aspects include
the risk-weighted exposure amounts using the Internal
Ratings Based Approach, the estimates of loss given
defaults, and the use of Advanced Measurement Approaches
based on internal risk measurement systems. However, if no
agreement is reached within six months among the
coordinating and other competent supervisors, the
coordinating supervisor can make its own determination.
That determination will apply to the entire institution
throughout the EU.

18. (SBU) This approach encountered opposition. A member of
the Bundesbank board, for example, was adamantly opposed,
citing national responsibility for subsidiaries of parent
institutions located in other member states. The ECB,
however, did not resist. It observed that there is a large
gap between what the lead supervisor championed by industry
and the coordinating supervisor envisioned in CAD III.
Nonetheless, the challenge is apparent.

19. (SBU) The Chairman of CEBS, Jose Maria Roldan, has taken
up that challenge. He does not share EFSR's view,
explaining that rather than having a "one-stop-shop," a
"more pragmatic approach is needed" within the present
institutional framework. Indeed, CEBS staff believe that
their main objective is to show that more intensive
cooperation is the solution. German Finance Ministry
officials, however, believe the coordinating supervisor
concept in CAD III as a step toward a single EU supervisor.
A Dutch supervisor put it another way: if a coordinating
supervisor approach cannot be made to be effective, then the
option of going straight to an EU supervisory authority will
gain currency.

Got the Move, But Not the Political Touch

20. (SBU) In the end, politics hold the key to any trans-EU
solutions. The Chairman of the European Parliament's
Economic and Monetary Affairs Committee livened up CESR's
December gala by lamented the "democratic deficit" of some
of CESR's ideas. Who is in charge of CESR? CESR is
sensitive to this issue. In its Himalaya paper CESR noted
that it is "firmly determined to develop its political and
democratic accountability links vis--vis the Finance
Services Committee, the European Commission and the European

21. (SBU) The Inter-Institutional Monitoring Group (IIMG)
also is cautious about the politics and the EU
"institutional balance," meaning power sharing between the
Commission, Parliament and Member States in the Council.
The IIMG, composed of representatives from all three EU
institutions, has endorsed coordinated implementation,
supervisory convergence and CESR's proposed mediation
mechanism. On regulatory convergence, however, it was "more
reserved." The IIMG worried that the "multiplication of non-
binding rules at Level 3 should not lead to a gray area
where legal certainty is absent and political accountability
is unclear."

22. (SBU) The draft Constitutional Treaty addressed some of
the political questions. Article 35 would give the European
Parliament the right to block the entry into force of
regulations delegated to the Commission in directives, power
that the Parliament now has only by the grace of a political
understanding with the Council. The Constitution also
states "where uniform conditions for implementing binding
Union acts are needed, those acts may confer implementing
powers on the Commission." There is no mention of
Parliament's role or of the accountability of supervisory
authorities, so some questions still appear to be open.


23. (SBU) If process defines outcomes, the implementation
phase of EU-wide financial service legislation will be an
interesting process. Getting the politics right is
essential. The power of the idea of regulatory convergence
would seem irresistible for those that wish the EU to be
truly an integrated financial market. The questions raised
by CESR and Dutch Finance Minister Zalm on the limits of
national supervisors coordinating to oversee pan-EU
activities are unavoidable. Officials at Deutsche Bank
welcome the trend of the current thinking. They are dusting
off their old think piece: "European Financial Service
Authority - A Matter of When, Not If."

24. (U) This report coordinated with Embassies Berlin and
The Hague and USEU Brussels.

25. (U) POC: James Wallar, Treasury Representative, e-mail; tel. 49-(69)-7535-2431, fax 49-(69)-