Now’s the time to break down barriers

In recent years, only a few large M&A deals have taken place: Santander Hispano’s takeover of Abbey springs to mind, as does the recently announced acquisition of HypoVereinsBank by UniCredit.

I am glad it is not just the financial services industry that is pleading for cross-border M&A in the financial sector. Consumers and business organisations argue that the entry of foreign banks would lower prices and improve the quality of financial products in their country. The appetite for consolidation in the financial services industry, however, is merely the result of competition to increase economies of scale, for example, in the fields of information technology, asset management and marketing.

Obstacles to M&A

Large financial groups operate on a global basis, spreading their business – with hardly any exception – over the three main economic regions of the world: the Americas, Asia and Europe. Strikingly, however, some of the large, EU-based groups tend to be bigger outside the EU than within it. Talking to the industry, I believe this is because of obstacles to cross-border M&A.

Although regulations are based increasingly on a global or regional footing as well as an international one, the supervisory authorities that enforce these regulations are still rooted nationally, with some elements of international or regional coordination. In the long run, the current arrangements for the EU need to be updated in order to fully realise the single market.

As a result of last year’s informal Ecofin Council meeting in Scheveningen, the European Commission is investigating possible barriers to M&A in the financial sector. These include, for example, legal, tax, economic and attitudinal barriers and the implications of supervisory rules and requirements. In particular, a rule concerning the supervisory approval process for the acquisition of a ‘qualifying shareholding’ in a credit institution (article 16 of the so-called Banking Directive) has been getting a lot of attention lately. My feeling is that this approval process – specifically allowing supervisors to reject M&A for prudential reasons, where ‘prudential reasons’ are open to interpretation – needs to be developed more clearly to prevent some supervisors from European member states protecting their markets from foreign entry. A more strict formulation of this M&A criterion would prevent unsound obstacles to cross-border M&A within the EU.

Mutual recognition

The current system of prudential supervision in the EU is based on the principle of home country control, combined with minimum standards and mutual recognition. This means a financial institution is authorised and supervised in its home country. By making use of branches or by providing cross-border services (over the internet, for instance) a financial institution can expand throughout the EU without additional supervision. The home supervisor also acts as the consolidated supervisor in that he or she is able to make a group-wide assessment of the risk profile.

In practice, however, financial institutions also operate through subsidiaries (separate legal entities) in other countries for a variety of reasons, such as taxation and limited liability. These subsidiaries are licensed and supervised separately by the host country authorities. As a result, internationally active groups are confronted with a multitude of local supervisors.

However, the scope for control by host countries is limited because the key decisions are often taken by the parent company in the home country. Moreover, the financial health of the subsidiary is linked closely to the wellbeing of the financial group as a whole. Therefore, effective control is primarily in the hands of the consolidated supervisor in the home country. This shows that the current supervisory system in the EU is not very efficient and places a heavy financial burden on pan-European financial institutions.

A system involving home country supervision and no duplication by host countries with different requirements and reporting formats would reduce the burden on financial institutions within the EU. It would also foster cross-border expansion and put European groups on a par with their counterparts from the US.

Medium-term solutions

A medium-term answer to cross-border expansion within the EU has been found in the extension of the mandate and responsibilities of the home supervisor. The Directive on Financial Conglomerates introduces the single co-ordinator responsible for group-wide supervision of financial conglomerates. Moreover, the mandate of consolidated supervision has been extended under the Capital Requirements Directive (CRD), which will give legal effect in the EU to the Basel II accord. The consolidated supervisor will, in full consultation with host supervisors, decide on the application of internal models for a banking group within six months. At the request of the European Commission and member states, the main role of the Committee of European Banking Supervisors is, for the moment, to contribute to the consistent implementation of the CRD and to promote the convergence of supervisory practices within the EU. Efficient solutions are crucial in order to achieve a truly single market for banks.

Shift of focus

Considering the single co-ordinator concept for financial conglomerates and the consolidated supervisor concept for banks, it is striking that the primary focus for insurance supervision is still the separate legal entities, while only limited attention is given to group-wide supervision. As discussions on the new, risk-based EU directive for insurance supervision (Solvency II) are intensifying, I would advocate an extension of the concept of consolidated supervision to the supervision of insurance groups; this would mean an alignment of supervision with rules for other financial institutions.

However, we need to go further if we want to improve future efficiency. Banking groups still face a substantial supervisory burden under the new CRD and are lobbying hard for a so-called lead supervisor approach. According to the supporters of the lead supervisor concept, the lead supervisor should be the single point of contact for the financial institution within the prudential supervisory framework for all reporting schemes. In general, this results in a shift of responsibility from the host supervisor to the home supervisor.

I clearly see the merits of this concept. However, it will take some time to solve a number of outstanding issues before we can actually consider this model. For example, how does the lead supervisor incorporate potential cross-border spill-over effects in his decision-making?

I think that, in order to ensure that the interests of all depositors and host countries are taken into account, a European mandate ought to be created. This could be put in practice by establishing a European system of financial supervisors, created by the national supervisors in tandem with a small, centralised body. Key supervisory decisions could be taken, and policies formed, at the centre, in the same way that the European System of Central Banks takes decisions on monetary policy. In this way, host countries’ authorities would be fully involved and the interests of their depositors taken fully into account. The day-to-day supervision would, however, be carried out by the lead supervisor in the home country, although he or she could make use of the network of local supervisors to perform on-site inspections.

Pan-EU approach

Taking it a step further, one could consider a single pan-European supervisor. The drawback of this is that the distance between the supervisor and the supervised institutions may be too large – physically and in terms of familiarity with local circumstances. But a European system of financial supervisors could combine the advantages of a European framework with the expertise of local supervisory bodies.

In my opinion, further consolidation of the EU financial sector would be beneficial to consumers and the industry. Although the wholesale market is fairly integrated, the retail side still remains fragmented. For this reason, the European Commission, member states and supervisors are trying to create a fully integrated financial market in the EU. In this respect, it is important that further consolidation is not blocked by unfair obstacles. Furthermore, it is of the utmost importance that the directive is implemented in a consistent manner in the EU. Supervisors play a key role in this respect.

In my opinion, the current supervisory arrangements in Europe can still be effective in the medium term. For the longer term, I like to think in scenarios. If existing obstacles to cross-border consolidation are removed, and more financial groups expand their activities across borders, I can see a scenario with a European structure for supervision to deal with cross-border issues.

Gerrit Zalm is the minister of finance of the Netherlands