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BrackenJanuary 29 2018

A ‘twin peaks’ vision for Europe

A two-pronged approach to financial oversight will be vital for the EU after the UK finally leaves, write Dirk Schoenmaker and Nicolas Véron of Brussels-based economic policy think tank Bruegel.
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The organisation of the European Supervisory Authorities (the ESAs) is based on a sectoral approach with one ESA for each sector: the European Banking Authority for banking, the European Insurance and Occupational Pensions Authority (Eiopa) for insurance and pension funds, and the European Securities and Markets Authority (ESMA) for the securities markets. But is this sectoral approach still valid?

Why twin peaks?

Some countries, such as Germany, Sweden and Poland, have adopted the single supervisory model. But there is also a global trend towards a supervisory model known as ‘twin peaks’ – with one supervisor for prudential supervision and another for markets and conduct-of-business supervision – based on positive experiences in Australia and the Netherlands, and more recently the UK, New Zealand and South Africa.

There are several arguments in favour of a twin peaks structure for the EU.

Brexit will create a need for a strong market and conduct-of-business supervisor to build an integrated capital market for the EU27. With the move towards a bail-in of bank bonds, cases of mis-selling of these bonds to retail consumers (who were not fully aware of the bonds’ risk profile) have come to widespread public attention. That requires a strong and proactive conduct-of-business supervisor, separate from the prudential supervisor.

Next, there are links between banks and insurers within financial conglomerates. Integrated prudential supervision would make it possible to supervise these conglomerates on a joined-up basis.

The prudential peak

Close interaction between banking and insurance supervision is needed for the effective supervision of financial conglomerates that combine banking and insurance. Research at Bruegel shows that 31% of banks and 36% of insurers belong to a financial conglomerate.

Why is such close interaction necessary?

During the financial crisis, several financial institutions experienced solvency problems. These could emerge in any part of the institution. It appeared that several financial conglomerates made use of double counting and thus had insufficient capital.

Double counting (also known as double gearing) is the practice whereby the same capital base at the holding level of a financial conglomerate is counted as regulatory capital for both the banking activities and the insurance activities.

But how can close co-operation between banking and insurance supervision be implemented in order to enable a joined-up view of the capital adequacy of financial conglomerates?

To start with, we suggest  closer co-operation between the European Central Bank, as the central supervisor of European banks, and Eiopa. This could start with a joint approach for the approval and monitoring of internal risk models, run by large financial institutions.

A market and conduct-of-business peak

London is the wholesale markets hub of Europe, providing corporate and investment banking services to the EU and beyond. Assuming the UK leaves the EU and its single market for financial services, UK-based financial firms would lose their passports to do direct business with EU27 clients, and Brexit would thus lead to a partial migration of wholesale market activities from London to the EU27.

A possible fragmentation of trading activity across several EU27 countries might result in increased costs and reduced access to capital for companies. A related risk is that of a regulatory race to the bottom among the EU27, leading to misconduct, loss of market integrity and possibly financial instability.

Building a vibrant market

On the upside, Brexit is also an opportunity to build more integrated and vibrant capital markets in the EU27 that would better serve all member economies, to improve risk sharing to withstand local shocks, and to make the EU27 an attractive place to do global financial business.

To prevent intra-EU financial market fragmentation with higher financing costs, we argue that a single set of rules (or single rulebook) is necessary but not sufficient. To achieve cross-border integration, consistent oversight of wholesale markets and investment banks can be achieved through the build-up of ESMA.

The twin peaks model holds the promise of a financial system that is both safer, thanks to joined-up prudential oversight, and fairer, thanks to greater protection for savers and investors, and more generally of users of financial services. It is desirable that the EU should commit itself explicitly to that vision.

Dirk Schoenmaker is a senior fellow at Brussels-based economic policy think tank Bruegel and professor of banking and finance at the Rotterdam School of Management, Erasmus University Rotterdam.

Nicolas Véron co-founded Bruegel, where he is a senior fellow, and is also a senior fellow at the Peterson Institute for International Economics in Washington, DC.

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