From Fragmentation to Financial Integration in Europe
Chapter

Chapter 2. Institutional Setup for the Single Market and Economic and Monetary Union

Author(s):
Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Author(s)
Jianping Zhou

The 1957 Treaty of Rome established the European Economic Community, ultimately putting a much wider group of European countries on a path toward the European Union (EU), where goods, services, people, and capital could move freely. This chapter presents a brief background history of the developments of European institutions underpinning the single market and the framework as it was on the eve of the global financial crisis.

The Development of European Institutions, 1957–2007

The European Parliament, the Council of the EU (the Council), and the European Commission (the Commission) (Figure 2.1) are the three key political institutions that hold executive and legislative power to implement policies related to the single market. The Council sets the EU’s overall policy direction and reform agenda. All three institutions are involved in the EU legislation process: the Parliament represents the EU’s citizens and is now directly elected by them; the Council represents the governments of individual member states; and the Commission represents the interests of the Union as a whole.

Figure 2.1An Overview of the European Union Institutions1

Source: EU-Lex.

1 According to the Treaty on the Functioning of the European Union.

The European Parliament is one of the EU’s main law-making institutions, along with the Council. Its main roles include debating and passing EU budget and other laws (together with the Council) and ensuring that other EU institutions, particularly the Commission, are working democratically. Until 1979, the members of the Parliament were appointed by each of the Member States’ national parliaments, but since then they have been directly elected.1 Over the years, the powers of the European Parliament had been expanded and strengthened.2 In particular, the Maastricht Treaty (1992) introduced the co-decision procedure in certain areas of legislation and extended the cooperation procedure to others. It gave Parliament the power of final approval over the membership of the Commission, which was an important step forward in establishing Parliament’s political control over the European executive. The 2009 Lisbon Treaty brought together various policy areas (including the budget) under the co-decision procedure, further increasing the power of the Parliament.

The Council (informally known as the EU Council) is where national ministers from individual EU member states meet to adopt EU laws and coordinate policies.3 More specifically, it passes EU laws proposed by the Commission (together with the Parliament), coordinates the broad economic policies of the EU member countries, and signs agreements between the EU and other non-EU countries. The Council brings together the heads of state of individual EU countries, with its presidency rotating among the 28 member states every six months. Decisions of the Council are taken by qualified majority as a general rule. Two types of majorities are needed to support the passage of a proposed law: a majority of countries (at least 15) and a majority of the total EU population (the countries in favor must represent at least 65 percent of the EU population).4

The Commission is the executive arm of the Union. Although it is composed of one commissioner from each member state, it represents and upholds the interests of the Union as a whole and is designed to be independent of national interests. The Commission is responsible for drafting all laws of the EU. It also manages the day-to-day business of implementing EU policies and spending EU funds. The Commission president is nominated by the Council. The appointment of all commissioners, including the president, is subject to the approval of the Parliament. As “guardian of the Treaties,” the Commission monitors the member states’ compliance with EU laws (Box 2.1).

While the fundamental decision-making procedure has not changed since the creation of the EU, the relative decision-making powers of the three institutions has evolved. For example, the Treaty of Amsterdam (1997) extended the co-decision procedure to 32 legal bases and reformed the procedure, putting Parliament as co-legislator on an equal footing with the Council. The Nice Treaty (2000) extended the co-decision procedure further to 37 legal bases.

The journey toward a single financial market has proven to be much harder than for a single market for goods. While the Treaty of Rome in 1957 set out to be a road map and created institutions to create a common market where goods, services, people, and capital could move freely, capital and banking markets were highly fragmented through the late 1980s.

In response, the European Economic Community members signed the Single European Act in Luxembourg in 1986 that resulted in significant institutional reforms. The Act represented the first major revision of the Treaty of Rome. It set the objective of establishing a single market by December 31, 1992. To achieve this objective, a more collaborative legislative process known as the Cooperation Procedure or the Article 252 Procedure was adopted, and qualified majority voting was extended to new areas. These reforms granted the Parliament formal legislative power. Under the procedure, the Council could, with support of the Parliament, adopt the Commission’s legislative proposals by a qualified majority. It could also overrule a rejection by the Parliament by adopting a proposal unanimously.

Box 2.1Timeline of European Financial Integration Policies

1957Treaty of Rome
1983EC White Paper on Financial Integration (COM (83)207)
1986Single European Act
1992Maastricht Treaty on the European Union
1999Establishment of the Monetary Union
2002Introduction of the single currency, euro
2010Establishment of the European Micro- and Macro-prudential Supervisory Authorities
Banking sector integration
1973Directive (73/183/EEC) on the freedom of Establishment for Credit Institutions
1977First Banking Directive (77/780/EEC)
1989Second Banking Directive (89/646/EEC): Single Passport for Banks
2012EC proposal for a regulation for a creation of a Single Supervision Mechanism (SSM)
2013EC proposal for a Directive for establishing a framework for the recovery and resolution of credit institutions and investment firms (COM (2012)280/3)
Financial Services
1999Financial Services Action Plan (FSAP)
2005The completion of an integrated market for financial services
2005EC White Paper on Financial Service Policy 2005-10 (COM (2005)629)
Insurance Sector integration
1964Directive (64/225/EEC) on the Freedom of Establishment in Reinsurance
1976Directive (76/580/EEC) on the Freedom of Establishment in Direct Insurance
1979Coordinating Directive (79/267/EEC) on Direct Life Insurance
CapitalMarket integration
1979Directive (79/279/EEC) Coordinating the Conditions for the Admission of Securities to Official Stock Exchanges
1980Directive (80/390/EEC) Coordinating the Requirements for the Admission of Securities to Official Stick Exchange
1988Directive (88/361/EEC) on the Free Movement of Capital

The eventual integration of banking, money, and capital markets took place after the introduction of the Maastricht Treaty in 1992 and the introduction of a single currency in 1999. The debate on an economic and monetary union (EMU) was fully re-launched at the Hannover Summit in June 1988. The 1989 report by the Delors Committee set out a plan to introduce EMU in three stages, with the creation of a set of new EU institutions that further underpinned the single market:5

  • The European Monetary Institute was established in 1994 as the forerunner of the European Central Bank (ECB), with the task of strengthening monetary cooperation between the member states and their national banks (the second stage of EMU).

  • The ECB replaced the European Monetary Institute on June 1, 1998, under the Treaty of Maastricht and began to exercise its full powers with the introduction of the single currency, the euro, on January 1, 1999 (the third stage of EMU) for those members of the EU that met specified “convergence criteria” and that did have an “opt-out” waiver. It sets and implements the monetary policy for the euro area and safeguards price stability in the area.

  • The ECB works with the central banks of all EU countries; together they form the European System of Central Banks. The ECB manages the foreign reserves of the euro area and ensures the smooth operation of the financial market infrastructure under the TARGET2 payments system and the technical platform for settlement of securities in Europe (TARGET2 Securities).

Over the years, efforts were made to achieve an integrated market for financial services within the national-based EU supervisory framework. Following the 2000 Lamfalussy Report, a four-level EU regulatory process (the Lamfalussy process) was set up to speed up the adoption of EU financial service directives (see Figure 2.1). It provided a framework and mechanism for timely decision making, based on the technical expertise of the “level 3 committees” (the Committee on European Banking Supervisors, the Committee of European Securities Regulators, and the Committee of European Insurance and Occupational Pensions Supervisors), open consultation, and political accountability. The Lamfalussy process aimed to foster the convergence of national supervisory practices, reach agreement on interpretations and applications of EU directives with non-binding guidelines, and foster greater trust among national supervisors. However, largely due to the lack of binding legal powers, the level 3 committees were unable to fulfill these tasks.6 For example, no agreement was reached with regard to a common supervisory reporting framework, common standards for clearing and settlements, or unified registration and supervision of credit rating agencies at the EU level.

Financial Stability Framework on the Eve of the Global Financial Crisis

Despite the rapid financial integration prior to the 2008 global financial crisis, financial stability arrangements in Europe were (and remain) strongly based on national financial stability frameworks.7 To monitor cross-border financial institutions and cross-border risks, arrangements were put into place to govern cooperation, information exchange, and a specific home-host division of labor between the national supervisors in line with the 1983 agreement known as the Basel Concordat. Home countries are responsible for regulating and supervising their banks’ foreign branches and performing consolidated supervision of cross-border banking groups; the supervision of their foreign subsidiaries, however, is the responsibility of the banks’ host countries. National supervisory powers are constrained by the “single European passport” under which banks licensed to operate in one European country automatically can operate in any other European country. Also, the effectiveness of the cross-border supervision under this arrangement has been undermined by the lack of an effective bank resolution framework, both at the national and at the EU level. The lack of ex ante, as well as ex post, burden-sharing arrangements among EU countries hindered cross-border resolution as banks failed during the crisis, and it remains one of the key policy challenges today.

At the onset of the 2008 crisis, the regulatory framework in Europe lacked cohesiveness. EU members maintained considerable flexibility in the interpretation and enforcement of common EU directives, leading to wide divergences in national regulations. This lack of harmonization at the EU level reflected mainly a well-identified problem with the EU’s four-level regulatory approach under the so-called Lamfalussy process (Figure 2.2): EU directives (levels 1 and 2) have often left member states with a substantial range of options; this made it difficult for level 3 committees to compare regulatory practices, conduct peer reviews, and enforce national compliance of EU common directives (level 4) with the EU legal framework. The resources available to the level 3 committees also severely limited their capacity to act and affected their performances.

Figure 2.2The Four-Level Regulatory Approach under the Lamfalussy Process

The lack of a harmonized set of core regulatory rules hampered the efficient functioning of the single market. Different national rules and regulations resulted in competitive distortions and encouraged regulatory arbitrage. In particular, for cross-border financial groups such regulatory differences went against efficient group approaches toward risk management and capital allocation, and made the resolution of cross-border financial institutions even more difficult.8 According to the De Larosiere report, “the European Institutions and the level 3 committees should equip the EU financial sector with a set of consistent core rules. Future legislations should be based, whenever possible, on regulations (which are of direct application). When directive are used, the co-legislator should strive to achieve maximum harmonization of the core issues.”

The increasingly integrated financial market in the EU also posed a great challenge for financial supervision that relied on close collaboration between home and host country supervisors. Integration implies contagion risks, and a level playing field would be difficult to ensure when rules and supervisory practices differ substantially at the national level. Supervision in Europe was (and remains) largely based on national, home state supervision but with a more complex home-host division of supervisory responsibilities for cross-border financial institutions. While the subsidiaries of foreign firms are regulated by the host countries, the branches are regulated by the home country of the foreign firms, but EU law provides various safeguards for the host country to, for example, protect its depositors. In the area of investment services, host countries retain significant control over the foreign branches, including the rights to examine branch agreements, control branch liquidity, and access relevant information. This has resulted multiple reporting lines and complex mechanisms of home-host cooperation between home and host supervisors.

The home-host collaboration was largely ineffective within the EU institutional setting. The EU law did not offer host supervisors sufficient means to challenge the home country supervision of a group. Host supervisors also lacked incentives to contribute to the resolution of a distressed cross-border institution when it involved sharing a substantial financial burden. A binding mediation mechanism arbitrating between home and host supervisors was lacking. When a national supervisor failed to act promptly, there was no mechanism in place at the EU level allowing for a timely collaborative action.9

The crisis also revealed the lack of consistent crisis management and bank resolution tools across the single market. Due to the lack of crisis management framework at the EU level, the resolution of a distressed cross-border financial institution requires intensive coordination and cooperation of national resolution authorities. However, difficulties arose, not only because of the lack of burden-sharing arrangements but also because of different crisis management and resolution tools (and the lack of them), company and insolvency laws, creditor rankings, and depositor protection. These differences presented significant obstacles to a timely resolution and/or an orderly liquidation of cross-border financial institutions.

The organization of deposit guarantee schemes (DGSs) in the EU member states prior to the crisis has proven to be another major weakness in the EU banking regulatory framework that remains to be addressed. DGS is an important element of a financial safety net that helps prevent bank runs and cement confidence in the financial system. The significant variations in terms of DGS coverage and funding across EU member states were evidently inconsistent with the objective of a well-functioning single market, as the banks of the EU countries with the more protective regimes and stronger government backstops are more likely to attract deposits, at possibly lower rates. The De Larosiere Report supports harmonized and pre-funded DGSs in the EU countries.10 However, the idea of a pooled EU DGS fund did not gain wide support, even from the De Larosiere Group.

Finally, but not least importantly, there was a lack of adequate macroprudential supervision at both the EU and national levels at the onset of the crisis. The EU lacked institutions charged with the tasks to systematically and effectively identify and monitor systemic risks and take policy actions when necessary; this was a weakness revealed in the supervisory frameworks of many countries around the world at that time. When macroprudential risks (such as those associated with rising and unsustainable macroeconomic imbalances) were spotted, no EU institution, including the ECB, had the explicit and formal financial stability mandate to take timely policy actions. Such mandate would be necessary for accessing all relevant information from national supervisors.

De Larosiere Report and a European System of Financial Supervision (2009–2011)

In response to the crisis, a European System of Financial Supervision was introduced after publication of the Commission’s 2009 Larosiere Report. Three European Supervisory Authorities were created in 2010, replacing the existing Committees of Supervisors: a European Banking Authority replaced the former Committee of European Banking Supervisors; a European Insurance and Occupational Pensions Authority succeeded the Committee of European Insurance and Occupational Pensions Supervisors; and a European Securities and Markets Authority succeeded the Committee of European Securities Regulators. The new EU financial supervisory architecture also included the macroprudential dimension with the establishment of a European Systemic Risk Board.

The performance of these new EU institutions will be assessed in detail in this book.

References

    AcharyaViral2009Some Steps in the Right Direction; A Critical Assessment of the de Larosiere Report” VOX March4. http://www.voxeu.org/article/critical-assessment-de-larosiere-report.

    European Central Bank2012Financial Integration in EuropeFrankfurtApril.

    European Commission2004The Application of the Lamfalussy Process to EU Securities Markets LegislationCommission Staff Working Document.

    High-Level Group on Financial Supervision in the EU chaired by Jacques de Larosière2009ReportBrusselsFebruary25http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf.

    DecressinJorgHamidFaruqee and WimFonteyneeds.2007Integrating Europe’s Financial Markets (Washington: International Monetary Fund).

The first direct elections of members of the European Parliament took place in 1979, in 9 member states with a turnout of 63 percent. Currently the Parliament consists of 785 members from 27 member states, a result of a total of 5 waves of enlargement. It works with 23 official languages, representing the interests of the EU citizens.

For example, the first extension of Parliament’s budgetary powers, under the Treaty of Luxembourg (1970), extended Parliament’s budgetary powers, while a second treaty in 1975 on the same subject further strengthened these powers.

The Council of the EU is different from the European Council, which sets the EU’s general policy direction and priorities but has no powers to pass laws. The European Council was established informally in 1974 as a forum for discussion between EU leaders, but has rapidly become the most influential EU institution that sets the political and economic agenda for the Union. Decisions of the European Council are generally based on consensus, unless the treaties provide otherwise.

In 2014, a system of “double majority voting” will be introduced.

The committee of the central bank governors of the 12 member states was chaired by the president of the European Commission at that time, Jacques Delors.

Funded by the private sector and topped up by the states only in exceptional cases.

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