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EU Financial Services Policy Since 2007: Crisis, Responses and Prospects

Core Content

This paper provides a comprehensive analysis of the European Union's financial services policy from 2007 to the present, focusing on the evolution of policy responses to the financial crisis and its aftermath. It highlights the transition from an initially inadequate response to a more effective one, with the establishment of banking union in 2012 as a pivotal turning point. The paper also examines the broader implications of the crisis on the EU's regulatory architecture and the ongoing challenges in achieving a truly integrated financial market.

Main Views

The paper presents the following main views:

• The financial crisis in Europe was largely home-grown, stemming from structural weaknesses in the EU's financial regulatory framework rather than being solely a consequence of the U.S. subprime crisis.
• The bank-sovereign vicious circle was a central driver of financial instability in the euro area, where national governments provided implicit guarantees to banks, and banks, in turn, relied on state support, leading to systemic risk and fragmentation.
• The EU's response to the crisis was initially inadequate, characterized by a lack of coordinated action and a passive approach to regulation, but became more effective after 2012, particularly with the introduction of banking union.
• Regulatory arbitrage was widespread due to the fragmented and inconsistent application of EU financial regulations across member states, exacerbated by financial repression and banking nationalism.

Key Recommendations

The paper concludes with several key recommendations for future reforms:

• Break the bank-sovereign vicious circle by implementing:

  • A European Deposit Insurance Scheme that provides equal protection to all depositors.
  • Sovereign concentration charges to reduce home bias in banks' exposures.
  • Phasing out national authorities' ability to ring-fence banks' capital and liquidity.

• Adopt a twin-peaks regulatory architecture:

  • Strengthen the governance and funding of the European Securities and Markets Authority (ESMA).
  • Expand its scope of direct responsibility over financial business conduct.

• Continue harmonization efforts:

  • Focus on banking union and capital markets union.
  • Address areas such as accounting, auditing, insolvency legislation, and investment taxation to move closer to a single market for financial services.

Key Events and Developments

1. Up to October 2008: Risk Build-Up and Early Responses

• The crisis began in July-August 2007 with the collapse of U.S. subprime assets, leading to the failure of Bear Stearns and BNP Paribas.
• Ireland's IKB recapitalization marked the start of a pattern of full bail-outs in Europe.
• The European Central Bank (ECB) and U.S. Federal Reserve provided unconventional liquidity support to stabilize markets.
• The EU had a partly harmonized regulatory framework, but it was fragmented due to the use of directives rather than regulations, allowing for national variations in implementation.
• National authorities retained significant autonomy, often encouraging bank expansion and ignoring systemic risks, due to financial repression and banking nationalism.
• The initial EU response was uncoordinated and ineffective, with national governments acting independently, leading to financial fragmentation and moral hazard.

2. From November 2008 to Mid-2012: EU Politics, the Larosière Report, the G20 and Bank-Sovereign Contagion

• The crisis intensified in 2008, revealing domestic risks in the EU, particularly in real estate and banking sectors.
• The Larosière Report (2009) proposed a single rulebook for financial services, suggesting the creation of European Supervisory Authorities (ESMA, EBA, EIOPA) and a European Systemic Risk Board (ESRB).
• These authorities were established in 2011, with ESMA gaining direct supervisory powers over credit rating agencies and trade repositories.
• The G20 emerged as a new global platform for financial regulation after the 2008 crisis, leading to Basel III and global reforms.
• Despite EU involvement in global standards, implementation remained inconsistent, with national variations persisting.

Conclusion

The paper concludes that the EU's financial services policy was ineffective in the first half of the crisis period but became more effective after the banking union initiative. It calls for further harmonization, strengthened supervision, and structural reforms to address the bank-sovereign vicious circle and enhance financial stability across the EU. The Brexit is noted as a critical event that has complicated the EU's financial integration efforts.

Summary of Policy Challenges

• Fragmented regulatory framework: Based on directives rather than regulations, leading to national variations and regulatory arbitrage.
• Bank-sovereign vicious circle: A structural problem where banks and governments reinforce each other's risks.
• Inconsistent implementation: Despite EU-level initiatives, national authorities retained significant autonomy.
• Lack of transparency: Stress tests were ineffective due to limited disclosure and national oversight.
• Political narratives: The crisis was often blamed on the U.S., obscuring European responsibility and policy shortcomings.

Final Remarks

The paper emphasizes the importance of a unified regulatory approach and systemic risk management in the EU. It suggests that harmonization and supervisory reform are essential for financial stability and market integration.