How about the interrelation between the SSM and the European Banking Authority (EBA)?

Legally, the mandates of the EBA on the one hand and the SSM on the other are clearly distinct as the EBA is a regulator whereas the SSM is a supervisor. In practice, however, both shape supervisory day-to-day practice, thus, on this functional level, there is indeed overlapping. The legislator has created a double majority requirement in order to prevent a dominance in the EBA of euro area countries who might be inclined to vote uniformly within the EBA, the common position being orchestrated by the ECB within the SSM. This solution, however, creates a sort of stalemate situation because no “block” – e.g. euro area countries against the Bank of England and others – can actually prevail with its view. You always need a compromise. This strongly devaluates the EBA’s power to harmonize the regulatory environment by issuing technical standards. The ECB, on the other hand, issues the Supervisory Manual whichis, legally speaking, not a regulation but, in practice, shapes supervisory procedures, assessments and methodologies. So, most likely, the ECB will spread its ideas on good supervision forcefully on the NCAs whereas the EBA has no comparable power.

This new setting aims at a better regulation and supervision of banks. How about regulatory arbitrage? Do we need more specific rules?

In my view, it is not possible to react to regulatory arbitrage by coming up with an ever more detailed and complex regulatory system every two weeks. Rather, we should focus on applying existing rules in a different way. A paper of mine (Tröger 2014b) explores this idea: if the rational of a rule applies, then the rule should be enforced despite a financial product’s or transaction’s appearance. If we stick to a legalist interpretation of prudential regulation, we will open up massive regulatory arbitrage opportunities.

It is always a challenge for the regulator not to hinder beneficial financial innovation and, at the same time, prevent regulatory arbitrage. Take the example of securitization: there is, of course, an efficiency story here. If you transfer risk from people who cannot bear it to those who can bear it, this is efficient. But we have seen in the past that securitizations were designed in a way that allowed accountants and supervisors to acknowledge that the securitized loans were no longer on the bank’s balance sheet and the exposures had zero risk weight while, in fact, the bank was still carrying the risks of these products through liquidity facilities, guarantees and other arrangements. This example demonstrates that the prudential rule of demanding capital against a bank’s risky assets, no longer applied due to a narrow construction by lawyers. The consequence should be that even if an innovation falls outside of the wording of a rule, but remains within its spirit, then the rule should still apply.

Some regulators have already read the rules like this in the past. Securitization transactions, for example, have been treated differently by different regulators. Most of them have accepted them. Some have not like the Bank of Spain that said to its big banks: you can do securitization but you still have to hold capital against the exposures that you are holding in the vehicles that bundle the securitized loans. And, of course, this way the whole construction is not profitable anymore.

This may work for the regulation of financial institutions. But if actors change their institutional set-up in order to step outside of the regulated realm, can regulatory discretion also help here?

It is true that, up to now, we have a very entity-centered approach to regulation by tying it to a bank license. This creates enormous opportunities to escape regulation by finding a way of doing precisely the same business, while not technically being a bank. However, it is clearly the same rational that has driven the original prudential regulation that we want to apply to certain occurrences in the shadow banking sector. In a recent, very influential paper, Claessens and Ratnovski (2014) argue: everything that needs a backstop is a shadow bank. And very many products in the shadow banking sector are, in fact, ultimately backed by the banking system. So, here you have the link. If you enforce capital requirements that are put on this ultimate backstop, you will take the economic viability from a lot of regulatory arbitrage models. We will need some more empirical studies to what degree this assumption is true. This kind of data-based normative research can be ideally conducted in the interdisciplinary environment at SAFE.

That sounds like you need an omnipotent supervisor.

The supervisor comes in at a very early stage. If there is a financial innovation, be it regulatory arbitrage driven or efficiency driven, you have to approach the supervisor and ask how they would treat it. At this level, the supervisor does not need to understand the overall risk structure and the social welfare effects this is going to create. He just has to understand: this is something I have seen in the past and, at that time, this sort of prudential regulation applied. Now, they want to do it differently. So, does this really change the game or is it rather a functional equivalent to what they have done in the past?

The financial crisis has taught us that supervisors on the ground understood pretty well what was going on. In the U.S., the on-site supervisors even documented that they saw highly hazardous exposures to certain risks. But frequently they did not feel backed by their own institution so they did not take any consequences. Thus, again, we have to change the cultural setting and tell these people that we want them to take action. 

Claessens, S., Ratnovski, L. (2014)
“What is Shadow Banking?”,
IMF Working Paper 14/25.

Tröger, T. (2014a)
“The Single Supervisory Mechanism – Panacea or Quack Banking Regulation?”,
European Business Organization Law Review, Vol. 15, Issue 04, pp. 449-497.

Tröger, T. (2014b)
“How Special Are They? – Targeting Systemic Risk by Regulating Shadow Banking”,
SAFE Working Paper No. 68.

SAFE profile page of Tobias Tröger