European Monetary System

(Table 5). Banks will thus operate in increasingly integrated capital

markets and will be exposed to shocks originating beyond their national

borders.

As to corporations, they may concentrate their operations (treasury,

capital market and payment management) in a single or few "euro banks",

while the disappearance of national currencies may break links between

firms and their home country "house bank". This dissociation would make the

domestic economy indirectly sensitive to foreign banks' soundness, thus

creating another propagation channel of banking problems across countries.

12. When considering the industry scenario for the coming years, the

viewpoint has to be broadened beyond the impact of the euro. Rather than

the exclusive, or even primary, force for change, the euro is expected to

be a catalyst for pre-existing trends driven by other forces. The recent

ECB report prepared by the Banking Supervision Committee on "Possible

effects of EMU on the EU banking systems in the medium to long term" gives

a comprehensive analysis of such trends, which can be summarised as

follows. First, regulation: the industry has yet to feel the full impact of

such fundamental, but relatively recent, regulatory changes as those

related to the single market legislation. Second, disintermediation: other

financial intermediaries and institutional investors will grow relative to

banks, pushed by demographic and social changes, as well as by the

increasing depth and liquidity of the emerging euro area-wide capital

market. Disintermediation is expected to take the form of increasing

recourse to capital market instruments relative to bank loans by firms, and

diminishing investment in deposits by households relative to mutual funds

and related products. Third, information technology: bank products,

operations and processes are changing rapidly, while technology offers

increasing possibilities for dissociating the supply of a large number of

services from branches and face-to-face contact with customers. The current

tendency in the EU banking systems to reduce over-branching and over-

staffing will grow stronger.

These factors will increase competition, exert pressure on

profitability and oblige banks to reconsider their strategies. Such effects

are already visible throughout the EU. They produce changes in

organisation, new products and services, mergers, strategic alliances, co-

operation agreements, etc. They also involve strategic risks, because the

pressure for profitability and some losses of revenue due to the euro, for

example from foreign exchange, may push some banks to seek more revenue

from unfamiliar business or highly risky geographical areas. Inadequate

implementation of new technologies or failure to reduce excess capacity may

also affect banks' long-term viability. In the short term, the structural

adaptation process could be made more difficult by the combination of

factors like the protracted financial difficulties of Asia and Russia, or

the preparations for the year 2000.

IV. CURRENT SUPERVISION

13. Against the background of the institutional framework and the

industry scenario I have outlined, let me now turn to the functioning of

banking supervision in the euro area. Two preliminary observations. First,

the objective of financial stability pursued by banking supervisors is only

one in a range of public interests, which also includes competition policy

and depositor and investor protection policy. Second, current supervision

and crisis management involve different situations and procedures and will

therefore be examined in sequence.

14. Starting with current supervision, let me consider banking

regulation first. As observed earlier, the regulatory platform for the euro

area banking industry combines harmonised rules with country-specific (non-

harmonised, but mutually recognised and hence potentially competing) rules.

The harmonised part of the platform includes most of the key

prudential provisions that have been developed in national systems over the

years. More than 20 years ago (1977), the 1st Banking Co-ordination

Directive adopted a definition of a credit institution and prescribed

objective criteria for the granting of a banking licence. In 1983 the first

Directive on carrying out supervision on a consolidated basis was approved,

and in 1986 the rules relating to the preparation of the annual accounts

and the consolidated accounts of banks were harmonised. In 1989 the 2nd

Banking Co-ordination Directive (which became effective on 1 January 1993)

marked the transition from piecemeal to comprehensive legislation,

introducing, inter alia, the principle of "home country control". A number

of other specific directives have subsequently addressed the main aspects

of the regulatory framework - notably, own funds, solvency ratios and large

exposures. A Directive imposing deposit guarantee schemes supplemented the

legislation in support of financial stability. All in all, the European

Union, including the euro area, now has a rather comprehensive "banking

law" consistent with the Basle Committee's rules and with the 1997 Core

Principles of Banking Supervision.

The country-specific, non-harmonised, part of the platform is also

quite relevant and very diversified. It includes, among other things, the

different organisational arrangements for the conduct of banking

supervision (central bank, separate agency or a mixed arrangement); the

tools used by banking supervisors (e.g. supervisory reporting, on-site

inspections); provisions for the liquidation and restructuring of banks;

and the definition and legal protection of financial instruments and

contracts. Even the key notion of a regulated market is harmonised only to

a very limited extent.

15. Such "neutrality" and "incompleteness" on the part of the EU

legislator with respect to key aspects that are normally incorporated in

the regulatory framework is a unique feature of EU banking regulations and

is likely to trigger a deregulatory process, pushed by competition among

the national systems and the different financial centres in the euro area,

and beyond that in the EU. Against the background of the increasing

competition and other changes in the banking industry, one can expect that

the regulatory platform will evolve in the years to come. Additional EU

legislation may prove necessary to complete and strengthen the harmonised

part. One important part of common legislation, namely the draft Directive

on liquidation and re-organisation measures for credit institutions, has

not yet been adopted and, indeed, has been stalled for years. This

Directive is needed to bring legal certainty to the framework for banking

crisis management. In this regard, it would be useful for the Eurosystem,

if necessary, to be able to exclude counterparties from the single monetary

policy on prudential grounds. Also, the non-harmonised part of the platform

will come under pressure to converge, as I have just mentioned, through the

process of "regulatory competition". Like any other rapidly changing

industry, the banking sector will require careful attention by regulators.

As indicated earlier, the ECB will have the possibility of contributing to

the rule-making process through its advisory tasks under Article 105 (4) of

the Treaty and Article 25.1 of the Statute of the ESCB.

16. On the whole, and taking a euro area perspective, the legislative-

cum-regulatory platform of the banking industry, although rather unusual

and very diversified in comparison with those of most currency

jurisdictions, does not seem to present loopholes or inconsistencies that

may hamper the pursuit of systemic stability. Seen from the point of view

of the regulatory burden, it is a light system. It will become even more so

if competition among national banking systems and financial centres

encourages national regulators to free their banks from regulatory burdens

that are not required by the EU Directives. Conversely, seen from the point

of view of its flexibility, i.e. how quickly it can adapt to new

situations, it is, on the contrary, a heavy system. This is the case both

because the EU legislative process is slow (three years or even longer may

be needed to pass Directives) and, perhaps more importantly, because many

provisions are embodied in the Community primary legislation (i.e.

Directives) rather than in Community secondary legislation (amendable

through simpler comitology procedures).

The establishment of EMU does not seem to determine a need for

revising the pillars of the current legal framework. What seems to be

necessary, however, is a more flexible legislative procedure which allows

for a faster and more effective revision of Community legislation, whenever

needed in relation to market developments.

17. Let me now turn to the execution of banking supervision. It

should immediately be recalled that supervision, contrary to regulation, is

a national task, exercised by what the jargon of the Directives calls the

"competent authority". Since the euro area has adopted a separation

approach between supervisory and central banking functions, it is natural

to examine first the functioning of the "euro area supervisor" (i.e. the co-

operative system of national supervisors) and then turn to the tasks and

needs of the "euro area central banker" (i.e. the Eurosystem).

18. The euro area supervisor can be regarded as a rather peculiar

entity composed of national agencies working in three modes: stand-alone,

bilateral and multilateral. Let us briefly examine each of them.

The stand-alone mode is the one in which the supervisor exclusively

operates in the national (or even local) context. Today it is by far the

most predominant mode. In most cases, this approach is sufficient to

achieve the objectives of banking supervision because most banks in Europe

are operating in a context that does not even reach the nationwide market

of the country of origin. Such a decentralised model is even more effective

because it allows the efficient use of information that may not be

available far from the market in which the bank operates. That is why it is

actually applied even within countries. In Italy, for example, over 600 of

the 900 licensed credit institutions at end-1998 were entirely supervised

by the Banca d'Italia branch of the town in which the bank is licensed.

The bilateral mode involves co-operation between two supervisory

agencies. It is used for cross-border supervision of the same type of

financial institutions, such as credit institutions, or the supervision of

different types of financial institutions operating in the same market,

such as credit institutions and securities firms. The instrument that has

been devised to organise bilateral co-operation between banking supervisors

is the Memorandum of Understanding (MoU). With the implementation of the

2nd Banking Co-ordination Directive, the Member States began to negotiate

extensively MoUs in order to establish the necessary co-operation between

"home" and "host country" authorities to supervise efficiently institutions

that have cross-border activities or foreign country establishments.

By the end of 1997, 78 bilateral MoUs had been signed between the EEA

banking supervisory authorities. The key aims of MoUs are to establish a

regular exchange of information between national supervisory authorities.

While the "gateways" for the exchange of information have been laid down in

Community legislation, MoUs provide a practical framework for communication

to be carried out between supervisors. Moreover, MoUs define procedures and

reciprocal commitments between pairs of EU supervisors related to the

various parts of the supervisory process, such as establishment procedures

and on-site examinations.

Finally, the multilateral mode is the one in which a group of

supervisors works collectively as, say, a single consolidated supervisor.

Such a mode is required when the problems involved are area-wide. They may

be area-wide for a number of reasons with regard to the institutions, or

groups, involved: their dimension; their linkages with a number of

different markets in various countries; the role they play in the payment

system or in other "systemic" components of the market, etc. Multilateral

co-operation can also enhance the quality of supervision by examining

common macroeconomic influences on the banking system and common trends in

the financial system that may not be revealed from the national perspective

only.

Today, the Banking Supervision Committee is the key forum for

multilateral co-operation. It is composed of representatives of the banking

supervisory authorities of the EU countries, either forming part of the

respective NCB or separate bodies. The Banking Supervision Committee's main

functions are the promotion of a smooth exchange of information between the

Eurosystem and national supervisory authorities and co-operation among EU

supervisory authorities. Another forum for dealing with the requirements of

the multilateral mode is the Groupe de Contact, a group of EU banking

supervisory authorities which, for many years, has discussed individual

banking cases in a multilateral way, but at a lower organisational level

than the high-level Banking Supervision Committee.

19. So far, the need to develop the multilateral mode has been

relatively limited, as the emergence of a single banking market in the

European Union has been slow and the euro was not yet in place. Thus, the

fact that the multilateral mode has not gone, for the moment, beyond

periodic discussions among supervisors and occasional industry-wide

analyses should not be a cause for concern.

I am convinced, however, that in the future the needs will change and

the multilateral mode will have to deepen substantially. Over time such a

mode will have to be structured to the point of providing the banking

industry with a true and effective collective euro area supervisor. It will

have to be enhanced to the full extent required for banking supervision in

the euro area to be as prompt and effective as it is within a single

nation.

There are no legal impediments to that. The existing legislation,

whether Community or national, permits all the necessary steps to be made.

Information can be pooled; reporting requirements and examination practices

can be developed and standardised; common databases can be created; joint

teams can be formed; and analyses of developments across the whole banking

system can be conducted. The Community legislation providing for the

unconstrained exchange of confidential information between supervisors does

not distinguish between bilateral and multilateral co-operation, but the

common interpretation is that it covers both modes. It will be the task of

the Banking Supervision Committee, for its part, to develop the

multilateral mode among EU banking supervisors.

20. If the above concerns primarily the euro area supervisor, what

about the euro area central banker, i.e. the Eurosystem? The euro area

central banker has neither direct responsibility for supervising banks nor

for bank stability. It is, however, no stranger in this land. It has a

vital interest in a stable and efficient banking industry; it is,

therefore, keen to see its action complemented with an effective conduct of

the supervisory functions by the competent authorities; it needs a clear

and precise knowledge of the state of the euro area's banking industry as a

whole and of its major individual players; and it may have a role to play,

as we shall see, in the management of crises.

For the Eurosystem, natural reference models are provided by the

central banks of countries that apply the separation approach, for example:

Germany before the euro; the United Kingdom after the creation of the

Financial Services Authority; or Japan. In all these cases the central bank

has a well-developed expertise in the micro and macro-prudential field;

each distinctively plays a role in the macro-prudential field by addressing

threats to the stability of the banking system and analysing the soundness

of the structural features of the system. For their own purposes, these

central banks also have precise and comprehensive information about the

banks in their respective country. This is obtained either from performing

practical supervisory duties, as in the case of the Bank of Japan or the

Bundesbank; or from the national supervisory authority; or through direct

contacts with the banking industry, as in the case of the Bank of England.

The Banking Supervision Committee is in a good position to co-operate

with the Eurosystem in the collection of information. Indeed, the so-called

BCCI Directive has removed the legal obstacles to the transmission of

confidential information from competent supervisory authorities to "central

banks and other bodies with a similar function in their capacity as

monetary authorities". This includes national central banks and the ECB. Of

course, the provision of supervisory information is voluntary and its

development will have to be based on an agreed view of the central banking

requirements the Eurosystem will have in this field.

V. CRISIS MANAGEMENT

21. In normal circumstances central banking and prudential

supervision have an arm's length distance between them. In crisis

situations, however, they need to act closely together, often in co-

operation with other authorities as well. Charles Goodhart and Dirk

Schoenmaker have made here at the London School of Economics a valuable

contribution to analysing the handling of major banking problems in the

history of industrial countries. One of their conclusions is that, in most

instances, central banks have indeed been involved. Banking problems are so

close to monetary stability, payment system integrity and liquidity

management that this finding hardly comes as a surprise. The advent of the

euro will not, by itself, change this state of affairs.

22. When discussing crisis management, it should not be forgotten

that, while central banks have a direct and unique role to play when the

creation of central bank money is involved, this represents just one

category of emergency action. Another category refers to the injection - by

politically liable Finance Ministries - of taxpayers' money into ailing or

insolvent credit institutions. There is also a third, market-based,

category, consisting of the injection of private money by banks or other

market participants. These three typologies of emergency action all require

the involvement of policy-makers, but they must not be mixed up when

evaluating the existing arrangements. Therefore, before discussing the much

debated question of the lender-of-last-resort, let me briefly comment on

the two, probably less controversial cases where central bankers are not

the providers of extra funds.

23. First, the "private money solution". This market-based approach

is clearly the preferable option, not just to save public funds and avoid

imbalances in public finances, but also to reduce the moral hazard problem

generated by public assistance to ailing institutions. Indeed, policy-

makers are increasingly aware that the expectations of a helping hand can

increase financial institutions' risk appetite in the first place. However,

even when a market-based solution is possible, on the grounds of private

interest, private parties may not be able to reach a solution for lack of

information or co-ordination. Public authorities have therefore an active

role to play for the market solution to materialise. The recent rescue

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