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de Larosière Group Recommendations: Misleading Incentives and the Super-Supervisor Scrum-Down

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On the 27th May 2009 in what will possibly be the final act of this Commission (and arguably the most important), CION (the insiders short-hand for the European Commission) will bring forward its proposals for banking supervision and regulation reform to ECOFIN (the European Finance Ministers) and then to the European Council  (Heads of State and Government) in June. It’s political with a big ‘P’ now.

 

 Note, that what will be brought forward to ECOFIN and The European Council is CION’s recommendations, not the De Larosiere report per se; it is the recommendations of CION predicated upon that report (I understand that the recommendations are pretty well dotted and crossed). These recommendations will actually be drafted by Commission Officials, who are a smart bunch of cookies, educated at the great Universities of Europe in economics of all sorts of flavours and hews! (cf my friend’s literary essay IN THE NAME OF THE ROSE).

 The CAD (Capital Adequacy Directive) process in Europe pre-credit crunch used to work differently; the CAD3 legislation was basically an enactment of the drafting of the Basel Committee, with some nips and tucks, tweaked by commissioner McCreevy’s team or as a result of some shouting at the microphone in the parliament! It’s different now, the Commission is drafting legislation and with enormous input and validation from the International Monetary Fund (the IMF); as always x-pollinated with Europeans. It’s still a bit of a club that banking supervision process but the members have changed - my friend’s deckchairs analogy pertains! 

In this context it’s easy to see now why the Bank for International Settlements (BIS) can no longer be the global supervisor. Clever Economists in the European Commission, who almost understand the objectives of Banking Supervision better than the small secretariat in Basel, because of their multi-faceted experience of industrial and competition policy issues for example and the realities of the requirements of their Economic forecasting, are necessarily going to have more traction with the banking super-highway and the monetary authorities than gnomes in Basel. Notwithstanding that, Basel will still I expect continue to produce the finest research in the globe on matters of risk management. But CION and “the Fund” (insider’s term for the IMF) are together in the front row, ready to engage in a scrum with the bankers. Which side would you prefer to be on? One thing is for sure. CION cannot be the locus of European Banking supervision from a political institutional perspective - that would not be acceptable to those of a more ‘economic’ political outlook (free market). One aspect then of the proposals to ‘The Council’ will be a new institutional proposal for sure from CION, again see my friend’s essay for some interesting speculation on that!

Jacques Martin Henri Marie de Larosière de Champfeu (‘JDL’ to the members of his ”Stammtisch”) is an interesting man for sure, he can hold a room, one thousand strong, with a dry humour and incisive logic, even though he was born before the Great Depression. He can make the topic of banking supervision seem as exciting as the final matches of a soccer season (no really!). Anyone who sticks his neck out and accepts the call to public service as he did (when he did not need to) to develop a report of such importance in a context such as we have now is bound to get brickbats and demolishing criticism, some of it personal. I doubt if Jacques even notices, I doubt if he would be in the slightest concerned about his critics. Once you see him in the flesh you understand clearly why, all of the bankers, politicians and apparatchix all over the world hold him in the highest of esteem and call on him when the going gets tough!

Brian Eno and his friends at The Edge are calling for an “Economic Manhattan Project”; well sorry Brian, CION has already engaged the financial Oppenheimer! For my British viewers and listeners who remember the first Reggie Perrin, for JLD, think Captain Mainwaring but with a brain the size of a planet and the charm of a man you would like to buy a second pint of Guinness on a quiet afternoon in Keogh’s in Dublin!

Marco Buti introduced JDL on Thursday morning with his comment that he believed that CION is leading global thinking on the reform of global Regulatory and Supervisory frameworks post crisis. Buti said that the consensus with the Americans, refereed by the IMF is coming towards the European perspective and that European perspective is what JDL thinks (although Otmar Issing’s thematic got a special mention).

JDL described the basis of his analysis of ‘La Crise’ as being the consequence of “Misleading Incentives” and “Securitisation Abuse’! Not wholly a regulatory failure but partially. He argued that enforced “Mark to Market” as opposed to periodic “Fair Value” exacerbated the process of collapse and that the failure of the Basel II process to get Capital Constraints upon Off-Balance sheet instruments implemented (as required by Pillar II [the Gordy Formula]) triggered the crisis. In addition he emphasised the inadequacy of “VaR and only VaR” in capturing the risk of a trading book. What de Larosière is aiming at is “Supervisory Efficiency” which he argues the current 3L3 committees quite simply do not have and that means he argues Europe is terribly exposed to the next potential ‘monetary slippage’! His main aim is the very high ground; his key commitment is to super-supervisors with teeth, in summary. He sees the IMF’s FSAP programme as absolutely crucial. He believes FSAP should be compulsory upon national governments, explicit and enforced (that means that bankers should take account of it too, as I argued in Dublin in 2006!) In the European case JDL is committed to his policy proposal (which probably will not get implemented) which is that a European Systemic Supervisor (a Super-Supervisor) should be implemented with very sharp teeth and “under the aegis of The European Central bank”, interlocked with the IMF FSAP methodology. This systemic super-supervisor is the locus of Macroprudential oversight, crisis early-warning and micro-prudential methodology, not the BIS!

The bit that will not get implemented because it is political with a small ‘p’ is ‘under the aegis of the ECB’; there will be a helluva of a cat-fight, turf-war, call it what it what you like about where this ‘authority’ will be located on May 27th!

 The de Larosière Report (the DLR [not the Canary Wharf train!]) is the final priority action of this Commission, it is “Top Priority”, JDL described it as an optimal theoretic compromise between market economics and social market economics. The 3L3 committees need teeth, McCreevy gave them budget last week, it’s up to the Ministers to give them authority. The last action of CEBS then will be the damp squib European Stress Test but there is an irony with CEBS.

CEBS is located in ‘Tower 42’, the old NatWest building in the City of London & it will be Alistair Darling and Gordon Brown who will fight hardest to emasculate the DLR propositions and dilute the IMF FSAP process, yet again! In my view there really is NO REASON whatsoever for the Scotsmen to do that this time but they will! Will they really know why? In terms of the political economy of all of this, the DLR is exactly what they might have advocated in opposition, as younger men. Now of course they are all over the place, at just that moment in time when we do not need them to be. I was a rugby player, the last thing you want to be doing is binding in the front row of an intellectual scrum down with those CION economists when you are not at your best and your second row is being hammered by corruption scandals! Not good, Not good at all! 

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