A joint response to the credit crunch

by Katinka Barysch

Ailing banks are being rescued, markets remain frozen, economic numbers are becoming gloomier. Of course, central banks and governments are focusing on fire-fighting, on cutting interest rates, on providing cash to liquidity-starved banks and to consumers. But slowly they are turning their thoughts to what comes next. How do we make sure that similar crises do not happen again?

EU leaders, at their Brussels summit last week, agreed that the responsibility to clean up the financial mess rested primarily with the banks and mortgage lenders that caused it. But they also promised that European governments were prepared to “take regulatory and supervisory actions where necessary”. Their to-do list is very similar to that of the US government, as laid out by US Treasury Secretary Hank Paulsen on March 14th: regulation that catches up with financial innovation; better ways to identify risky assets and higher capital requirements in case these go sour; and tighter rules for the credit rating agencies that are accused of over-rating packaged debt securities.

Neither the EU nor the US is planning big legislative packages for now. But if another bank or three fails over the next couple of months, the pressure to ‘do something’ would grow. “We are aware of the risk of over-regulation in response to the credit crisis”, said a top US regulator during the Brussels Forum last weekend. “But a response there will be. And we should not be timid.”

With memories of Sarbanes-Oxley still fresh in their minds, Europeans shudder at the thought of the US rushing into new financial markets regulations. Conversely, Americans are worried that cases such as Societe Generale in France, IKB in Germany or Northern Rock in the UK could trigger an over-reaction in some European countries. The risk of unilateral action is probably lower now because the US and the EU have reinforced their communication and co-operation on financial issues in recent years.

This could pay off now in terms of better co-ordination. The challenges of preventing future financial crises are effectively the same in Europe and America. We can look for solutions together. Or we can do so separately and then spend years trying to reconcile them so as not to impede transatlantic capital flows.

Our track record on this is mixed: the EU and the US have long worked together in existing forums, such as the Basel committee on banking supervision. For issues that are not covered there, they set up a financial regulatory dialogue in 2004. But it needed the big political push that came from the establishment of the Transatlantic Economic Council in 2007 for the two sides to make progress on even the most long-standing and vexing issue (namely the reconciliation of accounting standards).

Moreover, transatlantic co-operation can only work if the EU itself has a coherent stance. That does not yet seem to be the case.

In December Italy’s finance minister, Tommaso Padoa-Schioppa, argued that the turmoil showed the need for a European rule-book for banking and more powers at the EU level to supervise pan-European banks. He also pointed out the lack of an EU mechanism for handling crises: “Even with signs of a clear risk of contagion”, he wrote in the FT “no common analysis of the situation, no sharing of confidential information, no co-ordinated communication and no emergency meetings appear to have taken place among EU supervisors”. His EU colleagues in Ecofin were not convinced of the need for stronger EU powers, preferring a more evolutionary approach that leaves responsibility firmly with the member-states.

Is that enough? More than 40 banks in Europe now operate across borders. Imagine if Northern Rock had also sold mortgages in say, Belgium, Poland and Spain. Who would have taken the lead in finding a pan-European solution? Could a plethora of EU supervisors persuade the ECB (and the Bank of England) to help with liquidity?

The next Ecofin meeting in April is supposed to come up with new plans for regulatory convergence, stronger supervision and an EU-wide early warning mechanism. That will be difficult enough, given that some Europeans fear that the Commission may use the current market turmoil for a ‘power grab’ in finance. But the Europeans also need to talk to their counterparts in the US to make sure that whatever they decide fits with the response that is emerging on the other side of the Atlantic.

Katinka Barysch is deputy director of the Centre for European Reform.