Monday, June 20, 2011

Financial regulation: Britain the perennial outlier?

by Philip Whyte

Back in 2007, when the Labour government had abolished the business cycle and the City of London was booming, British policy-makers liked to vaunt the merits of ‘light touch’ regulation. Given the scale of British hubris in the run-up to the worst financial crisis since the Great Depression, the country’s EU partners can be forgiven for feeling a certain amount of Schadenfreude. Less justifiable, however, is the sense of vindication that has often accompanied it. Many European politicians have liked to give the impression that the financial crisis would not have happened if ‘Anglo-Saxons’ had regulated and supervised financial markets as strictly as Europeans; and that the task following the crisis is for Europeans to make sure that recalcitrant Anglo-Saxons are finally made to do so.

There are at least two reasons why this narrative is misplaced. The first is that Europe was not an innocent spectator in the run-up to the financial crisis, but an active participant in its genesis. Many European banks were as highly leveraged as Anglo-American ones (and vastly more so than hedge funds). Their lending standards deteriorated every bit as dramatically. And many enthusiastically underwrote or invested in exotic asset-backed securities like collateralised debt obligations (CDOs). (European banks’ voracious appetite for high-yielding securities with AAA-ratings was one factor that drove the growth in the market for CDOs). It does not necessarily follow, then, that the crisis would have been averted if regulatory and supervisory regimes in the Anglo-American world had been ‘more European’.

The second reason is that it ignores just how far the climate in Britain has changed since the crisis. Britain has not had to be bullied into abandoning its ‘light touch’ regime; it has done so of its own will. Changes to its regulatory and supervisory regime have been so wide-ranging that the UK is now at the strict end of the EU spectrum. For example, senior policy-makers, from the governor of the Bank of England to the chairman of the Financial Services Authority, have argued that EU rules on bank capital should be stronger, not weaker, than the Basel III accords. And the government has recently said that it will follow the recommendations of the Vickers Commission and ring-fence retail banking operations from investment banking ones – a move no other EU country is contemplating.

What does it matter if European politicians believe that the post-crisis task is to whip Anglo-Saxons into shape? Isn’t the belief harmless? Indeed, if it helps to rectify the problems that the crisis exposed, doesn’t it do more good than harm? Not necessarily. To start with, it risks creating needless friction between Britain and its EU partners. As host to Europe’s largest financial centre, the UK is disproportionately affected by some of the measures that the EU adopts – the recent Alternative Investment Fund Managers (AIFM) directive being a case in point. As other measures wind their way through the EU’s legislative pipeline and the recently-established European Supervisory Authorities bed down, it is in no one’s interest for EU initiatives to be seen in Britain as gratuitous attacks on the City of London.

Just as seriously, the popular European pass-time of bashing Anglo-Saxons diverts attention away from problems elsewhere in the EU. Consider Germany. In 2009, the country’s chancellor, Angela Merkel, told members of her party that they would no longer be dictated to by the City of London. Since then, her government has shown a striking reluctance to come clean about the weakened state of Germany’s own banks. This is why Germany played an active part in watering down stress tests for EU banks in 2010, and why it fought a rear-guard action to try and dilute the new Basel accords on capital adequacy. Seen from outside, Germany has appeared strangely reluctant to accept one of the central lessons of the financial crisis: that banks should hold more and better quality capital.

However absurd British paeans to light touch regulation seem now, there was more in common between Britain and the rest of Europe in the run-up to the financial crisis than is often recognised. Politicians, however, rarely find it easy to own up to failings at home. There was a brief moment in 2008 when the British government tried to pin all the blame for the financial crisis on events in the US – a claim that was hard to sustain given the carbon-copy, debt-fuelled boom that the UK went through. Unlike Britain, Germany never experienced a domestic credit-fuelled boom. This may explain why German politicians have found it easier to claim (and perhaps even believe) that they were the victims of shortcomings abroad, and why they have been slow to confront the problems at German banks.

Europe’s landscape, in short, has changed since the financial crisis. Britain is increasingly nervous about the huge contingent liabilities to which the country’s large financial sector exposes domestic taxpayers. It does not want to become Reykjavik-on-Thames. It is calling for tougher rules than even longstanding critics of light touch regulation are prepared to contemplate. The future of the City of London, it follows, will be influenced as much by the new climate in London as by the old one in Brussels (more hedge funds have left London in response to changes in the British tax system than because of the adoption of the EU’s AIFM directive). Critics will argue that Britain is as unilateralist as ever – and hence remains a European outlier. But if it is, it is in a very different sense from in 2007.

Philip Whyte is a senior research fellow at the Centre for European Reform.

Wednesday, June 01, 2011

EU ministers tackle defence austerity

by Tomas Valasek

How do you do more with less? The EU defence ministers agreed last week that the way to limit the impact of the economic crisis on their defence budgets lies in more co-operation. In a joint statement, they called for more military 'pooling and sharing': joint development and procurement of weapons, and partial integration of European militaries. EU member-states have trialled such ideas before but with limited success. Deep co-operation remains highly sensitive: governments are reluctant to build joint units because this may require them to share decisions on how and when to use them. The ministers' conclusions are correspondingly cautious: they call for a “structured” and “long-term” approach while offering few specific guidelines. It need not be this way: past pooling and sharing attempts offer plenty of lessons on what makes military collaboration successful.

In a recent CER report,['Surviving austerity: The case for a new approach to EU military collaboration', May 2011,]. I suggested ways for European countries to avoid past mistakes. Partial military integration works best when participating countries have similar strategic cultures, a high level of mutual trust, comparable attitudes to defence industry, and relatively low corruption in defence procurement. It also helps if countries are roughly similar in size, and serious about defence matters: that is, they are willing to use their armed forces and keen to maintain their ability to fight for future contingencies.

Several conclusions for EU defence ministers flow from these observations. Since many factors have to align for pooling and sharing to succeed, future defence integration will remain an exception rather than the rule. The conditions listed above only occur in some – and not necessarily geographically connected – parts of Europe. Hence, the idea that EU defence could begin around a single core group, the emergence of which would encourage others to join in a ‘snowballing’ effect, seems unrealistic. Future events may well prod European militaries to create a single, coherent military force. But no such outcome is foreseeable currently given widely varying levels of threat perception, political interest and military cultures across the Union.

The report also recommends that rather than pursuing ‘permanent structured co-operation’, the focus of EU countries and institutions should be on encouraging the formation of several “islands of co-operation” along regional lines, where members partly integrate their militaries. Some of these islands are already well established. The Benelux countries have had much success with pooling and sharing forces. The Nordic states are moving in this direction, as are France and the UK, which have recently concluded a bilateral treaty on defence co-operation. The recent EU defence ministers' communiqué makes a nod to the islands of co-operation idea by stating that multinational co-operation should also take place on a regional basis.

The EU's ability to nudge member-states towards such co-operation will be limited: the capitals will want a final say on with whom to partner, and to what end and depth. But this is not so say that there is nothing that the EU can do; in fact, European institutions have already been helpful. Their key role lies in spreading lessons learned in one region to the rest of Europe. The European Defence Agency, which EU countries set up to facilitate collaboration, has been collecting data on past and current examples of pooling and sharing; it should also catalogue why some have succeeded better than others. The EU military staff, which advises the EU high representative, has conducted a similar but forward-looking exercise: it collected information on what military skills or facilities the member-states are willing to pool and share. It should now use the data to highlight opportunities for collaboration.

The EU can also give member-states incentives to enter into permanent collaboration. Its best tool is the EU 'battlegroups': multinational, 1,500-strong units that are prepared, on a six-month basis, to deploy rapidly in and around Europe. While their primary raison d’être has been to give the EU the ability to quickly respond to crises, it was also hoped that the battlegroups would encourage governments to build permanent joint units. But on this last count, the experiment has disappointed: countries come together for six months, but then go their own separate ways. The EU should adopt recent Polish proposals that the battlegroups should always be composed of the same states, and that they should be on rotation on a predictable schedule, for example every three years. This would give the member-states reasons to maintain close long-term co-operation with partners in the battlegroup, and possibly to pool their units on a permanent basis, not just for the duration of the rotation.

Pooling and sharing will never compensate for inadequate defence budgets: when average spending in Europe, as percentage of GDP, drops by half – as it has over the past two decades – militaries will inevitably suffer. The EU member-states will almost certainly do 'less with less' rather than 'more with less'. However, properly applied, pooling and sharing can partly offset the impact of lower budgets. So while EU countries will still lose some of their military power to budget cuts, they will be better off with pooling and sharing than without.

Tomas Valsek is director of foreign policy and defence at the Centre for European Reform.