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Addressing the Stability of the European Financial System

October 22nd, 2008 Leave a comment Go to comments

A distinctive feature of the last decade has been the drastic change wrought by globalisation and financial innovation on the world’s financial systems. With the worldwide shift toward financial systems based on global markets, attention is focusing on the need to redesign existing financial institutions and markets, corporate governance schemes and regulatory frameworks in order to achieve long-term stability of said financial systems. Interest in restructuring the region’s financial systems has intensified as a result of last century’s financial stress and the consequent need for architecture for the changing economy.
Fries and Lane (as cited in Berndt 2002) asserted that building a sound financial system is a prerequisite for economic development and ensuring long-term financial stability. The development of bond and equity markets has also been found as one important way of reducing financial fragility.

Gale (2001), in the similar line of argument as Fries and Lane, claimed that financial systems are crucial for the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms. They allow intertemporal smoothing of consumption by households and expenditures by firms. They allow both firms and households to share risks.

Such vital importance of the maintenance of stable regional and global financial systems has spurred debate on who is best fit to oversee it. In the European Union (EU), the question of whether supervision should remain national or should it be shifted to the European level in order to maintain the efficiency and stability of European financial systems has been a moot issue(Neave 2005).

From the preceding discussions, it could be said that maintaining the efficiency and stability of the European financial system is already a supervision challenge at the national level and is progressively more of a concern in the European level as well. The conclusion that this paper has arrived at is that a supervisory system based on cooperation is, at the moment, the most advantageous arrangement given present conditions. While the existing institutional arrangements for supervision are adequate, their practical functioning needs to be enhanced by fostering cross-border cooperation.

In particular, there should be the fostering of information exchange among major financial institutions and market trends among supervisory authorities and central banks. This should be further enforced through switching from implicit to explicit agreements depending on the circumstances, when certain types of information exchange and coordination are required. Giovanni & Mayer (1991) agreed that this would be in line with the basic solution, which is cooperation, and further added that there needs to be a European level mechanism.

Measures at the European level could also be justified to ensure that the mechanism is applied in all relevant bilateral relations. To prevent crises in the process, two measures should be done: to observe binding pre-commitments by authorities to guarantee information exchange and to incite market discipline by requiring more public disclosure of information by financial institutions. If it turned out that a crisis still arises, there should be the development of multilateral cooperation and pooling of information, as well the development of mechanisms for coordination to facilitate unified solutions.

The deeper challenges in financial supervision are related to the characteristics of the European financial system and the increased competition and market integration that is stimulated by EMU. It will require agreement on the part of policymakers and supervisors to act rapidly on the completion of the regulatory framework and the adoption of the structure of financial supervision to market developments. Elements of the provisions worked out in the Netherlands provide at least some indication of the issues to be addressed at a European level. But because the tasks are different at a national and European level, it is unlikely that any national structure will offer a model suitable at the European level.

It would almost be cliché to state that financial systems are evolving rapidly and will change in response to the introduction of new regulatory proposals. In order to be effective and appropriate, financial regulation itself has to evolve in line with, or not in too far in arrears of, the market. This cannot be done if such amendments and adjustments have to be undertaken through primary legislation. Directives and their transposition to national law take a substantially long time to complete, which could be further detrimental to the stability of the European financial system. The potential solution would be to build a structure that would allow a more rapid response, effectively in the form of the ability of the European Union to introduce secondary legislations within the European context. As integration across sectors and across borders continues and the most appropriate supranational supervisory models emerge from best practices of domestic approaches, reforming the financial supervision of Europe to make it more attune with the times becomes more necessary and worthwhile.

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