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The Maastricht Treaty created the European System of Central Banks and the European Central Bank (ECB) to head the system. The treaty entrusts the ECB with the responsibility for monetary policy, but national authorities remain responsible for financial stability. In this chapter, we focus on the implications of national versus central assignment of lender-of-last-resort and supervisory functions for the degree of forbearance in closing distressed banks and for the level of diligence in bank supervision. One major conclusion is that, if only one of the two functions is centralized, then it will be more effective to centralize the supervisory function.

This introductory chapter begins with a discussion of the proposed revision of the rules for the regulation of capital adequacy developed by the Basel Committee on Banking Supervision. It then describes the differences among financial institutions and the three ways to ensure adequate capital: market discipline, supervisory review of firm economic models used to determine capital, and command and control regulation. An overview of the chapters included in this volume is presented.

Persaud provides in his chapter complementary analysis on the design of banking regulation and supervision in the light of the credit crisis. In the author's view, two fundamental flaws in financial regulation led to the biggest crisis of modern times. The first was to put market evaluations of risk at the heart of financial regulation, through external ratings and risk measures derived from market prices. The essential problem is that market prices may improperly evaluate risk in the presence of market failures. The second flaw was to assume that common standards, such as value‐accounting and risk measures are good and that diversity is bad, thus underestimating the advantages different players have to assume different risks.

If post-communist countries realized marketized bank–state ties through transition and international pressure to privatize their banks with foreign capital, western Eurozone states have more recently come under pressure to follow suit. European Banking Union centralized bank supervision and introduced a single resolution board at the expense of national authority. Thus under banking union, national regulatory and supervisory forbearance was curbed; barriers to banking market entry were no longer the purview of national authorities; disproportionate bank lending to one’s own sovereign would be discouraged; and bank bondholders, creditors and depositors—i.e. market actors—paid the price for bank failures first, before governments and taxpayers. While European Banking Union put the euro on stronger foundations, it also curbed national economic policy discretion and limited tools for adjustment. Taking Italy, Portugal, Spain and Germany as examples, this chapter explains why and in what policy areas Eurozone states’ sovereignty clashed with banking union.

From the 1970s on, banking supervision grew in size and importance. Which were the characteristics of the regulatory elite leading this activity? Based on archival material from central banks and supervisory institutions and on a collective biography analysis, this chapter explores the profile of the Basel Committee on Banking Supervision members, their role in the construction of an international regulatory institution, and some of their first achievements. It shows that some Basel Committee members were deeply involved in transnational networks of governance, others used their experience as banking supervisor in the private sector, while still others had a more national-centred career and stayed in the central banking or banking supervision sector. The Basel Committee members were the elite of banking supervisors. Over time, their committee evolved from a club to a standard-setter institution, illustrating the newly acquired influence both of banking supervision and experts and expertise in international financial governance.

European states have a long history of banking sector nationalism. Control over credit allocation is believed to contribute to economic development and competitiveness, insulation from external economic shocks, and control over monetary policy. We demonstrate the dramatic loss in domestic control over banks created by European Banking Union and explain the sudden shift from national to supranational banking supervision as follows. In the background, ongoing economic liberalization has made banking sector protectionism more costly, and because many large banks have internationalized, they now prefer centralized European regulation and supervision. In the foreground, we find it is primarily the European Commission and the European Central Bank that have pushed European Banking Union (EBU) ahead. Contrary to accepted wisdom, Germany has not been able to limit EBU to a great extent. Moreover, the Commission and the ECB have managed at critical junctures to isolate Germany to secure that country’s assent to controversial measures.

This chapter analyses the issues from the perspective of home country control and host responsibilities, and the role of the ECB as a single supervisor to minimize the potential conflicts between home and host participating Member States. From a cross-border dimension, the use of consolidated supervision is traditionally the starting point to configure the relationship between home and host, and in the EU context it is clearly positioned on home country control. However, it is evident that there is a potential threat with the lack of reciprocity within the consolidated supervisory relationship. This is particularly acute for those supervising group subsidiaries where the criteria for cooperation is not as clear as it is for branches. It is argued that this can potentially lead to conflicting interests between the parent and the subsidiary since risks on either side may not be visible to each other. Supervisory colleges and recovery planning are principal mechanisms to form a consensus for group perspectives and host perspectives. However, the level of administrative discretion that exists within the current mechanisms can lead to home country bias. Since the ECB is in the shoes of the group consolidated supervisor, it will really need to demonstrate that it truly reflects both sides.

As finance has become more globalized and global financial crises have become more frequent and severe, a set of international regulatory regimes has been established. These have generally taken the form of relatively informal networks of regulators focusing on particular aspects of the financial system. Over time these regulatory regimes have become more complex. States, operating first through the G7 and then the G20, began to oversee and direct these regimes more actively and politically. The regimes' engagement with internationally active business actors has increased, leading some to see them as having been captured by the industry. Initially they tended to be exclusive, but over time, and especially after the crisis of 2008, the number of countries involved has expanded. The degree and sources of their effectiveness continue to be debated.

This chapter discusses some reasons to suspect that supervisory changes over the last decade or so may have had significant effects on the overall lending of the U.S. banking industry. It investigates this possibility by testing three hypotheses about whether supervisors changed their policies and whether these policy changes affected bank lending behavior: Hypothesis 1: U.S. bank supervisors got tougher on banks during the credit crunch period of 1989–92, treating banks of a given financial condition more harshly than in previous years. Hypothesis 2: U.S. bank supervisors got easier on banks during the boom period of 1993–98, treating banks of a given financial condition less harshly than in prior periods. Hypothesis 3: Changes in supervisory toughness, if they did occur, changed bank lending behavior in the predicted directions. These hypotheses are tested using information on the supervisory process, confidential data on classified assets and CAMEL ratings from bank examinations, bank balance sheet and income data, and other variables for the condition of the bank, its state, and its region over the period 1986–98. A commentary and discussion summary are also included at the end of the chapter.

Banking was the first financial service to be subject to regulatory harmonization. However, banking regulation has mainly been designed to foster integration in the EU, rather than setting prudential rules (e.g. capital requirements). Over time, the EU has downloaded international capital requirements (the so-called Basel accords), albeit taking into account European ‘specificities’. In the negotiations of the Basel accords, the EU did not present a united front because its member states had different priorities, rooted in their domestic political economies. Banking regulation is a dual (i.e. a state and federal) competence in the US. The US, together with the UK, was able to upload its domestic capital requirements internationally in the late 1980s. The Basel I accord set in place a process of path-dependence and subsequently the US agreed to download Basel II and III.

This chapter provides a positive political-economy analysis of the most important revision of the U.S. supervision and regulation system during the last two decades, the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA). It analyzes the impact of private interest groups and political-institutional factors on the voting patterns concerning FDICIA to assess the empirical importance of different types of obstacles to welfare-enhancing reforms. The chapter is organized as follows. Section 7.2 briefly outlines a number of approaches to understanding the political economy of government involvement in the economy. Section 7.3 applies these theories to describe why, after little change since the end of the Great Depression, legislative reform of bank regulation began in the 1980s. This section also reviews the major legislative changes during the last twenty years and provides a more detailed description of the legislative history of FDICIA and its amendments. Section 7.4 outlines hypotheses about the factors that should affect the support for FDICIA and the amendments generated by the positive interest group and political approaches. Section 7.5 describes the empirical voting model and contains the results. It analyzes votes by members of the House of Representatives on three amendments related to FDICIA and its final passage. The concluding section draws tentative lessons from the political economy approaches concerning ways to make welfare-enhancing regulatory change more likely. A commentary and discussion summary are also included at the end of the chapter.

This chapter examines how the Single Supervisory Mechanism opens the door to non-Eurozone Member States to participate and have credit institutions supervised by the European Central Bank (ECB) that fulfil the criteria of significance within the Member State and have cross-border activities. The ECB is required to work closely with both participating and non-participating Member States , since a significant proportion of credit institutions will invariably have business activities in both participating and non-participating Member States. The participating and non-participating Member States will be expected to allow the ECB to take the lead and/or cooperate with the ECB as the competent home supervisor to ensure appropriate cooperation and coordination of supervision and information sharing to inform supervisory decisions. The aim of the ECB in this respect is to safeguard financial stability and facilitate sustainable market integration. The chapter looks at the procedures set out to explain how a non-Eurozone Member State enters a close cooperation agreement with the ECB to come under the umbrella of the Single Supervisory Mechanism.

This chapter attempts to describe the interplay between Economic Monetary Union (EMU) and Banking Union and the central function of the European Central Bank (ECB) in both areas. It offers a historical background to the development of European Union (EU) level prudential supervision on the basis of the Treaty on the Functioning of the European Union (TFEU) and examines issues at the intersection between monetary policy and banking supervision. Relatedly, financial stability is discussed as a public good that informs both areas of ECB activity. The chapter further examines difficult organizational choices, arising from the development of a Banking Union not foreseen in the Maastricht Treaty (which only included an ‘enabling clause’): Should the same institution (ie, the ECB) have both monetary and prudential competence? If so, what governance arrangements are necessary for this institution, also given that final authority over all matters rests with the Governing Council according to the Treaty itself?

This chapter discusses the Basel III capital requirements. Following the 2008 financial crisis, the Basel Committee on Banking Supervision issued reform proposals for capital regulation, entitled “Basel III,” as part of a series of initiatives sponsored by the Group of 20 (G20) nations. The centerpiece of Basel III is a series of amendments to the capital adequacy standards embodied in the worldwide framework for capital regulation created by Basel I and extensively revised and expanded under Basel II. These amendments specify three broad revisions to the Basel I and II architecture: (1) increases in minimum mandatory bank capital requirements; (2) new measures to control countercyclicality in capital regulation; and (3) new restrictions on what instruments qualify as capital and adjustments to risk-weightings.

This chapter examines the ongoing revisions to Basel 2, the international standards for banks' regulatory capital developed by the Basel Committee on Banking Supervision (BCBS) to replace the 1988 Basel Capital Accord (Basel 1), and their implications for developing countries. The 2006 text of Basel 2 had been considered closed before the credit crisis which began in mid-2007. This crisis has indicated major shortcomings in the regulatory framework for financial institutions which are now the subject of an agenda of wide-ranging reform. Strengthening Basel 2 is an important item on this reform agenda. This chapter considers two of the major subjects of the revisions of Basel 2: the rules for securitization exposures and the Market Risk Framework. It argues that the Basel 2 rules may engender new problems in the future, citing the possibility that banks may be exposed to risks associated with cross-border asset-backed investments as well as investments linked to operations in their own financial markets.

This chapter looks at the relationship between the home and host when it comes to resolution of banks. Specifically, it analyses the responsibilities of each when it comes to branches and subsidiaries. This essentially leads to two potential outcomes: group resolution and entity level resolution. The resolution colleges play an important part in informing resolution decisions. However, a significant level of discretion exists and the home resolution authority can play a role that influences the way information is shared. The chapter then explores the role of the ECB and the Single Resolution Board (SRB) in forming the decision of whether a bank is failing or likely to fail. It specifically considers the ability to intervene in the restructuring of banks inside resolution.

This chapter discusses the interconnected nature of cross-border banking between European Union (EU) Member States in terms of counterparty credit risk exposure at both country and institutional level. The Bank for International Settlements (BIS) consolidated data shows how inflows and outflows of loans and deposits are impacted by events over time. The potential impact of the bank legal form is also important: significant assets held by a branch, as opposed to a subsidiary, lead to different levels of exposure to the home and host Member State. The chapter then shows that cross border banking integration across the EU Member States is not homogenous. The size of the foreign bank presence in each Member State is distinct and can potentially give rise to the risk of contagion. Notably, the size of branch presence rather than subsidiary presence in a respective member state offers an indication of the extent it’s financial system is exposed to systemic spillovers from either the home or host state.

This chapter looks at the division of power and accountability structures in the European Banking Union, the principal emphasis being on political accountability. Other types of accountability are also examined where appropriate (e.g. budgetary, administrative, or legal accountability). The discussion begins with the division of competence between the national and EU authorities in the Banking Union. This is followed by examination of the role of the European and national parliaments, as well as the Council and Eurogroup, in holding the European Central Bank, the Single Resolution Board, and the national supervisory and resolution authorities to account for their actions in this area. The focus then shifts to the intra-institutional balance of power and the emerging patterns of geographical fragmentation. The penultimate section of the chapter focuses on access to information, which is crucial for all forms of accountability. The final section of this chapter offers a snapshot of some of the features of the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) which may hamper the effectiveness of the Banking Union and place its output legitimacy in jeopardy. The chapter concludes with proposals on how to strengthen accountability and transparency in the Banking Union.