Banking Supervision in Integrated Financial Markets: Implications for the EU



This incentive or information deficit implies that national authorities
try to optimize supervision without taking negative effects on or deriving
from other EU countries into consideration. This national approach does not
achieve efficient supervision from the perspective of an overall EU optimum as
the probability of failure will be inefficiently high. And as increasing integra-
tion renders cross-country aspects more important, the current supervisory
regime will increasingly deviate from the EU optimum.

In order to adequately align supervisors’ incentives, crossborder coordi-
nation of supervision has to be implemented. The current devices to arrange
bilateral cooperation in practice are Memoranda of Understanding. However,
they fail to make supervisors account for foreign externalities as sanctions
are missing for the case supervisors do not do so. Thus, I argue in favor
of further tightening coordination among national supervisory authorities.
Tighter coordination could most effectively be achieved by means of an EU
”Supervisory Coordination Authority” to which national supervisors would
be accountable. Such an authority would review and evaluate national su-
pervisory procedures. In case of disapproval, adequate sanctions would have
to be designed to guarantee compliance which the supranational scheme. In
order to minimize political opposition to delegate sovereign rights to the EU,
the new committee could be based at a well-established instance with rep-
utation in the field of supervision. Hence, I bring forward the argument
that the current mandate of the Banking Supervision Committee, located at
the European Central Bank, should be expanded in such a way that it can
function as a guiding instance for the national supervisory authorities.

This paper is structured as follows. In section 2, I give details on the
institutional design of supervision in the EU. In section 3, building on earlier
work by Giammarino, Lewis, and Sappington (1993), I develop an analytical
framework to study how a benevolent regulator-supervisor would optimally
regulate and monitor a bank which is prone to moral hazard. In section 4, I
deduce the optimal regulatory and supervisory scheme for a closed banking
system. In section 5, I show how a nationally optimal regulatory and super-
visory regime deviates from the international optimum. In section 6, I draw
conclusions for the optimal supervisory design within the EU. In section 7, I
conclude.

2 Implementation of Supervision in the EU

In the EU, capital regulation is implemented on a supranational level: The
Basel Capital Accord of 1988 has come into effect via the Solvency Ratio
(89/647/EEC) and Own Funds (89/299/EEC) directives and is, thus, bind-



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