Mr. Mario Nava:

I wish the Chairman, Deputies and the Senator a good afternoon. I am very pleased and honoured to have been invited to the Oireachtas to assist this committee in its inquiry into the banking crisis. I have been asked to provide the European Commission's perspective on the fitness of the European Union regulatory framework for banks and the supervisory policies, systems and practices in the run-up to the financial crisis, the lessons learned and improvements made in the past two years.

The regulatory framework for banks in the EU has evolved considerably over the past 15 years. A number of factors have driven this evolution. These include the need for the EU Single Market, international developments, rapid changes in the banking sector and shortcomings in bank risk management and the regulatory and supervisory framework. The EU regulatory framework takes into account the global standards for prudential regulation and supervision set by the Basel committee on banking supervision. These standards have been updated several times since 1988, most recently in December 2010 when the Basel III standards were adopted. Each of these updates has been implemented in EU law.

In 2000, the EU regulatory framework followed the principle-based approach which was embodied in a minimum harmonisation. Directives were used as the main legislative instruments, setting minimum requirements for prudential supervision. Member states were required to transpose those directives into their respective national legislation.

The use of directives as the main legislative instruments and the minimum harmonisation principle gave member states a degree of flexibility in setting the regulatory framework for banks, as long as they did not go below the minimum standards required by the euro. However, in line with the principles-based approach to regulation, member states typically did not resort to implementing over-prescriptive rules which would provide specific and detailed guidance to supervisors for exercising their duties. During this same period, national supervisory authorities were responsible for applying and enforcing the prudential requirements set out in the directives, which empowered each national supervisory authority to take the steps it considered necessary to implement prudential measures to safeguard the resilience of the banks and to supervise the financial stability of the banking sector as a whole. National supervisors had a considerable degree of discretion to apply stricter requirements than the minimum standards set out by the directives. In other words, nothing in the directives prevented member states and their national supervisors from taking appropriate measures to reduce further the risk of a bank failing or risk to the stability of the financial system as a whole.

The crisis has taught us a great deal about the failure of some European banks to manage their risk prudently and of some national regulators and supervisors to exercise their powers with sufficient rigour. Many studies and reports have been produced to analyse the consequences of the principles-based approaches pursued by national regulators and how national supervisors exercised their oversight and enforcement duties in the pre-crisis period. Reliance on soft and light touch approaches and low supervisory intensity encouraged by the principles-based approach to regulation, inadequate resources and insufficient attention to banks' corporate governance systems represented the most prominent causes of the various supervisory failures observed in several member states. Too often, national supervisors took a narrow focus on credit risk and underestimated the importance of other risks, such as concentration risk, liquidity and funding risks. Too little attention was given to market prudential considerations and effective early warning mechanisms which could have helped national authorities to detect emerging risks early and prevent bubbles from growing.

The EU capital requirement directive, which is known in the jargon as the CRD, was adopted by the European Parliament and the Council in 2006. It required national supervisors to conduct a thorough assessment of the risk management systems and governance of the banks they supervised and to take measures corresponding to the specific risk profile of the banks in question. The directive also stipulated explicit requirements for management of liquidity and concentration risks as well as risks arising from exposures to real estate markets. If national supervisors had used those powers to the full extent, a number of major difficulties could have been prevented. Robust risk management in the governance structure in banks and an effective oversight and control system represented the two indispensable conditions for the success of principles-based regulation. In the absence of those two preconditions, the regulatory effect intended by the directive could not have been delivered.

These deficiencies also revealed important shortcomings in the governance of the institutional framework for supervision itself and it sparked a period of unprecedented reforms in the EU, backed by an international consensus on the causes of the financial crisis and responses needed to address it. The reforms, therefore, had two distinctive dimensions - the regulatory dimension and the institutional dimension. I will discuss them in turn.

On the regulatory side there has been, in line with international developments, a pronounced shift to a more rule based approach, introducing a more detailed guidance in the regulatory framework for the supervisors to ensure that they step up their supervisory scrutiny. As a result, the new regulatory requirements have been made more prescriptive, the coverage of risk has been expanded and the prudential treatment of those risks has been strengthened. These regulatory reforms were carried out in two phases. The first phase, which is called CRD 11 and CRD III, which were adopted in 2009 and 2010, respectively, introduced quick fixes for some of the most pressing deficiencies highlighted by the crisis, namely, liquidity management, large exposures, remuneration, management of securitisation, trading exposures and supervisory co-operation. For example, banks were required to develop robust strategies, policy, processes and systems for the identification, measurement, management and monitoring of liquidity risks and funding positions. In the interbank market, banks were not allowed to lend or place money with other banks beyond a certain amount to limit the risk of contagion, which also increased the diversity of borrowing banks' funding sources. National supervisors were required to review banks' remuneration policies and empowered to impose sanctions if these policies did not meet with the new requirement.

The second phase, which is probably the most well known and goes under the name of CRR/CRD IV in the jargon, was adopted in 2013 and represented a more fundamental revision of the regulatory framework, responding in particular to the review of international prudential standards in the Basel III framework. This includes new rules regarding the quality and quantity of banks' regulatory capital, more detailed and harmonised rules dealing with liquidity, funding risks and excessive leverage, and measures improving banks' corporate governance, including rules realigning incentives. Supervisors have obtained enhanced sanctioning powers and are required to carry out their duties in a more intrusive, intense and forward-looking manner. Particular attention was given to measures improving supervisors' capacity to take appropriate remedial action at an early stage by putting more emphasis on macro prudential consideration.

This latest revision also aims to establish a single rule book to respond to the need for a more harmonised set of rules across the Single Market, to provide a true level playing field on which EU banks can compete. The degree of flexibility previously granted to member states and national supervisors, as I mentioned earlier, had led to divergent transposition of EU rules into national law. This created opportunities for regulatory arbitrage and hampered legal clarity. To achieve greater convergence, various options and discretions have been removed. Most provisions have been moved into the regulation known as CRR and that becomes directly applicable.

Parallel with the new prudential measures to reduce the probability of a bank failure, measures were also necessary to minimise the impact of possible failures and to equip resolution authorities with effective tools to deal with those situations. The new harmonised bank resolution regime embodied in the bank recovery and resolution directive, adopted by the European Parliament and the Council in 2014, was introduced in recognition of the fact that the normal insolvency regimes were not well suited to deal with bank failures. It was also a response to the need to protect certain critical stakeholders, for example, deposit holders, in functions of a failing bank and to reduce moral hazard in banks.

This legislation includes a requirement for banks and resolution authorities to draw up a recovery and resolution plan, gives bank supervisors an expanded set of powers to enable them to intervene in cases where an institution faces financial distress, provides the resolution authorities with a credible set of resolution tools, including bail-in, and improves co-operation between the respective resolution authorities.

Another initiative which should be mentioned in this context is the Commission proposal on banking structural reform dealing with the systemic risk of too-big-to-fail banks heavily engaged in trading activities. The proposal, which is still under negotiation in the Council and in the European Parliament, would provide for a ban on proprietary trading and empower supervisors to separate banks' risky trading activities from their retail operations. That is the regulatory side.

On the institutional side, the crisis demonstrated the need to adapt the institutional framework for financial regulation and supervision to a fast moving and inter-connected banking industry. First, the institutional reforms revolved primarily around the creation of the European Banking Authority. Its creation was necessary to promote convergency of supervisory practices in the EU and to improve communication and mutual trust among supervisors. In addition, the European Systemic Risk Board was created to respond to the failure of the national competent supervisory authorities to anticipate adverse market prudential developments and to prevent the accumulation of excessive risk within the financial system.

Institutional reforms went a step further at the euro area level and led to the creation of a banking union. The crisis clearly showed that in addition to a common set of reinforced rules for our banks, a single and independent supervisor to enforce those rules was also essential. Thus, the Single Supervisory Mechanism was created, with a view to breaking the link between banks and sovereign and ensuring the highest standards of quality and impartiality of supervision.

While the European Central Bank, ECB, has taken over supervisory responsibility for the 120 largest banking groups in the euro area, day-to-day supervision of the smaller banks remains, for reason of efficiency, the task of national supervisors under the general guidance of the ECB.

The second, equally essential, element of the banking union is the single resolution mechanism. The single resolution board, the new single resolution body, will ensure that banks participating in the banking union are resourced, if necessary, in an efficient and centralised way, with minimum impact on taxpayers. The cost of any such resolution procedures will be paid for by the private sectors and backed by a single resolution fund financed by bank contributions.

To conclude, taken together, the reforms I have mentioned represent a significant strengthening of the regulatory and institutional framework underpinning the EU banking sector. It would be presumptuous to claim that these reforms have consigned financial and, in particular, banking crises to history. However, it is undeniable that, if properly enforced, these reforms equip supervisors and the resolution authorities with a more robust set of tools, making a future crisis less likely, and, if one were to happen, less costly. I thank the members and look forward to their questions and the debate.