Fears of cross-border European crisis grow

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A couple of weeks ago, Peter Praet, a senior official at the Belgium central bank, made a striking observation during a conference at the London School of Economics. Speaking in relation to the worsening credit woes, he pointed out some financial experts feared that “if a major [European] institution were to get into trouble, the institutional mechanisms that are in place could be too weak to handle this”.

The concern is now being echoed with a vengeance in the markets. For as the crisis spreads, it is exposing institutional shortcomings in the regulatory pillars that underpin the financial system.

Today the spotlight is on the US, where the Bear Stearns crisis has exposed the structural flaws left over from the Glass-Steagall era’s regulatory separation of commercial and investment banks. Last autumn the focus was the UK, where the Northern Rock crisis revealed structural and operational weaknesses. Some experts fear continental Europe could be next – not least because of its fragmented political structure.

Some of these flaws are global in nature, such as the use of capital requirements that encouraged off-balance sheet financing or mark-to-market accounting systems that now look dangerously pro-cyclical.

In recent years regulators worldwide have grappled with the fact that the regulatory system has been evolving far slower than the financial sector – meaning that when a crisis strikes, regulators and central banks are forced to create policy on the hoof.

However, the manifestation of these regulatory flaws varies across the Atlantic.

Until last September there was widespread admiration for the UK system of financial regulation, which separates the powers of bank supervision, responsibility for financial stability and the exchequer. But when a crisis broke at Northern Rock it exposed two flaws. First, the three bodies failed to operate and communicate effectively over the quantity of general support to the market that the Bank should provide. Second, it exposed the lack of a special insolvency regime for banks and inadequate depositor protection.

Sunday’s decision by the Federal Reserve to create an emergency finance facility for primary dealers exposes another problem: the impossibility of denying systemically important investment banks access to emergency liquidity at a time of market crisis.

Moreover, the current pattern of regulatory fragmentation in the US – another legacy of Glass-Steagall – means the moral hazard problem created by the move is amplified. Most notably, the net result of Sunday’s decision is that the Fed is providing emergency liquidity to a set of institutions it does not regulate.

However, the biggest potential future worry is in Europe, where there is no roadmap for dealing with a cross-border European banking crisis.

If a crisis broke at a cross-border bank, it is unclear which authority would take charge or how the costs of a bail-out might be shared.

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