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UNCLAS SECTION 01 OF 05 FRANKFURT 000312 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EUR PDAS, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY ALSO FOR ICN COX, HULL 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT:  EU Financial Supervisory Framework: Standing on 
the Edge of the Future 
 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
¶1. (SBU) Summary:  The EU-wide financial supervisory 
framework created and made operational in less than three 
years is about to come into its own.  The three new 
supervisory committees, the Committee of European Securities 
Regulators (CESR), the Committee of European Banking 
Supervisors (CEBS) and the Committee of European Insurance 
and Occupational Insurance Supervisors (CEIOPS) will play a 
central role in implementing recent legislation that has 
basically retooled the EU financial services framework. 
CESR, the oldest of the three, is leading the way.  In one 
paper CESR laid out its implementation activities and, in a 
separate provocative think piece, asks the question, "What 
if intensifying coordination among national supervisors is 
not effective?"  One possible answer: give "the Network" of 
national supervisors legal and supervisory powers to deal 
with trans-EU issues.  This is like standing on the edge of 
the future. 
 
¶2. (SBU) The European financial industry has cut through 
practical, legal and political niceties by calling for the 
creation of a lead regulator.  While this has attracted push 
back from CEBS and the European Central Bank (ECB), the 
recently approved Capital Adequacy Directive (CAD III) 
incorporates the concept of "coordinating supervisor," a 
possible step along the way to a lead supervisor.  Ensuring 
political accountability will be essential before the EU 
progresses to a unified supervisor.  The idea, however, is 
irresistible to some.  Deutsche Bank, for example, welcomes 
the current trend and is dusting off its old piece: A 
European Financial Supervisory Authority - A Matter of When, 
Not If." End Summary 
 
Committee Creation: Back Waters No Longer 
----------------------------------------- 
 
¶3. (SBU) In a short three and a half years CESR, CEBS, and 
CEIOPS, each composed of all relevant member state 
supervisors, have been created and become operational.  CESR 
was the first.  Created in June 2001, CESR was conceived 
upon a recommendation by a group of wise men led by 
Alexander Lamfalussy (the Lamfalussy Group).  Lamfalussy, 
who headed up the precursor to the ECB, reasoned that 
knitting European financial markets closer together would 
require a flexible regulatory process to respond to dynamic 
markets and close cooperation among national supervisors to 
ensure uniform implementation on a pan-EU scale.  Finance 
Ministers replicated this basic approach in agreeing at the 
end of 2002 to create CEBS and CEIOPS. Like CESR,  CEBS and 
CEIOPS were matched by regulatory committees composed of 
Finance Ministry representatives.  The Financial Services 
Committee, which reports to ECOFIN, takes an overview and 
sets strategic directions.  Details of CEBS and CEIOPS took 
a while to resolve.  Both opened their doors for business in 
the fall of 2004. 
¶4. (SBU) Granted, each of these committees had precursors. 
What is different is that they all have a formal role in 
providing advice to the Commission on Financial Legislation 
and Regulation, and in ensuring consistent implementation of 
EU legislation in member states.  The European Council's 
Stockholm Resolution that gave birth to CESR states that 
"national regulators and CESR should also play an important 
role in the transposition process by securing more effective 
cooperation between supervisory authorities carrying out 
peer reviews and promoting best practices, so as to ensure 
more consistent and timely implementation of community 
legislation in member states."  Precursor supervisory 
committees were largely voluntary, with no space or only a 
small space in the formal EU regulatory framework.  All this 
is about to change. 
 
Long "To Do List:" Implementation Begins 
---------------------------------------- 
 
¶5. (SBU) Implementation of legislation now has become the 
focal point for EU financial services activities.  The 
Financial Services Action Plan has retooled basic elements 
of EU securities legislation and now will have to be 
implemented.  CESR is helping with the implementation of the 
Market Abuse and Prospectus Directives, the Regulation on 
International Accounting Standards, and amendments to the 
Directive on Undertakings in Collective Investments in 
Transferable Securities (UCITS).  In the wings is 
implementation for the more recently adopted Directives on 
Markets in Financial Instruments (MiFID) and on 
Transparency. 
 
¶6. (SBU) Even though their legislative list is not as long 
as CESR's, the other two committees will have responsibility 
for implementing major new directives.  CEBS is beginning 
its implementation work for the Capital Adequacy Directive 
(CAD III) that will fundamentally change risk capital 
assessments for financial institutions.  CAD III is being 
finalized by the Council and is pending in the European 
Parliament.  CEBS is designing a common reporting framework 
for capital requirements and the solvency ratio, has 
published draft guidelines on the supervisory review 
process, and introduced "prudential filters" aimed at 
neutralizing the effects of new accounting standards on 
regulatory capital.  CEIOPS is gearing up to provide advice 
for the Commission's major rewrite of capital adequacy rules 
for insurance firms (Solvency II).  The Commission is likely 
to make a proposal in 2006 or early 2007. 
 
Implementation:  Where the Rubber Hits the Road 
--------------------------------------------- -- 
 
¶7. (SBU) The logic of an integrated financial market is that 
all players to follow the same rules.  This can help ensure 
healthy competition and a relatively efficient allocation of 
capital.  In highly competitive and regulated financial 
markets, this also implies that the rules be enforced in the 
same way.  Lax enforcement might be considered to gain a 
competitive advantage, like an "off-shore" financial center. 
Such an approach would put a quick end to "mutual 
recognition" of one member state's supervisory surveillance 
by another, the cornerstone of the internal market. 
 
¶8. (SBU) CESR has done the most public thinking on this 
topic.  In a paper released at the end of October, CESR used 
three groups to categorize its implementation functions (so- 
called "Level 3" functions, Level 1 being the directives, 
Level 2 being the implementing measures regulations or 
follow up directives, and Level 3 being the nitty gritty of 
issuing rule books and supervisory guidance explaining how 
firms are expected to comply with the directives and 
regulations).  These are: (1) coordinated implementation of 
EU law; (2) regulatory convergence; and (3) supervisory 
convergence. 
 
¶9. (SBU) Coordinated implementation involves the legal 
transposition of directives into national laws and their day- 
to-day application.  CESR has established a Review Panel to 
carry out peer reviews using correspondence tables detailing 
how directives are being implemented in each member state. 
CESR members are to provide a self-assessment on their 
implementation.  The Review Panel will offer an opinion and 
suggestions for common approaches to implementation.  The 
correspondence tables, assessments and opinions would be 
made public.  To ensure consistent enforcement in all member 
states CESR has recommended that CESR members be granted 
equivalent rulemaking and enforcement powers by their 
respective national authorities. 
 
¶10. (SBU) Regulatory convergence is defined by CESR as 
creating common approaches.  Each supervisor takes decisions 
that create a body of jurisprudence in its jurisdiction. 
Acting together, CESR notes that its members can decide on 
common approaches that could be memorialized in meeting 
minutes, indicative guidance, or regulatory recommendations. 
These would not have the status of EU law, but be 
implemented on a "voluntary basis" by all supervisors. 
Areas that are subject to such regulatory convergence need 
not be covered by EU law, in CESR's opinion.  CESR's recent 
standards on clearing and settlement developed together with 
the ECB are an example. CESR also has worked on guidelines 
on implementation of the Market Abuse and Prospectuses 
Directive and has begun work on guidance for certain mutual 
fund issues. 
 
¶11. (SBU) Supervisory convergence relates to how supervisors 
approach the practical operation of rules and legislation. 
This means strengthened cooperation in practical ways.  One 
is to pull together provisions in directives that mandate 
mutual recognition and cooperation into one consolidated 
text.  CESR thinks this would serve as the basis to handle 
all situations requiring cooperation among supervisors.  In 
another practical implementation measure, CESR plans to set 
up a "mediation mechanism by its peers" to provide an 
acceptable solution where "home" and "host" supervisors 
disagree.  Joint supervisory visits and investigations by 
CESR members and compiling "EU jurisprudence" in a database 
of national decisions are other CESR initiatives to 
strengthen cooperation and, thereby, supervisory 
convergence. 
 
¶12. (SBU) CESR develops these ideas further in another, 
provocative thought piece entitled "Preliminary Progress 
Report: Which Supervisory Tools for the EU Securities 
Markets?"  This paper, referred to as the "Himalayas 
Report," given its lofty perspectives, elaborates the three 
categories of implementation functions cited above.  CESR 
sets the tone by proclaiming its "serious objective" is to 
"enhance its role as the `supervisor of national 
supervisors.'"  In this regard CESR suggests that its 
network of supervisors might consider more systematic peer 
reviews on member state implementation with "mission teams" 
making assessments and CESR publishing results where 
implementation is inadequate. 
 
¶13. (SBU) A more robust mediation mechanism could require 
mediation where there are disagreements or lack of 
cooperation among supervisors. 
 
¶14. (SBU) In the Himalaya paper CESR ventures onto the area 
of supervision of trans-European activities, such as 
investment firms, raising questions as to whether 
cooperation can be efficiently executed by many separate 
authorities, particularly in a financial crisis situation. 
Other areas demanding a possible pan-EU approach include 
public offerings, standard mutual funds, the application of 
accounting standards for listed companies, the regulation of 
credit rating agencies, and trans-European market 
infrastructures (exchanges and clearing and settlement 
systems).  CESR muses whether its network should take single 
EU decisions on such matters.  Backing up a bit from the 
edge, CESR reflects that a "trans-national" option is risky 
and should not be attempted unless the present system cannot 
provide proper solutions to supervisory convergence. 
Different local laws, regulatory powers and jurisdictions, 
and political accountability at the EU level present real 
obstacles to a pan-EU solution. 
 
Industry: Leading the Way to the Lead Supervisor? 
--------------------------------------------- ---- 
 
¶15. (SBU) The European Financial Services Roundtable (EFSR) 
cuts through the worrisome details and recommends that the 
trans-national option be exercised now, calling for a "lead 
supervisor for prudential supervision of cross-border 
financial institutions."  The EFSR proposes that the lead 
supervisor would be the single point of contact for the 
financial institution within the prudential supervisory 
framework, receiving all reports, validating and authorizing 
internal models, approving capital and liquidity allocation, 
and approving cross-border set up of specific functions. 
Local supervisors would be involved in supervision based on 
delegated authority from the lead supervisor.  The lead and 
local supervisors would set up "colleges" to advise the lead 
supervisor, and the relevant supervisory committees, such as 
CEBS, could mediate any disagreements. In the Roundtable's 
opinion, the lead supervisory regime will not only improve 
the quality of supervision at an acceptable cost, but also 
be an important catalyst for convergence of supervision 
towards best practices. 
 
Dutch Nudge: Just Thinking Out Loud 
----------------------------------- 
 
¶16. (SBU) The Dutch Presidency gave the notion of lead 
supervision a bit of a nudge.  In a November seminar on 
"Enhancing Supervisory Convergence," Dutch Finance Minister 
Zalm raised questions as to whether present coordinating 
mechanisms were effective, delivering as promised, and 
efficient.  He opined that different supervisory practices 
in different member states can "cause market distortions." 
Good supervisory arrangements, in his judgment, should 
stimulate rather than hamper the integration of European 
financial markets.  Noting that national supervisors can 
only operate under national mandates, he mused whether there 
should be "thinking about more European solutions for 
supervision of truly European financial groups.  Although we 
should not try to cause a revolution here, we are likely to 
see an evolution towards more European supervisory 
structures." 
 
CAD III Coordinating Supervisor:  Planting the Seed 
--------------------------------------------- ------ 
 
¶17. (SBU) The proposed CAD III contains a potential seed for 
a lead supervisor.  According to the Commission's proposal 
draft, the coordinating supervisor is the member state 
authority that has responsibility for supervision of a 
financial institution on a consolidated basis.  This 
supervisor needs to work with other relevant authorities of 
jurisdictions in which the institution is present to 
validate technical aspects of CAD III.  Such aspects include 
the risk-weighted exposure amounts using the Internal 
Ratings Based Approach, the estimates of loss given 
defaults, and the use of Advanced Measurement Approaches 
based on internal risk measurement systems.  However, if no 
agreement is reached within six months among the 
coordinating and other competent supervisors, the 
coordinating supervisor can make its own determination. 
That determination will apply to the entire institution 
throughout the EU. 
 
¶18. (SBU) This approach encountered opposition.  A member of 
the Bundesbank board, for example, was adamantly opposed, 
citing national responsibility for subsidiaries of parent 
institutions located in other member states.  The ECB, 
however, did not resist.  It observed that there is a large 
gap between what the lead supervisor championed by industry 
and the coordinating supervisor envisioned in CAD III. 
Nonetheless, the challenge is apparent. 
 
¶19. (SBU) The Chairman of CEBS, Jose Maria Roldan, has taken 
up that challenge.  He does not share EFSR's view, 
explaining that rather than having a "one-stop-shop," a 
"more pragmatic approach is needed" within the present 
institutional framework.   Indeed, CEBS staff believe that 
their main objective is to show that more intensive 
cooperation is the solution.  German Finance Ministry 
officials, however, believe the coordinating supervisor 
concept in CAD III as a step toward a single EU supervisor. 
A Dutch supervisor put it another way: if a coordinating 
supervisor approach cannot be made to be effective, then the 
option of going straight to an EU supervisory authority will 
gain currency. 
 
Got the Move, But Not the Political Touch 
----------------------------------------- 
 
¶20. (SBU) In the end, politics hold the key to any trans-EU 
solutions.  The Chairman of the European Parliament's 
Economic and Monetary Affairs Committee livened up CESR's 
December gala by lamented the "democratic deficit" of some 
of CESR's ideas.  Who is in charge of CESR?  CESR is 
sensitive to this issue.  In its Himalaya paper CESR noted 
that it is "firmly determined to develop its political and 
democratic accountability links vis--vis the Finance 
Services Committee, the European Commission and the European 
Parliament." 
 
¶21. (SBU) The Inter-Institutional Monitoring Group (IIMG) 
also is cautious about the politics and the EU 
"institutional balance," meaning power sharing between the 
Commission, Parliament and Member States in the Council. 
The IIMG, composed of representatives from all three EU 
institutions, has endorsed coordinated implementation, 
supervisory convergence and CESR's proposed mediation 
mechanism.  On regulatory convergence, however, it was "more 
reserved."  The IIMG worried that the "multiplication of non- 
binding rules at Level 3 should not lead to a gray area 
where legal certainty is absent and political accountability 
is unclear." 
 
¶22. (SBU) The draft Constitutional Treaty addressed some of 
the political questions.  Article 35 would give the European 
Parliament the right to block the entry into force of 
regulations delegated to the Commission in directives, power 
that the Parliament now has only by the grace of a political 
understanding with the Council.  The Constitution also 
states "where uniform conditions for implementing binding 
Union acts are needed, those acts may confer implementing 
powers on the Commission."  There is no mention of 
Parliament's role or of the accountability of supervisory 
authorities, so some questions still appear to be open. 
 
Comment: 
-------- 
 
¶23. (SBU) If process defines outcomes, the implementation 
phase of EU-wide financial service legislation will be an 
interesting process. Getting the politics right is 
essential.  The power of the idea of regulatory convergence 
would seem irresistible for those that wish the EU to be 
truly an integrated financial market.  The questions raised 
by CESR and Dutch Finance Minister Zalm on the limits of 
national supervisors coordinating to oversee pan-EU 
activities are unavoidable.  Officials at Deutsche Bank 
welcome the trend of the current thinking.  They are dusting 
off their old think piece: "European Financial Service 
Authority - A Matter of When, Not If." 
 
¶24. (U) This report coordinated with Embassies Berlin and 
The Hague and USEU Brussels. 
 
¶25. (U) POC: James Wallar, Treasury Representative, e-mail 
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
7535-2238 
 
Bodde