VZCZCXRO8077
PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHPOD RUEHROV RUEHSR
DE RUEHBS #0290/01 0621412
ZNR UUUUU ZZH
P 031412Z MAR 09
FM USEU BRUSSELS
TO RUEHC/SECSTATE WASHDC PRIORITY
RHEHNSC/NSC WASHDC PRIORITY
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE
RUCNMEU/EU INTEREST COLLECTIVE

UNCLAS SECTION 01 OF 03 BRUSSELS 000290 
 
SIPDIS 
 
NOT FOR INTERNET DISTRIBUTION 
 
E.O. 12958:  N/A 
TAGS: EFIN ECON ETRD EIND EINV EUN
SUBJECT: DE LAROSIERE REPORT ON THE FUTURE OF EU FINANCIAL 
REGULATION AND SUPERVISION 
 
¶1. (U) In November 2008, EC President Barroso tasked Jacques De 
Larosiere with leading a group to make recommendations on the future 
of EU financial regulation and supervision.  The group released 
their report on February 25.  The report addresses four issues: 
causes of the financial crisis, policy and regulatory repair, EU 
supervisory repair, and global repair. 
 
¶2. (U) The report proposes a framework for moving the EU towards: a 
new regulatory agenda (reducing risk; improving systemic shock 
absorbers; reducing pro-cyclicality), stronger coordinated 
supervision (both macro-prudential Qd micro-prudential), and 
effective crisis management.  The key recommendations are: 
 
--Basel 2 should be reformed to increase minimum capital 
requirements and reduce pro-cyclicality; 
--Mark-to-Market rules should be reviewed and IASB's governance 
should be further opened; 
--To improve macro-prudential supervision, a European Systemic Risk 
Council (ESRC) should be created.  Focusing on systemic risk, the 
ESRC will include all EU 27 CB governors and be chaired and staffed 
by the ECB. 
--To improve micro-prudential supervision, a European System of 
Financial Supervision (ESFS) should be created.  The ESFS will bring 
together national supervisors - who will continue to do day-to-day 
supervision - with enhanced level 3 committees.  The enhanced level 
3 committees will be given the power to pursue binding mediation in 
case of disagreement between supervisors. 
 
Chapter I: Causes of the Financial Crisis 
----------------------------------------- 
 
¶3. (U) The report notes that ample liquidity and low interest rates 
- amplified by financial innovation - were the major factors behind 
the current crisis.  In the U.S., very low interest rates, 
unregulated mortgage lending and insufficient oversight of the GSEs 
led to a widespread housing bubble.  Low U.S. savings rates, 
accompanied by the accumulation of huge global imbalances, led to a 
rapid expansion of credit in the U.S. and depressed yields as 
surplus countries recycled their surpluses into U.S. assets. 
 
¶4. (U) In this environment of high liquidity and low yields, 
investors sought higher returns through increasing leverage and 
investment in more risky assets, leading to a mispricing of risk. 
Both financial institutions and supervisors overestimated the 
ability of firms to manage the risks they faced, leading them to 
underestimate the amount of capital they should hold.  This was 
exacerbated by: a lack of transparency and increase in the size of 
the "shadow" banking system, which made it difficult to identify the 
size and location of credit risks; failure of model based risk 
assessments to estimate exposure to common shocks and tail risks; 
and, the perverse incentives created by the originate-to-distribute 
model. 
 
¶5. (U) When tightening U.S. monetary policy from mid-2006 led to the 
bursting of the U.S. subprime bubble, the pro-cyclical nature of the 
regulatory framework led to a downward spiral of prices as 
mark-to-market rules led to increasing asset sales at ever lower 
prices.  A lack of market transparency, combined with the sudden 
downgrade of credit ratings and the U.S. decision not to save Lehman 
Brothers, led to a breakdown in trust and a crisis of confidence in 
the markets.  The EU's regulatory response was weakened by an 
inadequate infrastructure for crisis management. 
 
Chapter II: Policy and regulatory repair 
---------------------------------------- 
 
¶6. (U) Given that global financial services regulation did not 
prevent the crisis, a profound review of regulation is required. 
The main recommendations of the report are:   --Basel 2: The BCBS 
should urgently amend the rules to: (1) gradually increase minimum 
capital requirements; (2) reduce pro-cyclicality; (3) introduce 
stricter rules for off-balance sheet items; (4) tighten norms on 
liquidity management; and, (5) strengthen the rules for bank's 
internal control and risk management. 
--Credit Rating Agencies (CRAs): The underlying economic model of 
CRAs needs to be reviewed in order to reduce conflicts of interest - 
particularly from the "issuer pays" model.  The use of ratings in 
financial regulations should be significantly reduced over time. 
CESR should be put in charge of registering and supervising CRAs in 
the EU. 
--Mark-to-Market (MTM): Given the strongly pro-cyclical impact of 
MTM, IASB needs to work towards an international consensus on when 
MTM should - and should not - be applied.  To successfully promote 
financial stability, IASB needs to open up more to regulatory, 
supervisory and business views and its oversight and governance 
should be strengthened - particularly by giving the regulatory 
community a seat on its board 
--Hedge funds: Regulation should be extended to all entities of a 
 
BRUSSELS 00000290  002 OF 003 
 
 
potentially systemic nature.  Registration and information 
requirements should be imposed internationally on hedge funds. 
--Over the Counter (OTC) derivatives: OTC derivatives should be 
simplified and standardized to reduce risk.  At least one Central 
Clearing Counterparty (CCP) for CDS should be located in the EU, 
supervised by CESR and the ECB. 
 
Chapter III: EU supervisory repair 
---------------------------------- 
 
¶7. (U) The current structure of EU supervision places too little 
emphasis on macro-prudential supervision.  A European Systemic Risk 
Council (ESRC) should be created and given responsibility for 
macro-prudential supervision.  Operating under the auspices and with 
the logistical support of the ECB, the ESRC would be composed of the 
members of the ECB/ESCB General Council (President of ECB, VP of 
ECB, Governors of the 27 Central Banks), Chairs of CEBS, CEIOPS and 
CESR and one representative of the EC. 
 
¶8. (U) The ESRC would collect and analyze all information relevant 
for financial stability.  It would work closely with - and ensure 
information flow with - micro-prudential supervisors.  The ECB 
should not, however, be given a role in the micro-prudential 
supervision of cross-border or systemically important financial 
institutions, as some have suggested. 
 
¶9. (U) To improve micro-prudential supervision, a European System of 
Financial Supervision (ESFS) should be created.  The ESFS would be 
an integrated system of European financial supervisors working with 
enhanced level 3 committees.  The level 3 committees (CEBS, CEIOPS, 
and CESR) would be eventually transformed into new "Authorities": a 
European Banking Authority, a European Insurance Authority, and a 
European Securities Authority. 
 
¶10. (U) Under the ESFS, existing national supervisors would carry 
out day-to-day supervision.  The enhanced level 3 committees would 
coordinate application of supervisory standards, guarantee 
cooperation between supervisors, and guarantee that the interests of 
host supervisors are properly safeguarded.  Colleges of Supervisors 
would be set up for all major cross-border institutions.  The ESFS 
would have a binding mediation mechanism - run by the new 
"Authorities" - to deal with cross border supervisory 
disagreements. 
 
¶11. (U) The introduction of the ESFS would follow a two-stage 
process: 
--Stage 1 (2009-10): focusing on preparing for the transformation of 
the level 3 committees into "Authorities" and upgrading the qualit 
of supervision 
 
--Stage 2 (2011-12): estabishing the "Authorities" and giving them 
the power to pursue legally binding mediation between national 
supervisors, directly supervise some EU-Wide institutions (such as 
CRAs), and represent the EU internationally with third countries on 
supervision. 
 
Chapter IV: Global repair 
------------------------- 
 
¶12. (U) The EU has an interest in the worldwide consistency of 
regulatory standards.  The Financial Stability Forum (FSF) is the 
body best placed to coordinate the work of international standard 
setters in achieving international regulatory consistency.  To be 
able to play this role, the FSF needs more resources and a stronger 
governance structure.  It should be made more accountable by 
reporting regularly to the IMF and by enlarging its membership to 
include all systemically important countries as well as the European 
Commission.  The FSF should report regularly to the IMFC and the 
IMFC should be transformed into a decision-making Council. 
 
¶13. (U) The IMF should be put in charge of developing and operating 
a financial stability early warning system, accompanied by an 
international risk map and credit register.  FSAPs should be made 
compulsory for all IMF members. 
 
¶14. (U) The EU's representation in international organizations and 
bodies is currently fragmented.  It is essential to organize 
coherent EU representation.  Regarding the IMF, in the context of an 
institutional and quota reform constituencies could be rearranged 
and the number of EU Executive Board members reduced to no more than 
two. 
 
Outlook - EU G-20 position and FSAP III 
--------------------------------------- 
 
¶15. (U) The European Commission is currently preparing a response to 
the De Larosiere report, which will be discussed at the ECOFIN on 
March 10 and the European Council on March 19-20.  The Commission is 
 
BRUSSELS 00000290  003 OF 003 
 
 
expected to endorse much of the report.  If Member States support 
the report's conclusions, Barroso reportedly hopes to use its 
principles to form the kernel of a common EU position on reforming 
financial services at the G-20 Summit in London. 
 
¶16. (U) Assuming Member State support, the Commission will work on 
turning the report's proposals into draft legislation over the 
summer, with the intention that the new Commission entering office 
in Fall 2009 would seek to have it enacted into law.  These 
regulatory and supervisory proposals would form the core of a new 
Financial Services Action Plan - or FSAP III. 
 
MURRAY