ECB Paper Examines Impact of Regulatory Options and Discretions in EU

Prior to the financial crisis, prudential regulation in the EU was implemented non-uniformly across countries, as options and discretions allowed national authorities to apply a more favorable regulatory treatment. The authors of the paper construct cross-country indicators of the effectiveness of the prudential framework for banks in the EU ahead of the global financial crisis. The authors investigate the national implementation of CRDs and derived a country-wise measure of regulatory flexibility (for all banks in a country) and of supervisory discretion (on a case-by-case basis). The paper also provides information on the measures of public support implemented by EU governments during the period 2008-2010 and classifies the various forms of financial assistance (recapitalization, credit guarantee, and liquidity provision). 

Overall, the analysis suggests that banks established in countries with less stringent national prudential regulation before the crisis were more likely to require government support during the period 2008-2010. The results broadly hold for the indicators of both supervisory discretion and regulatory flexibility, suggesting that the micro-prudential stance of national authorities had relevant implications for the management of bank balance sheets and for the risk-taking incentives of credit institutions. Prudential frameworks also explain banks’ liquidity buffers even in absence of a specific liquidity regulation, which points to possible spillovers across regulatory instruments. The Basel II framework did not include liquidity requirements. The study documents the existence of some regulatory spillovers, since lower liquidity buffers explained by more flexible regulatory frameworks—which established only capital requirements—increase the probability of banks to have been in financial distress. The study also suggests that the composition of liquid assets is important. 

The results show that a prudential environment in which important options and discretions are maintained at the national level is at best not conducive to a better allocation of risk and may actually foster risk-taking. This supports the ongoing efforts aimed at establishing a level-playing field in banking regulation and supervision across EU countries. The introduction of a Single Rulebook, intended to minimize the differences in prudential regulation across EU countries, provides a relevant contribution to reduce the heterogeneities in the risk-taking of credit institutions, by realigning the regulatory incentives on the basis of a common prudential framework.

Related Link: Working Paper (PDF)

Keywords: Europe, EU, Banking, Basel II, CRD, Financial Stability, Options and Discretions, Single Rulebook, Liquidity Risk, ECB