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Bank regulation in the European Union neighbourhood: limits of the ‘Brussels effect’

Summary:
The EU model of financial market regulation is increasingly copied by third countries. In this context, the EU’s efforts to promote its model beyond its borders should take into account the underdevelopment of financial markets in many partner countries, and the often insufficient capacity of regulators and supervisors. By: Alexander Lehmann Date: November 20, 2019 Topic: European Macroeconomics & Governance The EU’s policy in its neighbourhood in eastern Europe has for some time been to encourage countries to bring their regulatory standards into line with those of the single market, in exchange for increased access to EU markets.In financial services, this policy is motivated by the need to prevent financial instability being imported from third countries into the single

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The EU model of financial market regulation is increasingly copied by third countries. In this context, the EU’s efforts to promote its model beyond its borders should take into account the underdevelopment of financial markets in many partner countries, and the often insufficient capacity of regulators and supervisors.

By: Date: November 20, 2019 Topic: European Macroeconomics & Governance

The EU’s policy in its neighbourhood in eastern Europe has for some time been to encourage countries to bring their regulatory standards into line with those of the single market, in exchange for increased access to EU markets.

In financial services, this policy is motivated by the need to prevent financial instability being imported from third countries into the single market. For this reason, advanced countries can seek formal recognition that their regimes are ‘equivalent’ to the EU’s. But in emerging markets and developing countries, wholesale adoption of EU legislation runs up against the weaknesses of local supervisors, and might also result in the introduction of legislation that is irrelevant in underdeveloped financial markets.

The trade agreements that the EU concluded with Georgia, Moldova and Ukraine in 2014 are examples of this EU approach. The three agreements envisage regulation in the partner countries converging with that of the EU and set schedules for this to happen. Included in the schedules are the core elements of prudential rules for banks and all EU legislation on the payments system and capital markets in effect at the time the trade deals with concluded, with new EU legislation incorporated on a rolling basis. In the agreement with Ukraine, there is clear language tying access to the EU market to Ukraine’s adoption of legislation that is sufficiently close to the EU’s.

The countries of the western Balkans, meanwhile, are interested in regulatory convergence with the EU given the deep engagement of euro-area banking groups in local banking markets. For these countries, foreign-owned subsidiaries command a significant share of local banking assets, though these subsidiaries are typically small within the overall assets of the parent groups. The concerns of the host country supervisor may not figure prominently within a college of supervisors assessing the soundness of the entire group.

In 2015, six western Balkan countries signed a memorandum of understanding with the European Banking Authority (EBA). This settled the thorny issue of confidentiality in information exchange and has already facilitated cooperation in supervisory and resolution colleges. There are broad requirements for these countries to bring their regulatory and supervisory standards in line with the EU’s, but specifics and timeframe depend on host-country market development. In a sign of this close integration Serbia and Albania signed cooperation agreements with the Single Resolution Board, the only countries to do so apart from five major G20 economies.

In the four EU accession candidates (Serbia, Albania, Montenegro and North Macedonia) the European Commission has assessed the local financial sectors as “moderately prepared” to take on the obligations of EU membership. In Serbia and Montenegro, accession talks have started on the relevant chapters. Serbia and Albania adopted laws on bank recovery and resolution in 2015 and 2017 respectively. Both laws closely follow the model defined by the EU bank recovery and resolution directive (BRRD, 2014/59/EU), though requirements for the bail-in of bank creditors are very different, and the rules of implementation of course diverge from the EU’s.

Constraints in local markets and institutions

Exporting EU regulation to third countries irrespective of the broader development of institutions and laws will not automatically yield equivalent benefits in terms of financial stability as in the EU itself. Inadequate accounting standards and creditor rights might undermine this. In capital markets regulation a high standard law may, in fact, be counterproductive without good enforcement.

Some instruments that are central to recent EU legislation might be missing entirely in local markets, such as the requirements for subordinated bank debt that could be subject to a bail-in based on well-defined creditor hierarchies, if a bank has to be resolved. Other EU targets may be out of line with local market development (such as the level of deposit insurance coverage). Capital markets in EU neighbourhood countries are even less developed than banking sectors, and adopting some recent EU legislation (such as the Directive 2014/65/EU on markets in financial instruments, MiFID II) would be well out of proportion.

More practically, local supervisors might lack the resources to enforce complex regulation. Some evidence of this emerged in the November 2019 update of the World Bank database on practices in bank regulation and supervision. Across the 160 countries surveyed, there have been significant increases in the number and complexity of regulations since the global financial crisis. This has not been matched by an increase in supervisory powers and capacity. Rules on disclosures and stress testing of bank assets place particularly severe strains on supervisors.

Source: Bank Regulation and Supervision Survey, World Bank, Nov. 2019.

Brussels might, therefore, be risking the unilateral imposition of EU rules on third countries and thereby discriminating against market participants originating in jurisdictions with incompatible standards.

However, this seems less of a concern in banking regulation than in product standards. EU banking regulation, on the whole, reflects international standards, most importantly the Basel III framework and the resolution regime promoted by the Financial Stability Board. These are in essence sensible targets, though the timeframe for adoption should be proportionate to the development of markets and institutions.

But the effort to promote in emerging markets financial regulation that resembles that adopted in the EU since the financial crisis should be focused on those countries where euro-area banks already have extensive stakes, primarily emerging Europe and Latin America. There is also a justified interest in aligning supervisory practices, which will facilitate the coordination of cross-border supervision and crisis management.

In the four western Balkan candidates for EU membership, cooperation and information exchange in the cross-border colleges could be further strengthened. Local supervisors could be strengthened through targeted technical assistance. Given the extensive stakes of euro-area banks, the interests of home and host-country authorities are likely aligned. A strong local framework will also define standards for new investors – such as those from Russia and China – in the local banking markets.

It is not clear that convergence with technically complex EU financial regulation should be a condition for preferential market access under trade agreements. Local market development should be taken into account. For Georgia, Moldova and Ukraine, the obligation to ‘approximate’ their laws to the EU standard should be interpreted flexibly, focusing on principles rather than transposition. Deadlines for the adoption of EU legislation should be scheduled in line with countries’ own regulatory strategies, and new EU law should be adopted only when relevant and sensible for local market development and financial stability.

Alexander Lehmann
Alexander Lehmann, a German citizen, joined Bruegel as a visiting Fellow in October 2016 and is now a non-resident fellow. His work focuses on financial integration and regulation. Currently he is also engaged as adjunct professor at the Hertie School of Governance in Berlin, and as a member of the German Economic Team in Belarus and Georgia.

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