Banking Regulation and Exchange Rates in the European Union - Essay Example

Banking Regulation and Exchange Rates in the European Union 2009 Introduction The European Union was fully achieved by the Treaty of Maastricht in 1992 that laid the foundations of the establishment of a monetary union and a single currency. Seven major member countries of the European Union, later increasing to eleven, barring the United Kingdom, formed the European Monetary Union and adopted Euro as the single currency on January 1, 1999 and replaced the individual national currencies at the irrevocably fixed exchange rates on that day. By then, trade liberalization between member states had been achieved over a period of three decades since the Treaty of Rome in 1957 during which period each member state carried on with financial deregulation in different degrees. It was recognized that a level playing field between banks of member states could be achieved if there was consensus on the minimal harmonization requirement with the aim of achieving a Single Market Program rather than full harmonization between all member countries, mutual recognition of the rules applied in the other member states and home country control over financial institutions. Despite trade liberalization, it was recognized that explicit barriers to trade existed because of controls over international capital movements, foreign exchange transactions and entry of foreign financial institutions (Bongini, 2003). The European Central Bank (ECB) and the Council of Ministers replaced the central banks of the member countries in matters deciding monetary policies and exchange rates (Lamine, 2006). Free movement of capital among the member states of the European Union had already been introduced through the Treaty of Rome (Article 56). On January 1, 1999, the remaining safeguard clauses in matters of balance of payment (Article 119 and 120 of the EC Treaty) were abolished for the member states that adopted the single currency. On 19 December 2001, regulation 2560/2001 harmonized the costs of domestic and cross-border payments across the Eurozone (Kamerling, 2006). The ECB, formed in 1998, was created on the model of the Bundesbank but also incorporated best practices of other central banks of member countries. It is a supranational entity created as a quasi-governing body hence more independent of state interference than any other central bank. The EU, too, has developed as a “regulatory state” in the sense that it has used regulatory policies to bring about governance in member countries rather than distributive policies since the EU budget has been limited (Quaglia, 2008). Hence, the regulatory authorities of EU have taken up the role formerly associated with the state in interaction with the private sector. Prior to the formation of monetary union, central banks of member states, as those of other countries, had been powerful regulatory agencies directing the flow of the economy and hence international movements of capital and exchange rates. It now fell on the ECB to monitor movements of such economic parameters. In this paper, I will discuss the effect of banking regulation by the European Union on the exchange rate. For the purpose, I will analyze the exchange rate scenarios between member countries before and after the Union. I will begin with the banking regulations, of which capital requirements of banks have been the most important, in the European Union, in accordance to the Basel accords and the laws associated with these. Thereafter, I will discuss the effect of banking regulation on exchange rates before and after the monetary union. Finally, I will discuss specific cases that have been argued on conflicts of exchange rates. Historical account of the evolution of the monetary union The Common Market was established in the European Economic Commission through the Treaty of Rome in 1957. However, besides various disagreements over the Common Agricultural Policy, primarily by France, the lack of a single currency or that of a specific conversion rate, made the aims of the common market was not successful in the initial decades. Besides, the common market enabled increased capital flows between member states. Hence, there were attempts of a unified capital market in Europe in the 1960s (Schenk, 2006). At the time, some of the members of the European Economic Cooperation (EEC) faced balance of payment problems because of which capital convertibility was not pushed through in these countries. At the same time, the biggest capital market in Europe – London – where trade in capital with other member countries of the EEC occurred, was liberalized. As a result, a distinction came into existence between the long term capital flows for the purpose of international trade and the short term flows into the capital markets. The Eurodollar market, followed by the Eurobond market came into existence in 1963 in the London capital market and became great successes across Europe. France reacted with a Eurosterling market in Paris. The Eurocurrency market, of which Eurodollar comprised 70-80 percent, grew to twenty four times the initial amount, the Eurobond replaced US bonds for international transactions and syndicated loans in Eurocredits boomed in the 1960s (Battilossi and Cassis, 2004) However, these markets suffered huge losses following the global financial crisis of 1974. By then, dollar-based American organizations had become the main players in the London Eurodollar market which eventually resulted in strengthening of the American banking system instead of European banking systems. While the domestic financial market in the US was highly regulated, the Fed aimed at increasing the competitive strength of US banks in the international, particularly European arena. Yet, through these financial innovations that continued to exist, the European banks were integrated much more than economies were. Governments of member states of the EEC then wanted to monitor domestic economies to bring about stability while international capital flows between banks continued (Perron and Ambrosius, 2000). The national Eurocurrency markets in Europe were regulated by national governments. The Eurocurrency market also became a major attraction of Middle East funds, which witnessed phenomenal growth particularly after the 1974 oil shock as well as a means of channelizing European and Middle Eastern funds to the US. Hence, the financial innovations in the European financial markets resulted in a boom in the American banking system and weakening of European banks’ competitive strength. In response, major European banks reacted by abandoning the cooperative policies and expanding internationally. As international trade grew to be increasingly dollar-based and American banks grew in supremacy, European countries found their domestic economic policies and balance of payment commitments under the Bretton Woods system under strain. In order to deal with the balance of payments problems of European countries, these countries reached a consensus over the Common Agricultural Policy, which paved the way for a Common Market. The Europeans also increasingly urged for a reform of the international monetary system so that the American dominance in the dollar-denominated system could be reduced. The devaluation of the French franc and the German mark in the late 1960s paved the way for abandonment of the Bretton Woods system (Battilossi and Cassis, 2004). The idea of the single currency in Europe was mooted in the 1960s, first by Jean Monnet in 1961 for the purpose of the common market and then by De Gaulle in 1965 who proposed an international monetary system with gold as the international reserve currency in place of dollar so that Europe could dissociate itself from the economic and hence political domination of the United States. However, the gold standard failed as the Vietnam war resulted in fall of the value of the US dollar and finally with the collapse of the Bretton Woods system in the 1970s paving the way for the monetary union in Europe. By the 1990s, American banks had lost their competitive edge, particularly over their large exposures in developing countries, making it easier for banking regulations to take effect in EU, especially as exchange rates between member states became increasingly volatile (Battilossi and Cassis, 2004). During 1992 and 1993, most of the European currency markets were unstable, much because of Bundesbank’s deflationary policies, after which the European Commission changed the Exchange Rate Mechanism (ERM) by which member states maintained fixed but adjustable exchange rates between themselves. All ERM markets were affected in their equity and discount rate markets every time Bundesbank announced a change in its discount rate (Ghosh and Ortiz). Through the decade, the exchange rate mechanism between European currencies came to be pegged to the German bank and Bundesbank’s policies. The EMS was almost like a fixed exchange rate system against the mark. Therefore, along with the decision to signing the Single European Act in 1986 and the commitment to complete the internal market by 1992, the move towards a single currency was gaining ground. Subsequently, lifting of all capital controls between the member states in 1990 questioned the validity of the ERM any longer (Kenen, 1995). Changes in regulation of banking activities The regulatory system that the European Union put in place with regard to monetary policies, exchange rate and banking regulation policies was the result of shared evolution of the regulatory frameworks in member countries. As the European Economic Community initiated the process of convergence of the trade and financial frameworks, the European Council, as early as 1973, adopted a series of directives that required member countries to harmonize banking regulation. This was followed up by the Banking Coordination Directive of 1977 which required the establishment of capital ratios of all banks within the Union. This became the basis of the post-Basel I EU directive over capital requirements for all banks and credit institutions in the EU. Over the years, the Basel Committee, which reached its first accord in 1998, and the European Union have worked closely to develop an international banking regulation framework (Tarullo, 2008). The formation of the ECB has brought about huge changes in the governance of central banking in member countries. While the Bundesbank had been an independent central bank even earlier, Banca d’Italia had been the least independent prior to the formation of the monetary union. Bank of England, which opted out of the European Monetary Union, too became more independent in terms of legal operations after banking reforms in 1997 and has been offered as an alternative model for banking regulation for the EU (Quaglia, 2008). However, the ECB has followed a rule-based governance policy while central banking policies prior to the Union had been associated with political and economic compulsions. The absence of a cohesive political environment of the EU has made it possible for the ECB to follow a rule-based regulatory policy in terms of monetary authority. Prior to ECB, Bundesbank, among the central banks of member states, had been most successful in terms of monetary targeting as it had been successful in maintaining the inflation rates within control by monetary policies that were mostly free of political interference, which was the case in Italy and France through much of the period between 1960s to 1980s (Quaglia, 2008). The Bundesbank had also been involved in external monetary relations, which had been the primary responsibility of the finance and economic ministries of Germany. In 1973, as the Brettons Woods system became unstable, Bundesbank moved out of the prevailing exchange rate mechanism that required to stabilize the US dollar. From then on, the central bank aimed to keep the monetary policy free from exchange rate fluctuations but that was a difficult policy to be implemented. While the central bank had preferred a flexible exchange rate mechanism over a fixed one, it limited its monetary policy objectives to be aligned with exchange rate movements. Hence, the exchange rate regimes that the ministries developed were based on inputs from the central bank. While the central bank monitored day-to-day management of currencies, it was the federal government that took decisions over devaluing or revaluing the currency. However, the exchange rate policy had a direct effect on monetary policies and price stability so the Bundesbank often exerted pressure on the federal government over particular policies. However, in times of financial crisis, like for example in 1992, the federal government could influence over policies recommended by the central bank. In this particular crisis, for example, the federal German government provided huge currency support to the French franc thereby affecting the exchange rate policy. In essence, the exchange rate policy mechanism in Germany, as in most member countries, before 1999 had been balancing acts between domestic economic and foreign policy objectives. Since the monetary union, the Bundesbank has been attempting to carve out more role in banking regulation but the policy-makers in the finance ministry rather than the central bank has been primarily instrumental in banking regulation policies (Quaglia, 2008). Capital requirement is the most critical aspect of banking regulation, particularly in the context of globalization and high exposure of banks to risky assets, frequently leading to global financial crises, most notable of which has been the recent sub-prime crisis that originated from the United States but spread across the world including the European Union. An agreement on international banking regulation was first mooted by the Basel I Accord in 1998 by the G-7 countries, following up on the Committee on Regulations and Supervisory Practices formed by the G-10 countries (comprising Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the UK and the US) in 1974 after the bankruptcy of the Herstatt Bank that same year, creating significant disturbances in currency markets across the world. Housed in the Bank for International Settlement in Basel, Switzerland, the committee does not have its own staff but, through representation of the central banks of the respective countries, provide directives for banking regulation to member countries. The Basel II banking regulation accord negotiated by 13 of the world’s most important financial centers over 1999 to 2004 proposed stricter international financial regulations by using the banks’ own credit risk models to decide on the minimum capital requirements. By this, each country would implement a uniform “internal rating” system for its banks for the purpose of capital requirements. However, this would require very detailed and complicated rating system so that all the participating countries can develop a uniform rating system for banks. The policy implications of Basel II accord would greatly overhaul the banking regulation framework in the member countries, which becomes particularly significant in the context of the global financial crisis that erupted in 2007. Until Basel II becomes applicable, the capital requirement of a bank is calculated simply by calculating the riskiness of its various assets. With Basel II, the minimum capital requirement for large banks would become completely different. By this, large banks would be allowed to use their own credit risk models for the purpose of determining minimum credit requirements, which is justified on the basis that large banks have specific issues that determine the risk profile. However, this internal-ratings-based approach to banking regulation has been questioned regarding its applicability in domestic regulatory systems as these have been arrived at through negotiations and not on the basis of regulatory systems that have already been practiced in one or more country. The European Commission has been involved since the initial period of negotiation for Basel II even though neither the European Commission nor the ECB is directly a member of Basel Committee. Both were observers and could only provide discussion papers. It also tried to influence the Basel negotiations through the regulatory dialogue with the United States since 2002. However, ECB cannot have full membership to Basel Committee till it has full legal competence for banking supervision as central banks of national countries. Article 133 TC provides ECB with external competence for banking regulation and the European Court of Justice has ruled that this can be considered the basis for ECB in the negotiation for trade in services. But, the deliberations of Basel committee go beyond trade in banking services. The competence of ECB towards banking regulation in European countries, therefore, is limited (De Mesteer, 2007). Since the formation of the single currency, the member countries of the European Monetary Union no longer can enter into agreements with countries in the rest of the world or decide on monetary or exchange rate policies on their own. Article 111.3 of EC became the basis of all foreign exchange agreements with third countries. Although all bilateral agreements entered by the EU members before the Euro was formed for the purpose of continuity, the legal framework for all new such agreements have now been altered on the basis of Article 111.3 of the European Commissions (EC) (Lamine, 2006). However, the bilateral agreements concluded before the adoption of Euro has not interfered with the functioning of the single currency which has in fact grown stronger over the decade. Notable among such agreements with third parties that have continued include that of France with West African Monetary Union and with the Economic and Monetary Community of Central Africa. These agreements have been allowed to continue with the replacement of the French franc with Euro. The EU has also entered into an agreement with Vatican City State, Monaco and San Marino, allowing these states to use the Euro even though these are not members of the monetary union, because these states had been using a legacy currency of the euro prior to the formation of the union. The Conference of Maastricht in 1992 ratified the continuation of the pre-union exchange rate agreements through Declaration No 6. France and Italy were given the mandate to conclude the agreements, keeping the ECB and the Commission aware of the proceedings (Lamine, 2006). The single currency is now recognized as the successor of the national currencies of the member states at the fixed conversion rate. As a result, all long-term debt entered into earlier with third parties, foreign exchange transactions involving two currencies within the EMU as well as with third parties, fixed and floating interest rate obligations as well as all other obligations in the ECU basket currency had to be discharged against Euro (Lenihan, n.d). Specific articles for banking directives Article 56ECT has removed all restrictions on free movement of capital between member states which can impose strictures only with respect to taxation and prudential supervision of banks and financial organizations. The first harmonizing act for banking directives was adopted by the EC in 1973, through directive 73/183EEC, which prevented discrimination against foreign financial institution in any of the member states. Subsequently, several directives for the purpose of access rules, protection and control have been imposed. These include the principle of a single community authorization for a new financial organization, solvency, risk management and guarantees. There are directives for criteria on own funds, solvency ratios, large exposures, deposit guarantee, consolidated supervision – particularly against financial crime – and most recently, the capital requirements in accordance to the Basel II accord. Even though the member countries have not been willing to give up national control, the EC directives are aimed towards harmonization of banking supervision and control to enable free flow of capital across the Eurozone (Cervenkova, 2008). These directives have wide ramifications in terms of exchange rate movements through capital movements within the member states as well as outside. Effect of banking regulation on exchange rates Exchange rate targeting fell after the collapse of the Bretton Woods system as rising inflation rates and stabilization policies came to be the major focus of most countries. As a result, both exchange rate and monetary targeting became the policy orientation in European countries like France and Italy. At the same time, countries like Germany, which had stronger currencies, found the imported inflation rates return to normal levels that could provide ground for economic recovery. The effect of a weak dollar on intra-Europe exchange rates resulted in a policy shift from exchange rate targeting to monetary targeting. While countries with smaller deficits, or surpluses, wanted a deflationary monetary policies while others wanted expansionary policies. This asymmetry in monetary policies paved the way towards a cohesive monetary union that would have symmetric banking and monetary regulations (Houben, 2000). With the introduction of the single currency, risks of devaluation or revaluation of currencies affecting regional trade remained only with the economies that did not adopt the euro. Prior to the adoption of the euro, member states of the EU had attempted at a gold-parity exchange rate for within-union transactions but this mechanism was not successful. For example, the nominal value of fixed values of exchange would alter if, in case of fixed exchange rates, the currency was devalued or revalued, or in case of floating exchange rates, the market value of a currency changed. This happened when the French franc was devalued in 1957, making it liable to pay an additional 20 percent on the Coal and Steel Treaty. Even after the formation of the European Union, the United Kingdom has not joined the monetary union. When the pound fell against the euro, the UK had to make additional payments to the European Investment Bank to make up for the minimum paid-up capital requirement (Usher, 2000). Especially when national currencies diverged even without formal devaluation or revaluation, the gold-parity unit of accounts failed to bring national currencies to uniform levels. This happened particularly with respect to the agricultural market that operated on a single market at a single price. As the German and Dutch national currencies diverged, prices had to be revised to maintain parity within the Union. Through a 1992 regulation, the conversion rate between the single currency and the national currencies were based on the agricultural conversion rate which in turn was based on representative market rates. Hence, a trading amount might need to be altered within a marketing year if the national currency diverged from the agricultural conversion rate by more than 2 percent. The member states of the monetary union could float currencies to compensate farmers for the divergence. Such problems were done away with when the euro was introduced. By regulation 2699/98 on agricultural agreements, all prices and amounts fixed through legal agreements under the common agricultural policy for member states of the monetary union are expressed in euro. For member states of the EU not belonging to the monetary union, the euro amounts are converted into national currencies at the market exchange rates. So, members of EU not participating in the monetary union are subject to trading and exchange rate risks while the member states of the monetary union can avoid the latter (Usher, 2000). Analysis of selected cases The failure of the Bretton Wood system’s gold parity in 1973 led European countries to the European court. For example, the cases 41, 43 and 44/73 Societe Fenerale Sucriere v Commission (1977) involved the fines liable to be paid by three sugar undertakings to the Commission, quoted in the old unit of account as well as in French franc. The petitioners argued that they were liable to be paid only in the old unit of account and hence could convert the fine to Italian lire at the old official parity, which was at a much higher parity than the then existing market exchange rate. Through this, the petitioners could reduce the nominal value of the fine by a considerable amount. On the other hand, the Commission argued that since the fine was also quoted in French franc, in case the petitioners wanted to convert it to any other currency of any member state, it should be at the current market rate. The Court agreed with the Commission’s view and felt that it was within the purview of article 15 or Regulation 17. This mechanism of calculating fines continued till the adoption of the euro. A similar case came up with the Commission laying a fine of 75,000 ECU on Konika UK Ltd and Konika GmBh in nominated ECU accounts held by the Commission in banks at Birmingham and Cologne in 1988. The Court ruled that the fine was to be paid at current market rates as there was no mention of national currencies in the order (Usher, 2000). In the Zuchner v. Bayerische Vereinsbank (1981) case, the European Court of Justice turned down the usual practice of banks debiting 15 percent uniform service charge on certain transactions by saying that in the case of Dyestuff, competitors had the right to oligopoly power by adjusting to the predicted conduct of other competitors even while direct contact between firms were prohibited (Stroux, 2004). The Alpine Investment BV v. Minister van Financien (1995) case was over the Dutch law over strict public laws. According to the law, the ministry imposed a law restricting investment companies contacting investors for off-market commodity futures by telephone without prior consent in writing. The ministry received complaints from foreign investors and the government extended the law to other member states of the EU (Academie de droit europeen, 1999). Comparative Summary and account of the consequences of changes Thus, the single currency and banking regulation among the member states of the European Monetary Union has evolved over the years of economic cooperation in a bid to make the exchange rate scenario between the countries stable. Even though the Treaty of Rome and the Maastricht Treaty had envisioned a common market, variations in exchange rates made the system unstable, particularly as capital controls between the countries were lifted. The changeover to a single currency has made exchange rate between national currencies more stable. At the same time, banking regulations regarding capital requirements, large exposures have made the system symmetric across countries. However, as the ECB does not yet have a legal commitment to represent banking regulations, it has been able to provide only consultation support to the Basel Accords which aim to develop the directives for banking services globally. This has become all the more critical as banking regulations of global banks are deemed very important in the context of global financial crisis like that emerged in 2007 requiring specific guidelines towards banks’ capital requirements and large exposures. Works Cited Battilossi, Stefano and Youssef Cassis (ed.) European Banks and the Competition and Cooperation in International Banking, Oxford University Press, 2002 Bognini, Paola Agnese, The EU Experience in Financial Services Liberalization: A Model for GATS Negotiations?. Vienna: Suerf Studies, 2003. Available at: http://works.bepress.com/paola_bongini/11 Cervenkova, Lenka, The Legal Framework of the Banking Industry in the European Union, 2008, http://www.law.muni.cz/edicni/dp08/files/pdf/mezinaro/cervenkova.pdf De Mesteer, Bart, Multilevel Banking Regulation: As Assessment of the Role of the EC in the light of coherence and democratic legitimacy, Working Paper No 3, Leuven Center for Governance Center, 2007, http://www.ggs.kuleuven.be/nieuw/publications/working%20papers/new_series/wp03.pdf Ghosh, Dilip Kumar and Edgar Ortiz (ed.), The Global Structure of Financial Markets: An Overview, Routledge, 1997 Houben, Aerdt C F J, The Evolution of Monetary Policy Strategies in Europe, Springer, 2000 Kamerling, J, The Free Movement of Capital, Europa, 2006, http://www.europarl.europa.eu/ftu/pdf/en/FTU_3.2.4.pdf Kenen, Peter B, Economic and Monetary Union in Europe: Moving Beyond Maastricht, Cambridge University Press, 1995 Lamine, Baudouin, Monetary and Exchange Rate Agreements between the European Community and Third Parties, European Commission, 2006, http://ec.europa.eu/economy_finance/publications/publication658_en.pdf Lenihan, Niall, The Legal Implications of the European Monetary Union Under US and New York Law, http://www.suerf.org/download/studies/study20032.pdf Perron, Regine and Gerold Ambrosius, The Stability of Europe: The Common Market: Towards Integration of Europe, Presses Paris Sorbonne, 2004 Quaglia, Lucia, Central Banking Governance in the European Union: A Comparative Analysis, Routledge, 2008 Schenk, Catherine, "Financial Market and Systemic Risk: The response of central Banks in the 1960s and 1970s", Address prepared for the International History Conference, Helsinki, May 2006 Stroux, Sigrid, US and EC Oligopoly Control, Kluwer Law International, 2004 Tarullo, Daniel K, Banking on Basel: The Future of Internal Financial Regulation, Peterson Institute, 2008 Usher, John Anthony, The Law of Money and Financial Services in the EC, Oxford University Press, 2000 Academie de droit Europeen, Collected Courses of the Academy of European Law, Book 1, Kluwer Law International, 1999 Read More