It is often perilous (and always expensive for the common good) to be in charge of executive and controlling functions at the same time. The latest audit by the European court of auditors gives a crispy opportunity to dig into the conflicting missions of the ECB.

The report comes at a delicate juncture for the central bank, which just started to scale back its asset purchase programme by prolonging it simultaneously. As an economist at BNP amusingly pointed out, the ECB did ‘a Nike version of tapering: don’t say it, just do it’.

Many will see educated economic or legal reasons behind this European tapering. We have a different reading. As discussed in our previous post, we think that the two missions of the ECB – monetary policy and financial supervision – are conflicting. The ECB, we believe, is forced to taper its policy as the cost of financial instability dominates the expected benefits of monetary policy. Interestingly enough the Italian referendum highlights both sides of the equation. As suggested before, we do not see social unrests as a generator of macro-financial trends, but rather as a ‘revealer’ and accelerator of underlying forces.

Back to the audit.
Please consider ‘Single Supervisory Mechanism – Good start but further improvements needed‘ by the European court of auditors.

The Single Supervisory Mechanism, or SSM, is one of the pillars of the young European banking union. It belongs to the micro-prudential side of the ECB’s supervisory mission. It encompasses authorities such as the European banking authority (the stress tests…), the pension authority or the securities and markets authority.

The report starts by setting the scene …
(emphasis ours)


“III
The main pillars of banking union were to be the centralised supervision of euro-area banks, a mechanism to ensure that failing banks were wound up at minimal cost to the taxpayer and the economy, and a harmonised system of deposit guarantees. The first step, that of centralised supervision, entailed the creation in 2014 of a Single Supervisory Mechanism (SSM) to take over much of the supervisory work previously done by national authorities. The SSM was placed under the authority of the European Central Bank but also closely involves the participating Member States.What is this report about?

… and recalling the objectives of the audit :

“IV
The Court has a mandate to examine the operational efficiency of management of the ECB. We therefore focused, for this audit, on the way the ECB set up the SSM and has organised its work. In particular, we looked at the new mechanism’s governance structure (including the work of internal audit), arrangements for accountability (including external audit), the organisation and resourcing of banking supervision teams (both ‘off-site’ and ‘on-site’ at bank premises), and the on-site inspection procedure.”

Unfortunately the auditors mention a straight, bold disclaimer:


“V
We became aware, however, of an important obstacle in all areas of our intended audit – namely, the emergence of disagreement with the ECB over the exact terms of our mandate and right to access documents. Arguing that they lay outside our remit, the ECB was not willing to share a number of documents that we needed to complete our work. As a result we were only partly able to assess whether the ECB is managing the SSM efficiently in the areas of governance, off-site supervision and on-site inspections.

 

Surprised?
Why is the ECB failing to disclose its governance structure? Could it be related to some conflicts of interests between the ECB’s controlling mission (financial supervision) and its executive one (monetary policy)?

The Financial Times makes a similar reading in ‘Audit shows risks for ECB’s role as bank watchdog’:


“The report from the European Court of Auditors also flags potential “conflicts of interest” at the Frankfurt¬based central bank, which must carry out its new tasks alongside its traditional responsibility for monetary policy. The auditors findings are the first independent review of the ECB’s bank supervision department, which has just begun its third year of activity. The decision of finance ministers to transfer oversight of their banks to the European level has been seen as one of the defining moments of the eurozone sovereign debt crisis. Specific concerns raised in the auditors’ report include the ECB being overly reliant on staff from national central banks and banking supervisors.”

And also :


“The ECB has consistently defended its performance in building up its bank supervision arm, arguing that it had, in effect, been asked to construct a new system, stretching across 19 countries, in record time”

Let’s give full credit to the European Central Bank about this: building a common European banking framework has been a tremendous work on its own.

Should this hinder transparency however?
Alas, the SSM bodies are not young at this. The European Banking Authority for instance regularly failed to deliver transparent and reliable information about its stress tests.

The audit tackles the delicate question of separation of functions:


“VII
The ECB is bound by legislation to observe a clear separation between its monetary policy and supervision functions. The latter is overseen by a Supervisory Board, which proposes decisions to the ECB’s Governing Council. However, within the ECB the SSM Supervisory Board does not exercise control over the supervisory budget or human resources. This raises concerns about the independence of the two areas of the ECB’s work, as does the fact that some ECB departments provide services to both functions without clear rules and reporting lines that would minimise possible conflicts of objectives.
IX
The ECB’s efforts to ensure transparency and accountability for the SSM towards the European Parliament and the general public are potentially weakened by the lack of a proper mechanism for assessing and then reporting on supervisory effectiveness.

 

The auditors note:


“42
The ECB decision on the implementation of separation establishes that certain ECB departments can be designated ‘shared services’ to provide support to both the monetary and supervisory functions. Shared services are established in the interest of efficient and effective delivery of services, in order to minimise duplication of work. Notwithstanding the positive features outlined above, there are risks associated with these arrangements (see Table 3).

43
Risks arising from failure to implement the separation principle in full may also be present in other functional areas of the ECB. Such risks include, but are not limited to, the sharing of confidential information. The shared services are exempted from the provisions on exchange of information between policy functions set out in Article 6 of the ECB’s decision on the implementation of the principle of separation (i.e. exchange of confidential information does not require prior approval by the Executive Board), although the general principles on access to information apply.

45
Apart from Decision ECB/2014/39, we were given no documentation on the implementation of the principle of separation, including any ‘Chinese walls’ within shared services or evidence of monitoring that the separation principle is adhered to.”

 

The auditors make the following propositions :


“How could the SSM be improved?
XV
Our recommendations are as follows:
(a) In the area of governance, the ECB should:(i) seek to improve efficiency by further streamlining the decision-making process;
(ii) examine the risk posed by the system of shared services to the separation of functions, establish separate reporting lines for cases where specific supervisory resources are concerned and look into giving the Chair and the Vice-Chair of the Supervisory Board stronger involvement in the budgetary process.; and
(iii) assign internal audit skills and resources in such a way that higher-level risks are covered as and when appropriate.

(b) In the area of accountability, the ECB should:(i) make available all documents requested for the Court to exercise its audit mandate; and (ii) develop and make public a formal performance framework to demonstrate the effectiveness of its supervisory activities.

 

The ECB takes a legal route to counter the audit statements and recommendations:


“… In this respect, the ECB disagrees with the Court’s statement that the ECB provided very little of the information requested. The ECB, in accordance with its obligations under the ESCB Statute and the SSM Regulation, fully cooperated with the Court to facilitate the audit and invested considerable amount of resources and time in order to provide the audit team with a substantial number of documents and explanations. Some documents (such as minutes of the Supervisory Board; individual supervisory decisions) could not be provided, however, because they did not concern the operational efficiency of the management of the ECB, as required by the ESCB Statute and reflected in the SSM Regulation.

184
The ECB disagrees with the statement that the audit has confirmed an audit gap which has emerged since the establishment of the SSM. In the ECB’s view, the Court received all the information and documentation necessary to assess the operational efficiency of the management of the ECB in accordance with Article 27.2 of the ESCB Statute and Article 20(7) of the SSM Regulation.”

188
The ECB would like to clarify that it has not ‘’imposed’’ a limitation on access to documents. Access to documents by the ECA should be in line with its mandate as stipulated by Article 27.2 of the ESCB Statute and Article 20(7) of the SSM Regulation. Therefore, there is no lack of cooperation, but a different interpretation of the remit of the audit.”

 

 

We suggest :

– The audit points at acute governance failures foreseen in our previous posts.
– We believe that financial instability is tightly related to such failures, be it on the supervisory side, the monetary side …
– … or both, as the audit seems to suggest.
– Using financial instability as an additional ‘policy tool’ is pure folly: it means doubling down with no monetary backstop left …
– … unless fiscal policy would overtake this legacy, another defiance to economic gravity.
– Even if – to some extent – they are foreseeable, policy governance failures lead to social costs whose long term effects are disproportionate.
– Asset bubbles and social unrests are part of them .
– There are several ways to promote better governance for public policies:
> Imposing a robust and independent supervisory framework is one of them.
> Following more foreseeable rule-based policies (instead of tool-based) is another one.

We see this audit as a positive opportunity to leverage the structural efforts built around the European banking union. It should be the ECB’s interest to normalize its concentrated, post-crisis governance structure, in particular if this implies a recognition of policy inadequacies or banking failures.

That’s precisely what we would expect to find in the (undisclosed) minutes of the Supervisory Board …

 

Jacques

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