Since December 2010, the European Systemic Risk Board (ESRB) is responsible for macro-prudential oversight of the financial system within the European Union. The ESRB is independent from politics and resides with the ECB, which also ensures its secretariat. The ESRB shall “contribute to the prevention or mitigation of systemic risks to financial stability in the Union that arise from developments within the financial system” (EU Regulation 1092/2010, Article 3.1). So far, so good. But in the same article, the EU burdens the ESRB with the additional task to “contribute to the smooth functioning of the internal market and thereby ensure a sustainable contribution of the financial sector to economic growth.” The logic of this escapes me. The EU has other institutions to promote the internal market. Worse, this additional task removes important macro-prudential tools from the ESRB’s arsenal.

One prudential approach to systemic risk is to directly reduce the systemic importance of financial institutions. This can be done by limiting their size and organizational structure or by restrictions on the scope of their activities. For example, the UK government wants UK banks to ring-fence their retail operations from more risky activities. In cross-border banking, a possible macro-prudential measure is to require international banking groups to ring-fence their foreign operations, by switching from branching to subsidiarization. The Icesave debacle has illustrated on a small scale the riskiness of branching. Yet the Icesave practice of harvesting European deposits through foreign branches is still widespread. Dutch banks have collected more than € 80 bln of non-Dutch savings in this way. This has increased their size and interconnectedness and the systemic risk for the Dutch taxpayer.

An EU-wide switch from branching to subsidiarization reduces systemic risk, as foreign activities are organized in separate legal entities, under local supervision. As a negative side effect, however, it also limits the free flow of capital and liquidity inside the EU and makes cross-border banking a little bit less efficient. And this is incompatible with the ESRB’s additional task of “contributing to the smooth functioning of the internal market”.

Ideally, the ESRB should be able to reflect on the question whether EU banking regulation has overshooted in enabling banks to move money across borders. This could lead to a reappraisal of the EU’s common passport approach to banking regulation. In short, the ESRB should be able to question the interconnectedness in the EU’s banking system and plea for fences in the financial system. But by requiring it to “contribute to the smooth functioning of the internal market”, the EU has emasculated the ESRB at birth.