Central Bank losers: the inside story of how the ECB and the Bundesbank are being pushed aside as financial regulators.

By pushing through his single regulator concept for financial market supervision, German finance minister Hans Eichel has dealt a blow to the ambitions of the Bundesbank, the European Central Bank and the European System of Central Banks. What's more, after Europe's largest economy and financial market rejected the concept of central-bank oversight, the weight in European financial supervision is moving Eichel's way, towards decentralized financial regulators that are responsible to elected governments and lawmakers. This shift has far-reaching consequences not only for European financial institutions and their customers, but also for many participants in world financial markets.

The failure of the once-mighty Bundesbank to become the country's leading bank supervisor has, of course, especially important implications for the single European market for financial services. In reforming Germany's financial system more along the British single-regulator model, Eichel is setting a standard for continental Europe: He is blocking ECB plans to play a leading role in financial supervision in the European Union.

The Berlin government hasn't lost much time. Only days after German legislators agreed to slim down the Bundesbank to the new realities of a European System of Central Banks where the ECB is in charge of setting monetary policy and controlling the euro, the government of Gerhard Schroeder joined other EU partners in a drive to secure the primacy of national European financial regulators over the ECB's ambitions. At an informal meeting in April of finance and economic ministers, Eichel and his British counterpart, Gordon Brown, asked the ECB finance and economic ministers to help secure the financial services objectives agreed by the European Council; promote cooperation between national regulators and supervisors of financial institutions; deliver the provision of technical input into EU legislative processes in order to speed it up; and spot and respond to financial stability problems. Specifically, Eichel and Brown asked that ECOFIN establish five new oversight panels: two that would regulate banks, two that would regulate insurance companies, and one, the European Forum for Financial Market Stability, that would serve as an umbrella financial-sector supervisory body.

In essence, the Brown-Eichel plan aims at improving coordination among financial supervisors in a European market for financial services that, since the introduction of the euro, is integrating at high speed. As Eichel makes clear: "There is no intention to establish a full-fledged pan-European supervisor because oversight over banking, securities markets and insurance should remain at the national level." What Brown and Eichel are proposing is to follow the new coordination framework suggested by a Committee of Wise Men on the regulation of European securities markets set up in July 2000 under the chair of Alexandre Lamfalussy, the former Belgian central banker.

Following the recommendations of the Lamfalussy Report, two new Brussels committees were established: the European Securities Committee (ESC), with both regulatory and advisory functions, and the advisory Committee of European Securities Regulators (CESR). The ESC is composed of representatives of ministries of finance of member states and is chaired by the European Commission. The CESR, which operates as a body independent from the Commission, brings together the heads of the national public authorities competent in the field of securities regulation and supervision.

Should European Union finance ministers come to the conclusion by September to follow the Brown-Eichel proposal of a Lamfalussy-style committee structure for banking and insurance markets, this would be a blow to the already existing Banking Supervision Committee (BSC) of the ECB, chaired by Edgar Meister, a German central banker. In the 15-member countries of the European Union, banking supervision is now widely dispersed among national finance ministries, central banks and separate supervision agencies. Since central banks in the eurozone have lost their role in setting monetary policy to the ECB, they are eager to increase their role in banking supervision--and the BSC is seen by central bankers as a key forum for this.

But ECB president Wim Duisenberg, his deputy Tommaso Padoa-Schioppa, and Meister have been working hard to expand central bank-run supervision in the European Union. "A sideline role of the ECB in bank supervision would risk violation of the Maastricht Treaty" warns Duisenberg. Under the Maastricht Treaty, the ECB has the task of "contributing to the smooth conduct of national policies pursued by competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system." This, of course, is stating the obvious, as the inclusion of central banks in banking supervision is not questioned by European finance ministers.

When Eichel opened the new Federal Agency for Financial Market Supervision in Bonn on May 6, the "pre-emptive strike" of the British and the Germans against the ECB's ambitions was, of course, a heated subject. Eichel and his top finance officials are much relieved that the government's bold single-regulator plan and the fiercely contested proposals for Bundesbank restructuring became a reality on May 1 and April 30, respectively.

For that, Eichel had a stroke of good luck. When the final vote on the government's new immigration law on March 22 resulted in a walkout by Bundesrat opposition members, his sweeping legislation to streamline the Bundesbank and establish a single agency to supervise banking, securities and insurance sailed through. It was an important parliamentary victory. While there seemed to be enough votes to get the single regulator bill through the upper house, the general expectation was that the Bundesbank reform bill would be buried in the conciliation committee. Until the last minute, representatives of the 16 German states were demanding more influence on appointing members of the new Bundesbank council and objecting to the demotion of the nine state central banks--the Landeszentralbanken (LZB)--to mere regional branches.

To many, the unexpected passage of Eichel's two-pronged reforms was a modern day miracle. Eichel and his finance ministry officials had drafted the controversial plan in utter secrecy. When it was unveiled on January 25 of last year, Eichel shocked Germany's political world.

But many bankers approve of Eichel's proposals. "Speedy passage and implementation of the government's draft law are in the interests of savers, investors, companies--in their role as issuers--and the financial industry," said Bernhard Speyer, Deutsche Bank's expert on financial supervision. And Wolfgang Arnold, managing director of the Private Bankers Association, argued that, "Enactment of Eichel's twin reforms will help ensure that Germany's role as a player in the global financial marketplace keeps growing."

At times, Berlin's ambitious reformers looked to have lost the battle. But Eichel's team didn't give up and offered several compromises. First, a scheme for a governing council of a centralized and streamlined Bundesbank in which the (total) six members would be chosen by the government was dropped. Rather, the new Bundesbank council would be enlarged to eight members, just four of whom would be appointed by the government. The Bundesrat, meanwhile, would have the right to appoint the other four members--albeit with the government's consent. Ernst Welteke, the Bundesbank's president, will be the only present council member that ex officio continues as president of the "new Bundesbank."

Second, Eichel had to yield to a larger role for the Bundesbank and its regional network--in particular the LZB--in day-to-day bank supervision. But that was a price worth paying. In return, Eichel forced the states to give up some of their powers and influence related to the LZBs--where frequently the top jobs were given to retired politicians. The LZB's presidents are now demoted to regional branch heads in a new, centralized Bundesbank. Slimming down the huge Bundesbank bureaucracy with about 16,000 staff should save costs and increase efficiency.

Moreover, Eichel was able to get the backing from some states and opposition members for the establishment of a Federal Agency for Supervision of Financial Services that would be independent, but accountable to the finance minister--and thus to parliament. The new single-regulator agency will have its own budget, entirely paid by the supervised financial institutions, with at least a bit more flexibility to pay higher salaries for its highly qualified staff. The installation of an administrative council and an advisory committee at the new supervisory authority is welcomed by the financial industry. "It will help ensure that the expertise of the market participants can flow appropriately into regulatory procedures and practice" says Bernhard Speyer. And Speyer sees another important advantage: The concept of a single regulator accommodates the European perspective. This applies both in terms of bolstering Germany's competitiveness as a financial center and in terms of the emergence of a European financial supervisor, which will inevitably happen in the medium term.

Axel Nawrath, the senior finance official who helped Eichel broker a deal with the state governments on the Bundesbank restructuring, sums up the achievement: "The March 22, Bundesrat passage has cleared the way for new supervisory structures in Germany which will set standards for the future. The creation of the new Federal Agency for Financial Market Supervision by combining the previously independent banking, insurance and securities supervisory agencies is an important reform element in the interests of securing Germany's future as a financial center."

"With this concept of integrated supervision" he continues, "we establish the preconditions for a competitively neutral supervisory authority with greater orientation towards the capital markets; we have warded off the threat of gaps in supervision by combining responsibilities; and we are assuring competitiveness, in particular, in comparison to other European financial centers."

Since the power of setting monetary policy and interest rates shifted to the ECB, the Bundesbank hasn't been a pretty sight. Matters got even worse when the Berlin government began pushing for the sprawling bank's overhaul. Fierce infighting broke out among Germany's central bankers. Led by Bundesbank president Ernst Welteke, the "centralists" were at odds with the "regionalists" and their political backers who defended the LZBs' independent status. Both have been waging a fierce public battle to become the sole banking supervisor in the country.

And both lost this battle. At the end of a protracted political bargaining process, the Bundesbank was able to secure a supporting role in day-to-day bank supervision and, to a certain degree, in setting bank supervision--albeit under the overall leadership of the new single regulator. As the Bundesbank's supportive role in banking supervision is anchored in the new law, Germany's central bankers shouldn't complain too much.

But will the initiative of the British and German finance ministers be blocked by the central bankers? Eichel's deputy and former German candidate for the top post at the IMF, Caio Koch-Weser, is optimistic. He is convinced that Germany and the UK will get things moving in strengthening the hand of financial regulators on the European stage. "The reaction of the other ECOFIN members to our initiative was very encouraging," he says. More intense cooperation of European financial supervisors, says Speyer of Deutsche Bank, "is a development that is welcomed, because the increasing integration of Europe's capital markets warrants a commensurate supervisory structure--i.e., one that has a European dimension, too." Speyer thinks that the framework proposed by Eichel and Brown "could be the nucleus for European supervisory institutions." The new European committee structures that Brown and Eichel propose are challenging the ECB and the European System of Central Banks at their very core. While they would certainly improve multilateral cooperation among European bank controllers, they could also sideline central bank-run bank supervisors.

But there is another aspect to consider: Creating separate committees for banking, securities and insurance supervisors will create new problems: It will only cement the proliferation of fora and would make cross-sector risk assessment more difficult. The creation of several new committees might make future moves towards a European and unified cross-sector institution more difficult. Moreover, the essential inter-governmental structure of such a committee would imply that national discretion, which is the source of competitive distortions in the single financial market, would remain.

In any case, the power struggle between Europe's central bankers and finance ministers over banking supervision is heating up. As deputies of finance ministers and central bank experts are working on new proposals to be presented in September and implemented by the end of the year, the ECB is moving to beef up its banking supervisory arm with a secretariat at the ECB that could act as a coordination and communications platform in a financial crisis in the eurozone.

Such moves are meeting stiff opposition from European finance ministers and supervisors. "When it comes to a banking crisis in a European country" says Germany's new top financial supervisor Jochen Sanio, "finance ministers and not the European Central Bank must have the ultimate responsibility because its taxpayers' money that may have to be committed. Therefore, I can only see financial supervision structures that are independent from central banks to do the job in crisis prevention and crisis resolution." Or, as Sanio says, "The ECB won't have to pay if a financial institution fails in the eurozone. Who pays should also have the say."

RELATED ARTICLE: Buba's internal politics.

In a way, the Bundesbank's failure to become Germany's leading bank supervisor is a result of self-inflicted wounds. After the ECB was established, Bundesbank leaders started an aggressive public campaign aimed at expanding their role in bank supervision and downgrading the importance and the potential of the existing Federal Banking Supervisory Office (FBSO), and its president, Jochen Sanio. It was argued that the once-mighty Bundesbank would lose influence in the ECB and the European System of Central Banks, where many of the central banks are in charge of bank supervision in their countries. Another line of reasoning--put forward by the commission of experts led by Karl Otto Pohl, the Bundesbank's former-president--was that the Bundesbank would gain self-esteem by becoming Germany's single bank supervisor after having given up its monetary policy function. Welteke and Meister, the members of the Bundesbank's Direktorium responsible for bank supervision, were openly talking about how they would integrate the bank supervision agency with its 650-member staff into a department of the Bundesbank. While Meister was dominating the media, Sanio couldn't speak out publicly about why he was against putting Germany's bank supervision under the roof of the Bundesbank, or why he was in favor of establishing an integrated financial supervisory agency.

After March 22, when the Bundesbank reform unexpectedly drew near, there was much speculation about who from the existing six-man Direktorium would be nominated to the "new Bundesbank" council, and which four candidates would be presented on the states' ticket. Early on, the German newspaper Handelsblatt, after canvassing the political waters in Berlin and the state capitals, came up with a surprise: The Greens were reminding their Social Democratic coalition partners that they also would like to get a seat on the eight-member council, and that Eichel should not overlook qualified women. The obvious inference was to Christine Scheel, who as chairperson of the Bundestag's Finance Committee, played a key role in getting Eichel's reforms through parliament. But Eichel stuck to the familiar macho-formula, arguing that he must reappoint as many Direktorium members presently serving as possible in order to strengthen the reputation of the reformed Bundesbank.

In this way, Eichel was able to fend off pressure from his own party, the Social Democrats, and the Greens, for a slot on the three-person government ticket. As international pressures were building not to let Bundesbank Vice President Jurgen Stark go, the Finance Ministry signaled that it would stick by the former secretary of finance under the former Kohl government. Since Welteke's deputy was not afraid to criticize the Berlin government, Stark's removal would have been a bad signal to the financial markets.

As it turned out, Stark was asked to stay. Early on Welteke urged Eichel to reappoint Hans Georg Fabritius, a new council member whose term expires in 2008 and who is in charge of payment systems and risk management. There was an assumption among political insiders that the Bundesbank's chief economist, Hermann Remsperger, would be replaced in his position by another former bank economist, Hans-Helmut Kotz, who was president of the LZB of Bremen, Niedersachsen and Sachsen-Anhalt. But in confirming Remsperger on the government ticket--while also taking Kotz on board--Eichel signaled his desire to leave the monetary analysis work of the Bundesbank in proven hands and to strengthen the new Buba's capital market work.

There were surprises, however, on the states' ticket that was presented through the upper house, the Bundesrat. Nobody expected that Edgar Meister, the vocal member of the former Bundesbank Direktorium in charge of bank supervision, would be put forward on the SPD's state ticket. The other candidate supported by SPD-run states was, as expected, Hans-Helmut Kotz, who will look after capital market analysis and exchange market operations. Hans Reckers, the president of the LZB Hessen, and Franz-Christoph Zeitler, president of the LZB of Bavaria, were proposed from the states run by CDU/CSU governments. Reckers, who served former German finance minister Gerhard Stoltenberg, will be in charge of risk controlling, employment relations and administration. Zeitler will be the Bundesbank's legal council and also responsible for notes and coins.

In filling the two top positions of the Federal Agency for the Supervision of Financial Services, Eichel and company are moving in less politically infested waters. As expected, Eichel put Jo Sanio, the 55-year-old head of the bank supervision agency, into the presidency of the new integrated financial supervision agency. Carl-Burghard Caspari, the Finance Ministry official, who worked on the major modernization projects of Finanzplatz Deutschland in the last two decades, will be Sanio's number two. Both are considered to form an experienced team at the top of the new BAFin.

-- KLAUS C. ENGELEN

Klaus C. Engelen is the international correspondent for Handelsblatt in Dusseldorf, Germany.