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European Affairs
Special Report: Managing Europe's New Money
Complex Steps to Financial Integration Will Bring Big Economic Benefits
Hervé Carré
European Union leaders, meeting in Barcelona this spring, have set ambitious objectives for creating an integrated financial market in Europe as part of a wider agenda for structural reform of the European economy. Eight measures in a so-called Financial Services Action Plan (FSAP) are to be adopted before the end of this year, including legislation on market abuse, on pan-European pension funds and on international accounting standards.
The adoption of these measures will maintain momentum in the process, but one should not forget that an integrated financial market has been a community objective since the 1970s, nearly thirty years ago. Seen from this longer perspective, recent progress leaves no room for complacency. The 2005 deadline for the full implementation of the Financial Services Action Plan, the blueprint for European financial integration, looks increasingly tight.
When finance ministers discussed these issues informally in April, the focus was on the economic benefits of financial integration. Although these benefits are generally regarded as self-evident, they are, nonetheless, rarely articulated in a clear and understandable way. For this reason, the financial integration process has come to be seen as primarily a legal process. This is not the case.
The Financial Services Action Plan is an economic tool. Each of its 42 measures responds to specific economic requirements of an integrated and efficient EU financial system. It is as much about economic reform as about regulatory convergence, and it is important to stress how the plan's implementation can help the European economy. Let me cite a few examples.
The proposed Directive on Prospectuses is not just about agreeing on a common legal framework for issuing equity or debt. It is about creating the conditions for a truly liquid EU financial market. The common prospectus will allow issuers access to a much larger pool of potential investors. At the same time, it will make investors more confident in acquiring equity or bonds from issuers beyond their national borders.
Another example is the Directive on Takeovers, which is not just about creating a common legal framework for mergers and acquisitions. It is about facilitating the process of corporate restructuring in Europe. It is about allowing institutions to acquire a big enough size to fully exploit the opportunities of a single financial market. It is about allowing shareholders a greater say in how their companies are managed.
The aim of the discussion now taking place in Europe was to stimulate the interest of ministers. The process of financial integration obviously involves complex legal and regulatory issues. The economic advantages should not, however, be obscured by these complexities. The political will required to implement the Financial Services Action Plan by 2005 depends upon a clear understanding of these wider economic benefits.
The collapse of the Enron energy-trading company has important implications for Europe's process of financial integration. Hitherto, the policy debate has focused mainly on accelerating the pace of integration. Since Enron, the debate has expanded to include the exact nature of integration to be achieved. More specifically, there is a growing sense that U.S. arrangements cannot automatically be regarded as the basic standard for an integrated EU financial system, and that's a major change.
Entirely new approaches are being considered. The aspects of EU financial integration affected by Enron include:
Corporate Governance: The profile of this issue has clearly risen. Attention is now focusing on the behavior of management in the face of financial crises, the role of stock options in influencing management decisions, the failure of management to respond to warnings of junior staff, etc. The central issue will be whether there is a need for legislation to enforce the appropriate standards of corporate governance throughout the European Union.
Accounting Standards: The EU has favored International Accounting Standards (IAS) because they emphasize substance over form. We think that the Enron collapse strengthened this preference. In using special vehicles to conceal debt, Enron exploited an excessive focus on form in U.S. accounting rules. Despite more than 600 pages of rules on these vehicles, the U.S. Generally Accepted Accounting Principles (GAAP) failed to expose Enron's true debt burden. We hope, therefore, that our U.S. colleagues will also come to appreciate the merits of International Accounting Standards, and we will welcome this convergence.
The Role of Auditors: The key issue in the Enron collapse was the failure of the company's auditors to identify the existence of off-balance sheet debt. It seems obvious that auditors, who receive large consulting fees, can face a conflict of interest. Different solutions for reducing this conflict of interest are currently under discussion. Possible options could be the outright prohibition of any non-audit service, an obligatory auditor rotation on an annual basis, the appointment of auditors directly by shareholders for a multi-year contract, or auditors could also be encouraged to give their own verbal assessment of the audited numbers.
The Role of Financial Analysts: These were mostly bullish on Enron until almost the very end. It has been suggested that many analysts suffer conflicts of interest when working for an investment firm. Can the desire to underwrite future investment banking business influence an analyst to be more optimistic about a company's prospects? Recent investigations suggest that this is an area to be examined.
The Role of the Credit Rating Agencies: This is another group that reacted too late in the Enron case. Some have argued for a closer examination of these agencies, particularly of how their financing comes mostly from the assessed companies. The role of rating agencies is said to increase with the implementation of so-called Basel II Agreement, setting new international capital standards. The debate about the agencies' role and possible need for regulation is still ongoing. What is clear is that these credit rating agencies have a powerful position in the financial markets, and this should not be abused.
Complex Financial Transactions: For complex financial transactions, such as derivative instruments, special challenges exist in terms of transparency. There is a debate on how to respond to these challenges. Some would wish to regulate and supervise this sector more closely. Others caution against over-regulation of these important tools for risk sharing. Either way, we must keep in mind that the origin of the Enron collapse had nothing to do with these instruments per se, but was due rather to dishonest behavior by the company management.
Many of these issues were discussed and reviewed at the recent informal meeting of the EU Finance Ministers and Central Bank Governors in Oviedo. The outcome of the discussion was that most of the issues were already addressed, or were being addressed, in the Financial Services Action Plan. Nevertheless, a special group of high-level legal experts has been asked to assess the extent to which there may be regulatory gaps in our response to Enron. This group will report in June.
Last but far from least, we are also working on the fight against terrorism in the financial sector. Targeting the financing of terrorism is one of the most effective ways of combating terrorist acts. This is why measures against the financing of terrorism are a priority area for Europe.
The European Union has responded swiftly, and in a coordinated way, to the urgent task of blocking terrorism funds. About $35 million in terrorist assets have been blocked since September 11. Given the heterogeneity of the legal systems in Europe, the results and the prospects of this anti-terrorism policy are already impressive.
Various measures have been adopted over the past seven months. These are in force on a common basis in all EU jurisdictions. There is close cooperation between authorities implementing the measures within the European Union and third countries. Significant progress in strengthening money-laundering legislation has been achieved.
Perhaps the most difficult problem is positive identification of suspect individuals who can operate under many names. The more information available on individuals and organizations, the more efficient enforcement will be. This argues for the closest possible cooperation between the relevant authorities within the European Union and other countries.
The Commission is supporting candidate countries in their efforts to install functioning systems to prevent money laundering and terrorist financing, but it is clear that further progress is still needed. o