ANALYSIS: National regulators are still first line of defence but can be overruled if they fail to act, writes  ARTHUR BEESLEY

MEPS HAVE given their assent to the creation of a new system of pan-European financial regulation. The big question now is whether the regime is robust enough to prevent any repeat of the banking crash two years ago.

Although the new authorities will have no shortage of power, the true test lies in how they exercise their rights of oversight and intervention. Note that Ireland’s financial regulators had plenty of armour at their disposal before the banking system imploded but failed to rein in imprudent lending and lax governance. As the Government props up Anglo Irish Bank, AIB, Bank of Ireland and other lenders, the consequences for taxpayers are appalling.

The new European system is designed to prevent a build-up of financial strain in one country’s institutions that could threaten the stability of others. Should trouble emerge in one organisation, the objective is to prevent the eruption of a full-blown systemic crisis by quickly taking decisive steps to quell the flames.

Contagion risk is highest when large cross-border banks run into difficulty. However, the old regime was hampered by the lack of a pan-European mechanism to bind national regulators to united coherent action. The resulting confusion, with different rules applying in different jurisdictions to the same institutions, served to amplify risks as bank after bank came under pressure after the Lehman collapse.

But how will these new authorities work?

The first is the European Systemic Risk Board, an agency of the European Central Bank in Frankfurt, which will be responsible for providing early warnings of system-wide risks and issuing recommendations for action to deal with such risks.

In addition, there are three supervisory authorities to oversee the banking, insurance and pension sectors. These bodies – based respectively in London, Frankfurt and Paris – were first proposed a year ago by the then internal markets commissioner Charlie McCreevy and championed by his successor, Michel Barnier.

So what changes? Day-to-day supervision will still be carried out by national regulators, who will continue to retain far more staff than the new European bodies.

In the new order, however, the pan-European regulators will be able to overrule national agencies if coordinated action is required in respect of a particular group or if national agencies incorrectly apply EU rules.

National regulators can also be overruled if EU finance ministers declare a financial “emergency”. The new authorities would have binding legal powers in such situations to impose measures on national regulators to safeguard the orderly functioning of markets. They can impose joint action on national regulators, for example by calling for an EU-wide temporary ban on “short-selling” trades in times of exceptional volatility. In certain cases, they would also be able impose decisions on individual institutions.

All of this amounts to a forceful legal mandate for the new bodies, yet key questions still remain. Will the system work? Would it prevent, for example, a repeat of Ireland’s property bubble? And would Anglo and other Irish banks have posed less of a threat to the State if they were regulated under this system?

Quite possibly so, although the effectiveness of the new regime will depend on the zeal of individual regulators and the degree to which they are given a free hand by governments. At times of strain on the financial system, institutions will seek to apply maximum pressure on political leaders.

While Ireland’s excesses were apparent to observers within and beyond the country, the old system operated on the basis that national regulators had the last word. Outsiders didn’t interfere and national regulators had the imprimatur of their governments. Now national regulators are tied together in a single EU net and open to binding directions from above if they snooze.

In addition, the creation of the Systemic Risk Board brings potential to issue formal warnings from Frankfurt if a property market overheats or credit standards markedly decline. For fear of putting the frighteners on markets, such warnings may well be issued in private. While they would not carry legal force per se, they could prove a potent catalyst in a scenario in which most European governments are prone to instability in their neighbours.

Furthermore, the new regime comes at a time of increased regulatory vigilance generally, something that was absent in the era of the “light touch” and hoped-for “soft-landings”.

Whether this new system makes a difference will largely depend on vigilance, for abundant regulatory power is impotent without it.