Another Merkel blunder: in financial market supervision reform, the Bundesbank loses big.

• Author: Engelen, Klaus C.

Now that policymakers have begun picking up the pieces from the financial crisis, reforming failed financial market supervision structures, and strengthening regulation, there have been winners and losers.

In the United States and United Kingdom, the central banks--the Federal Reserve Board and the Bank of England--have gained responsibilities and power, as the Dodd-Frank Act and as the British government's new financial regulation reform consultation papers of June 2010 and February 2011 made clear.

But what about Germany, where the battle cry of Chancellor Angela Merkel's new governing coalition was "Tear down BaFin!"?

In the Winter 2010 issue of TIE, we alerted global market participants to the Berlin government's plan to dismantle Germany's cross-sector financial market watchdog, the Federal Financial Supervisory Authority, or BaFin, in a move that was seen by many as politically motivated.

Putting all the blame for supervision failures during the horrible German banking meltdown--especially for such disaster cases as IKB, HRE, and the Landesbanks--on BaFin and not the Bundesbank as "dual supervision" partner was an easy sell in the election campaign. After all, BaFin was established as part of the most important financial market modernization project of the eleven-year reign of Social Democrats running the Ministry of Finance. It was, therefore, disliked by conservative and liberal politicians from the beginning. When the SPD was voted out of power in the federal elections in September 2009, BaFin lost its political protection.

Established as an independent public-law institution, BaFin is subject to legal and technical oversight by the Ministry of Finance. It is funded, however, by fees and contributions from the banks and other institutions that it supervises and therefore is not dependent on the federal budget.

After a resounding election victory, the coalition of the Christian Democratic Union, its Bavarian sister party, the Christian Social Union, and the pro-business Free Democratic Party under Chancellor Merkel promised followers to make the Bundesbank the country's leading financial market supervisor.

This was an opportunity that Bundesbank President Axel Weber didn't want to miss. Just after the election, in a stunning preemptive strike, Weber put forward a seven-point reform plan under which the Bundesbank would assume full authority to supervise banks and other financial service firms such as insurance companies, giving it fully integrated solvency supervision (as opposed to market supervision which, at that time, was to remain at BaFin). Weber called it the "integration model." Germany's present system, partially modeled after the British Financial Services Authority, would be scrapped.

On October 2, 2009, the Bundesbank's board backed Weber's proposals to the Berlin government, arguing that streamlined supervision could help fix gaps and overlaps in financial oversight that had contributed to the massive losses German banks incurred in investments linked to subprime mortgages. The board implicitly tried to shift the blame for the collective failure in supervision to BaFin, in spite of the fact that the Bundesbank as "dual supervisor" also contributed its share of breakdowns in supervision. Pointing to the failure of the Financial Services Authority in the United Kingdom, the Bundesbank and the ruling coalition legislators advanced the so-called "twin peak model" as a better solution, under which solvency and market supervision would be separated in order to manage conflicts of interest in a more transparent and explicit manner.

Since the ruling coalition legislators came to their deliberations on the reform law with a strong proBundesbank bias, things didn't look good for BaFin, a federal agency with i,600 employees and offices in Bonn and Frankfurt. And what was headlined as "the takeover of BaFin" was seen as a major personal setback to Jochen Sanio, BaFin's president, who took over the new federal agency when its doors opened in May 2002. The prospect of having to move from Bonn to Frankfurt--a much more expensive area--under an unknown organizational structure at the...