Europe's second pillar: a European deposit insurance system, complementing monetary union, can help to contain the European race to the bottom in financial sector subsidies and regulatory arbitrage.

• Author: Dubel, Hans-Joachim

What do places such as Reykjavik, Edinburgh, Dublin, Brussels, Dusseldorf, Munich, Milan, Vienna, and Stockholm have in common? These regional European financial centers sacrificed basic regulatory and oversight principles over the past decade for the sake of unmitigated growth. They harbored an ambition to quickly join the top-tier European financial capitals of London, Frankfurt, and Paris. Home to banks such as Kaupthing, RBS, HBOS, Depfa, Fortis, KBC, WestLB, IKB and BayernLB, Unicredit, Erste, and Swedbank, these cities are now the hosts of some of the worst casualties of the current financial crisis.

One of the key promoters of the new regional centers was Charles McCreevy, Irish finance minister from 1997-2004, whose biggest coup in 2001 was to lure Depfa, the German public-sector covered bond issuer, from Frankfurt to Dublin by offering its management substantial tax savings and relaxed banking supervision. Once in Ireland, Depfa--stretched by razor-thin margins in public finance--operated under the high asset-to-liability mismatches that German regulators had been eyeing for years and finally ended in 1999. The 2008 financial crisis wrought disaster on Depfa, which had been taken over in 2007 by Munich-based Hypo Real Estate. Alarmed by what it was hearing, German regulators in March asked Ireland for permission to review Depfa's books, which prompted them to instruct Hypo Real Estate in Munich to instruct Depfa in Dublin to close positions. Despite that order, when Hypo Real Estate had to be rescued with a 35 billion [euro] German public bailout package in October, Depfa Ireland was still exposed to huge money market roll-over risk and remained the key source of Hypo Real Estate's problems. The supervision chaos was personified by German finance minister Peer Steinbruck, who on October 15 mistakenly claimed that German supervisors had no right to inspect a bank located in Ireland.

The example reveals the structural "prisoner's dilemma" under which European bank regulation and supervision must operate. Absent coordination, individual European countries can adopt moral hazard strategies, hoping to gain individually while the rest of Europe is losing. The super-dilemma is that almost all European states embark on some variant of such strategies, and hence their list keeps growing as the mutual incentives to avoid reforms remain strong. Personal income taxes are low for investors in Switzerland, Liechtenstein, and Monaco, or for bankers in the United Kingdom. Ireland, Luxemburg, Iceland offer corporate income tax havens. Subsidies for specific funding products abound, including French savings passbooks and German Bausparen. Regulatory competition appears in all areas, such as strong subordination of depositors in the German and Spanish covered bond legislations, or special public ownership and intervention privileges still taken for granted throughout most of the continent under the excuse of the property rights guarantee of the EU Treaty (Germany, Spain, Italy, France, Poland, and Hungary excercise this guarantee with regard to public retail banks).

A feature common to all is the lack of incentives to facilitate information exchange about bank safety and soundness across borders and to take joint action by supervisors, a matter that has increasingly attracted attention of internationally active banks that are the main losers from multiple supervision lines, mushrooming regulations, and lack of supervisor co-ordination, and therefore have been pushing for a cross-border framework for years.

When the financial crisis reached its culminating point in 2008 and bank balance sheets, rather than lending operations or locations, became the targets of public intervention, a whole series of new policy coordination failures materialized.

The race to the bottom had begun in late 2007, as central banks globally beginning to lower collateral standards for open market operations in order to stem the growing liquidity crunch. The European Central Bank had acted early by allowing large volumes of mortgage bonds to be repoed, although doubts about their quality had been raised. The U.S. Federal Reserve only followed later.

Ireland surprisingly in September 2008 removed any limits on bank deposit insurance coverage, which prompted Germany to follow suit and left Britain confronted with the threat of large deposit outflows. Soon much of the rest of Europe was raising coverage limits. Rather than containing the rush to...