Preventing Europe’s Next Banking Crisis

As shockwaves from America’s subprime disaster continue to reverberate, there is growing doubt about Europe’s ability to handle a financial crisis on a major scale. Severe lapses in bank regulation – in Germany, Britain, and perhaps France – have damaged the credibility of national systems of supervision. But this is only part of the problem. The European Union remains hopelessly ill-equipped to handle the crises that haven’t yet happened: cross-border crises sparked by EU banks’ increasing interdependence.

EU financial integration began in earnest in the 1980’s, and the European Commission and European Council made great strides in financial-sector reform. Among the milestones were the decisions in 1986-1988 to remove all restrictions on cross-border capital flows, and the launch in 1999 of a legislative action plan on financial services. The euro was introduced and quickly became the world’s second currency, behind the dollar.

Perhaps less conspicuous, the EU’s decision to adopt International Financial Reporting Standards in 2000-2002 triggered an extraordinary move toward the global harmonization of accounting rules. Meanwhile, the Commission’s steadfast defense of competition in the banking sector – particularly in Portugal, Germany, Italy, and Poland – ended an era of protectionism in the guise of prudential control; this helped to spur cross-border financial integration to an extent unprecedented in developed economies.

These achievements came during a period of remarkable stability in Europe’s financial markets. Even during the 1992-1993 dark days of the European Monetary System, Europe looked like a safe haven in an unsettled financial world. Many countries outside the European Community suffered banking crises, including neighboring Norway, Sweden, Finland, and Turkey, as well as many East European nations during their transitions from communism.