At a lunchtime meeting on 30 April, Colin Mayer noted the contrast between the major difficulties encountered by the member states of the European Community in reaching agreement on the regulation of financial services and the ease with which they reached agreement to harmonize the regulation of banks. Mayer is Price Waterhouse Professor of Corporate Finance at the City University Business School, Co-Director of the Centre's Applied Microeconomics programme, and Chairman of the European Science Foundation Network in Financial Markets. His talk was based on his paper, `European Financial Integration: A Framework for Policy Analysis', written jointly with Damien Neven, in European Financial Integration, which he co-edited with Alberto Giovannini (see box). The meeting formed part of CEPR's research programme on `Financial and Monetary Integration in Europe', supported by the Commission of the European Communities under its SPES programme, and further financial support was provided by Cambridge University Press.

Mayer argued that the differences between the financial services available in the various member states of the European Community are greater than those between goods. Nevertheless, the European Commission should only intervene to regulate the market in such services when there is both a risk of market failure and a danger that regulation by national governments would introduce cross-border externalities incompatible with the overriding principle of free trade.

Mayer noted that the case for bank regulation is well established. Market failure leading to bank runs as witnessed in the nineteenth century and the 1930s can have disastrous consequences for depositors and for the whole economy if a general banking collapse disrupts the payments mechanism for transactions in goods. The Commission's principle of `home country authorization' stipulates that a financial institution licensed in any member country must be free to trade and to open subsidiaries throughout the Community. Intervention by the Commission to harmonize regulatory standards is therefore required to avert the danger of competitive under- regulation as national governments seek to maintain the competitiveness of their own banking sectors, which may risk destabilizing their currencies. The future emergence of a single currency is also likely to have major effects on the design of prudential regulation that must be addressed at the Community level.

Mayer attributed the Community's difficulties in reaching agreement on the regulation of non-bank financial services to the inappropriate extension of regulations that were initially designed for banks. Focusing on investment businesses, he argued that for most financial institutions the primary dangers investors face are fraud, negligence and incompetence. Capital requirements should be high when firms' capital holdings and quality are closely related; regulation should screen for honesty and competence so far as is possible, but it must depend on penalties; and this requires both an effective monitoring system and rules to minimize investors' exposure when monitoring and screening are difficult. The design of regulations should therefore differ markedly across different types of financial institution.

Whereas investors using banks, brokers and dealers are exposed to the risk of financial failure of the institutions with which they transact, investors using investment managers face no such financial risks, provided that their funds remain separate from the investment managers'. Banks, brokers and dealers should therefore be subject to capital requirements to provide investor protection: investment managers should not.

Mayer argued that the Commission's proposals to extend banking regulations to cover non-bank institutions are not just undesirable and politically unrealistic. They should also be unnecessary, since if any one member state's system of financial markets and regulation is indeed superior to the others', then it will become established through competition over time as the dominant system throughout Europe. In the non-bank sector, investors may now choose from services of institutions in different countries. If one country wishes to promote a competitive financial sector with few barriers to entry, it should be free to do so. Then investors should be free to purchase financial services from institutions operating under a variety of regulatory regimes, provided that they are aware of the levels of protection offered by the various markets or alternatively that national regulators are required to provide adequate compensation in the event of failure. Mayer concluded that the Commission should ensure that regulatory systems have the necessary resources to provide adequate compensation in that event, but it need not impose common regulatory rules. There is now a clear risk that unduly onerous regulation and excessive harmonization will stifle the closer integration of European financial markets: without a clearly defined set of rules, government failures may outweigh the market failures they are attempting to correct.