While a general set of rules for European banks was progressively established in successive capital requirements directives, substantial flexibility remained in how those rules was interpreted at the national level. The Lamfalussy process was launched in an effort to iron out these differences, but the process rested entirely on cooperation between national supervisors, with no possibilities for binding mediation or enforcement at the European level – and it was fiercely resisted by countries with financial centres. The divergence this permitted in the application of regulatory and supervisory standards allowed serious financial imbalances to build-up in some jurisdictions, which then of course created serious blowback for the euro area. But similar to fiscal policies, an inconsistent framework also undermined the value of prudential policy itself. As, for example, definitions of forbearance and non-performing exposures differed widely across countries, investors simply did not trust in banks’ stated asset values and provisions. In other words, the confidence effects that prudential policy is supposed to provide disappeared when they were most needed. For structural policies there were no binding European rules at all, as they were seen as having a primarily national significance. Inconsistency between policy areas These governance arrangements were not only internally inconsistent, however; they were inconsistent with each other.
Good governance underpins any successful business model and it is of utmost importance that DFIs follow best practices that promote integrity, transparency and accountability. To achieve this, DFIs should strive to strengthen behaviour and risk culture within the organisation. Strong governance entails crafting well-defined mandates that will insulate the organisation from undue external interference. Focus should also be given to foster a culture that welcomes active debates and critical thinking at all levels of the organisation to guard against groupthink. Last but not least, to sustain effective and high performance, continuous upskilling of the board, senior management and staff is crucial to be able to seize opportunities and overcome challenges as they arise. While the DFIs of today have grown in size and outreach, there remain opportunities for them to maximise their full potential. Innovation is lacking in developing diversified financial products that are tailored to meet the specific needs of targeted sectors. This is compounded by their limited capacity and capability to manage the potential risks arising from financing high risk sectors due to information asymmetries. DFIs should aim to become the centre of reference for new growth sectors and emerging markets and develop expertise in risk assessment and management of high risk projects in those sectors. Underlying the strategies for a good business model is the need for DFIs to strengthen research and analytical capabilities to address their lending capacity by developing innovative solutions.