Including updates on remuneration, the Anti-Money Laundering Directive, good regulation and stress testing


Identifying ‘risk takers’ in banks proving problematic

The European Banking Authority (EBA) is ‘genuinely concerned’ about inconsistencies in the way in which risk takers are identified in banks, as part of wider-remuneration requirements under the Capital Requirements Directive (CRD) III, which came into force in January 2011.

As part of CRD III, firms are required to identify the categories of staff that have a material impact on their risk profile. A recent EBA survey of remuneration policy indicated that firms use a large variety of criteria for this internal exercise but these are not always sufficient in terms of adequately capturing the risk impact aspect of this exercise or to taking into account less quantifiable risks such as reputational risk.

The number of ‘Identified Staff’ differs considerably between countries, but there is a clear tendency to select very low numbers, according to the EBA. This affects the core of the CRD III requirements, ‘undermines’ the effectiveness of EU reforms on remuneration and may lead to regulatory arbitrage and competitive disadvantages.

The EBA said that some supervisors are struggling to adequately identify risk takers in firms and have expressed the need for clear criteria and a process in this area. Moreover, on the first cycle of application of CRD III, the EBA reports that too many resources were spent on identifying risk takers, rather than focusing more on risk alignment principles. The UK’s ‘approved person’s regime’ may be a template that other countries could use to alleviate these difficulties but the EBA has not committed to any recommendations at this stage.

On a positive note, the EBA said the impact of CRD III remuneration requirements on corporate governance has been consistently strong across all countries. Implementation of most other aspects of CRD III remuneration requirements has been generally good; however, certain aspects still remain ‘underdeveloped’.

One such area relates to the relationship between variable and fixed remuneration; the EBA found that the average ratio was 122 percent for executives, and 139 percent for other employees. However, it identified some instances of ratios as high as 429 percent and 940 percent, respectively. Therefore, on average, variable remuneration considerably exceeds fixed remuneration, which the EBA argues could incentivise staff to take too much risk in the short-term in order to assure a certain minimum pay level.

In a repeat of the negotiation process for CRD III during 2010, the European Parliament is inserting amendments to limit the permissible ratio between variable and fixed remuneration in the new Capital Requirements Directive (CRD IV). The EC later removed this proposal from CRD III, replacing it with a requirement for the EBA to prepare remuneration guidelines. However, given ongoing concerns about the risk appetite and culture at banks, more prescriptive rules may be introduced this time round- requiring firms to enforce a constant ratio between the variable and fixed remuneration of its employees.

Clearly, this proposal, if adopted, could have considerable ramifications for banks’ pay structures, and potentially for their business models. There seems to be a significant potential for unintended consequences, as a likely response banks could increase base pay, rather than decrease bonuses, which would increase fixed costs and make businesses more vulnerable to adverse changes in market conditions. This is clearly an area to watch.


Tweaking the Anti-Money Laundering Directive

Of all the current financial regulations in place, the third Anti-Money Laundering Directive (AMLD 3) (2005/60/EC) has held up pretty well in the face of the financial crisis. The EC believes that there are no fundamental shortcomings in the current framework that will require substantial change when the Commission brings forward legislative proposals for the third reiteration of the Directive (AMLD 4) later this year.

However, some tweaking of AMLD 3 is necessary to respond effectively to evolving threats of money laundering and terrorist financing, according to the EC. Of note, the consultation considers whether tax crimes should be included as a specific category of ‘serious crimes’ under Article 3(5) of AMLD 3 and/or whether further definition of tax crimes is required. This is in response to new Financial Action Task Force (FATF) standards which included tax crimes (related to direct taxes and indirect taxes) as a ‘predicate offence’.

The EC are also considering broadening the scope of the AMLD 3 beyond existing ‘obliged entities’ to potentially include the gambling sector more widely (not just physical and online casinos which are already covered in the Directive), all agents operating on behalf of financial institutions, real estate/letting agents, dealers in precious stones and metals and national central banks.

The changes also include the following:
  • incorporating more risk-based elements in the framework
  • possible amendments to the third-country equivalence regime
  • clarifying customer due diligence requirements
  • possible clarification of the definition of ‘beneficial owner’, and the introduction of measures to promote the transparency of legal persons and arrangements.
  • greater harmonisation of sanctions for non-compliance with AMLD3
  • clarifying how supervisory powers apply in cross-border situations
  • incorporating new provisions to deal with politically exposed persons (PEPs) (for both PEPs at a domestic level and for those working for international organisations)
  • incorporating new provisions on data protection, in the light of the Commission's January 2012 proposals
The EC’s consultation closes on 13 June 2012, after which it will prepare an impact assessment and outline legislative proposals for the fourth Anti-Money Laundering Directive later in autumn 2012. It is also planning to organise a public hearing on 23 November 2012.


OECD sets out principles for good regulation

The Organisation for Economic Co-operation and Development (OECD) has published guidance to help its members build and strengthen capacity for regulatory quality and reform. The report outlines several inter-related principles which traverse all stages of the regulatory policy making process and constitute what the OECD considers ‘best practice’. The guidance is the fruit of over a decade of analysis and country reviews and represents a ‘maturing of thinking and learning from experience’, according to the think-tank.

Firstly, the OECD believes that governments should have an overarching policy for regulatory quality which informs decisions across all industry regulators. The policy should have clear objectives and frameworks for implementation to ensure that, if regulation is used (regardless of the industry), the benefits should outweigh the costs. To buffer this process, the report recommends that mechanisms and institutions should be established to actively provide oversight of regulatory policy procedures and goals to ensure that regulation serves the public interest.

Regulatory Impact Assessments (RIA) should be used at the early stages of the policy making process according to the OECD. Moreover, ‘periodic systematic programme reviews’ of the stock of significant regulations is recommended, enabling policy makers to step-back from their regulatory regimes to examine its cost effectiveness and whether it is achieving its desired aims. These reviews should be disclosed regularly to the public and to regulated entities, together with rigorous cost benefit analysis and information on how regulatory tools such as RIA, public consultation practices and reviews of existing regulations are functioning in practice.

There should be a consistent policy covering the role and functions of regulatory agencies in order to provide ‘greater confidence that regulatory decisions are made on an objective, impartial and consistent basis, without conflict of interest, bias or improper influence’, according to the report. In line with the push towards a single-rule book in financial services, the OECD recommends co-ordination mechanisms between the supra national, the national and sub-national levels of government to identify cross cutting regulatory issues which require an inter-governmental approach.

Of particular note, the OECD calls for a ‘whole-of-government’ approach to regulatory reform, with emphasis on the importance of ‘consultation, co-ordination, communication and co-operation to address the challenges posed by the inter-connectedness of sectors and economies’. Such an approach is proving a significant challenge in the European Union recently, given the pace of reforms for the financial services industry. A slew of regulatory proposals have been adopted in response to the financial crisis over the past three years. However, the regulatory reform process is now entering a very difficult phase where detailed technical rules and standards are being thrashed out by legislators and financial regulators. Adherence to the OECD guidelines would suggest that these rules and the accompanying implementing standards shouldn’t be rushed through without broad consultation and communication. Financial regulators need to be given enough time and resource to achieve high quality reform, supported by appropriate and meaningful consultation with market participants and rigorous assessment of the costs and benefits of reforms.

Based on the OCED’s research, ‘best practice’ regulatory processes tend to result in better regulations. In spite of the fact that much still needs to be done to address weaknesses identified by the financial crisis, European financial regulators need to start (re)applying these principles wholesale, in the interest of better regulation, as well as the competitiveness of the financial industry and European economies.


Basel Committee positive about progress on stress testing

Back in 2008, the Basel Committee for Bank Supervision (Committee) reviewed the performance of stress testing practices during the crisis and found weaknesses in various areas. In response, it published Principles for sound stress testing practices and supervision (May 2009) based on its findings and as part of overall efforts to incorporate early lessons from the crisis.

Four years later, the Committee reviewed the implementation of its stress testing principles. It has found that stress testing has become an ingrained part of the supervisory assessment process in many countries. However, there have been some problems. Stress test frameworks and methodologies, by their very nature, are dynamic and require constant modification. The high degree of global economic and financial uncertainty has not helped matters and, although many supervisors and banks had operational stress testing frameworks in place, these were not revised in line with expectations in order to broaden and deepen stress testing capabilities at both banks and supervisors.

The review found that countries are at varying stages of maturity in their implementation of the principles. Nearly half of the countries were considered to be at an early stage. These countries showed some progress toward implementing the principles, but they may not have issued or finalised prudential requirements on enterprise-wide stress testing since the principles were published.

In contrast, only a few countries were considered to be advanced, displaying evidence of rigorous regular review process that included a combination of on-site and off-site assessments, some review and feedback on detailed stress testing models used by banks, evidence of follow-up actions and a well-embedded supervisory stress testing programme that was not limited to externally imposed scenarios.

The remainder of countries fall between the above two groupings. These countries have issued some formal requirements or guidance consistent with the principles, are generally performing regular supervisory stress tests on large banks in their jurisdictions and are reviewing stress testing in the context of annual internal capital adequacy assessment process reviews and specific risk reviews.

In terms of remaining challenges ahead, the Committee called for more detailed and comprehensive reviews of banks’ enterprise-wide stress testing governance and modelling-- moving beyond just testing a firms’ capital and liquidity risks in response to negative shocks. A number of Committee members noted the resource-intensive nature of industry-wide stress tests. Many, however, found that these exercises have been helpful in terms of enhancing the visibility of stress testing and providing a structured basis for dialogue with banks on their capabilities.