Including updates on the IMF criticising CRD IV proposals, regulation haircuts and money laundering and financial institutions


IMF criticises CRD IV proposals

The IMF is “disappointed” with the European Commission’s legislative proposals to implement Basel III, known as the Capital Requirement Directive (CRD) IV. It is calling for changes as the legislation is finalised in the coming months.

In a supplement to its UK country report, the IMF expressed “serious concern” about potential proposals, suggesting that it had “fallen short of its recommendations.” In particular, they emphasized the need to fully implement the internationally agreed Basel III framework. They also stressed the importance that national authorities have discretion to set higher standards than Basel III in specific circumstances and to operate countercyclical macro prudential policy — including adjusting capital and liquidity requirements or varying risk weights— in order to address emerging financial and systemic risks.

Specifically, the IMF raised the following problems with CRD IV:
  • The common standards are too weak: enforcing maximum harmonization at the level of Basel III minimum requirements is inappropriate given prevailing balance sheet uncertainties and the lack of EU-wide resolution arrangements.
  • Definition of “capital” has been diluted: the EC has softened its definition of core tier 1 capital in a number of areas relative to Basel III requirements. Basel III uses strict definitions of what counts as capital and the IMF underlined the importance of sticking to these definitions rigidly.
  • Liquidity ratio: the EC’s proposal lacks a firm commitment to implement the leverage ratio by 2018, as was agreed under Basel III.
The IMF fully supports various efforts to advocate for stronger standards in CRD IV. As we reported in a recent article there is a split in Europe between those countries (led by the UK) advocating for higher capital requirements together with topped-up provisions on significant banks that exceed Basel III minima, and those (led by Germany and France) who believe Basel III should be the maximum standards to protect their banks’ competitive position in global markets.

It will take at least six months for the package of measures contained in CRD IV to be approved by the EU Council and Parliament and the success or otherwise of the various parties involved will probably be influenced by the general state of the European financial system and how other jurisdictions (namely the United States) proceed with implementing Basel III. On the latter point, the French administration, for example, has stated previously it will not follow Basel III standards, unless the United States does so as well.  


The case for counter-cyclical haircuts

Regulating haircuts could be a useful tool in reducing the probability of a systemic liquidity crisis, according to new research by Andrew Haldane, Executive Director at the Bank of England.

As we would expect, haircuts on secured finance transactions are markedly pro-cyclical. As prices on the underlying asset decline, counterparties start demanding additional collateral to compensate for the added risk.

To investigate the relationship between haircuts and liquidity, Haldane, together with a number of researchers from the University of Auckland and the Bank of England, developed a banking network model which was interconnected through secured and unsecured lending, and then applied different haircut policies to the model.

The results indicate that if haircuts remain at a relative high (at around 20%) and constant throughout an economic cycle, the probability of a liquidity crisis remains very low. In contrast, lowering haircuts during an economic upturn (i.e. adopting a pro-cyclical policy) increases the risk of systemic collapse by a large magnitude.

To prevent liquidity stress, policy makers should control collateral requirements directly, either by imposing a minimum haircut limit on secured finance transactions or, alternatively, looking to reduce the inevitable pro-cyclical tendencies of the financial system as systemic risk increases. By adopting such measures, Haldane believes that the financial system is greatly protected against instances of system-wide liquidity stress. However, both strategies require banks to build up high quality liquid asset to protect against shocks in the event of haircuts being reduced.

These findings are timely, as haircuts have been cited by many governments as a potential macro prudential policy tool. For example, Timothy Geithner, United States Treasury Secretary, proposed controlling haircuts internationally by introducing minimum standards for margins on derivative transactions in a recent speech in Atlanta. Similarly, the UK government had identified haircuts on secured financing of over-the-counter transactions as one possible measure for executing macro prudential policy.

While the results of the paper are compelling — representing the first quantitative analysis on the impact of haircuts on the financial system — the research is not without its limitations. Firstly, we have little theoretical understanding of how haircut-based policies might affect banks’ behaviour. Secondly, there is limited empirical case law on how we could implement these policies effectively. Haldane admits these gaps suggesting we can’t be sure how banks might change their behaviour to compensate for tougher rules, for instance by switching back into unsecured lending.  


Administrative requirements of a financial transaction tax

Implementing a broad-based financial transaction tax (FTT) requires overcoming considerable administrative challenges, according to a recent IMF working paper.

The working paper suggests that broker-dealers and other major traders should be made responsible for charging and collecting an FTT in situations where exchanges or clearinghouses are unable to do so. However, small and occasional market participants should only remain subject to a tax when transacting with broker-dealers and not for other trades, according to the working paper.

Collecting the tax through exchanges or clearinghouses should reduce many of the costs associated with the compliance and administration for supervisors and traders alike — removing the need for market participants to register, collect and remit the tax. While the difficulties of taxing instruments that are not centrally cleared still remain, the IMF points to recent regulatory changes (i.e. over-the-counter regulations) in some countries and ongoing institutional developments (i.e. prominence of CLS Bank in settling foreign exchange transactions) which have made it easier to levy an FTT on a wider range of instruments than ever before.

FTT legislation requires clear provisions governing the territorial scope of the tax, the taxable event and its timing, the tax base, and the taxable persons involved. While these provisions might seem basic, the diversity of financial transactions, and the complexity of some instruments, give rise to a number of difficulties, such as whether the tax base should be instrument’s notional value or the amount of money that has been exchanged as part of the transaction.

While the interest in FTTs has grown since the financial crisis, the IMF observed in a 2010 report that a backward looking charge on financial instruments, based on past balance sheet items, was a more efficient way in recovering some of the fiscal costs of government support during the crisis. It outlined that FTTs reduced the value of securities, increased the cost of capital to users and had the effect of lowering overall liquidity in financial markets.

In spite of this assessment, the European Commission in January 2011 indicated that that it will be examining the implications of introducing an FTT in the European Union (EU), as part of an overall impact assessment on financial sector taxation which is scheduled to be published later this summer. Moreover, the European Parliament in March 2011 adopted a resolution urging the introduction of an FTT within the EU. Therefore, given the live nature of debates currently taking place in Europe, the IMF’s assessment of the policy and administrative feasibility of an FTT should provide useful insights into the practical implications facing governments if they decide to introduce a tax on financial transactions.  


OECD release principles on financial consumer protection

The OECD has called on all its members to put in place dedicated consumer protection agencies with the necessary authority and resources to fulfil their mandates, according to draft principles released on 1 August 2011 by the international think-tank.

The principles, which will feed into G20 discussions in Paris later this year, are designed to mitigate the risks that financial consumers will face fraud, abuse and misconduct in their interactions within the financial system.

The OECD has identified the following principles necessary for basic financial consumer protection:
  • robust legal and regulatory frameworks for financial consumer protection
  • standalone consumer protection bodies
  • improved financial education
  • equitable and fair treatment of consumers
  • proper disclosure and transparency
  • improved financial education
  • objective and adequate advice for consumers
  • protection of rights and data
  • adequate complaints handling and redress mechanisms
  • promotion of competition in financial markets.
A renewed focus on financial protection is necessary given the increased transfer opportunities of risks to consumers in various segments of the financial system (i.e. spread betting), rapid technology and financial product development (i.e. high frequency trading), the entry of non-traditional financial services providers (i.e. supermarkets) and misaligned incentives within the industry (i.e. bonus linked to short term performance metrics).

EU legislative reforms (i.e. MiFID II) already place a strong emphasis on consumer protection within their frameworks. The European Securities Market Authority (ESMA) is keen to evolve a consolidated EU supervisory and regulatory approach towards investor protection, aimed at restoring investor confidence. It will take actions to warn investors about certain products, or ban them outright, if national regulators fail to take action to sufficiently protect financial consumers, according to the Chairman of ESMA, Steven Maijoor.

The OECD principles are voluntary in nature and are designed to complement, not replace, existing international standards. Hopefully, the widespread adoption of these principles will bring some credibility back into an industry which has been damaged during the financial crisis. Selling unsuitable products to financial customers is counterproductive, as short terms gains will be followed by investors ultimately turning their backs on the industry. Importantly, the OECD has also recognised that with principles come a number of responsibilities on the part of customers. It has suggested that the customer protection legal and regulatory framework needs to reinforced and integrated with other financial inclusion and education policies given the relatively low levels of financial literacy and access to basic banking services in some OECD countries.  


Money laundering and financial institutions

Financial institutions being captured by criminal influence is one of the key vulnerabilities within the current Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) framework, according to a study by the Financial Action Task Force (FATF).

The report indicates that Politically Exposed Persons (PEPs) may have the ability to circumvent existing regulations and compromise financial institutions both inside and outside their jurisdictions, pointing to conviction of former Ukrainian Prime Minister Pavel Lazarenko in the United States .In this case, Lazarenko was able to use both foreign and domestic financial institutions in the Ukraine to transfer stolen monies to a variety of oversees accounts.

The FATF report focuses on publicly available information and seeks to strengthen the current ALM and CFT framework by exposing its vulnerabilities. Annex 1 to the report contains a summary of the corruption cases examined by the FATF, which all relate to PEPs. The types of corruption include bribery and kickbacks — of both foreign and domestic officials — embezzlement, extortion and self dealing.

In addition to the capture of financial institutions, the report identifies the following key vulnerabilities within the current AML and CFT framework:
  • ineffective enhanced due diligence on PEPs
  • ineffective communication between states and financial institutions.
FATF notes that the report will serve as a catalyst for future work in developing guidance or best practices on AML and CFT measures relevant to combating corruption.