The European Systemic Risk Board (ESRB) believes that a “credible regulatory framework” is needed to ensure the proper functioning and oversight of all reference benchmarks. In its response to the European Commission’s (EC) proposals on reforming benchmarks, ESRB describes LIBOR and EURIBOR as “partly flawed” and supports overhauling how they are calculated and governed.
These seminal benchmarks aren’t the only ones needing reform. The pan-EU macroprudential regulator has highlighted shortcomings in the calculation of most benchmarks and indices, suggesting that many are open to gaming and are characterised by weak governance processes. Specifically reforms should be rolled-out on credit default swaps and repo indices, commodity price indices and proprietary benchmarks, particularly those that define payoffs from structured retail products.
ESRB recommends that the setting and administration of benchmarks should be regulated. Benchmark providers and contributors should be subjected to “stringent control” and “independent oversight” mechanisms. ESRB believes that “deliberate distortion of benchmarks is a market abuse and should be punished accordingly” and welcomes the EC’s amendments to the Market Abuse Directive II/Regulation. The ESRB also supports the work of the European Banking Authority and European Securities and Markets Authority which are currently preparing guidelines for reference rates and other benchmarks-setting processes.
ESRB wants transparency in the methodology used to calculate benchmarks. But it generally supports a form of “lagged transparency” of individual submissions, to protect contributors against intensive market scrutiny during stressed conditions.
Market participants should identify and evaluate how they use benchmarks, including whether standard contracts contain adequate contingency provisions if LIBOR is not available. Rules for conceivable eventualities should be worked out in advanced to ensure that continuing provision of the benchmark rate in the case of failure. Increasing the number of contributors and their geographical diversification would help. But supplying a reliable benchmark during periods of market stress or thinly traded markets remains a challenge. The ESRB favours the development of some sort of “contingency mechanism” that would automatically supply a reference rate in cases where a benchmark is unable to accurately reflect market conditions.
Overreliance on a single benchmark should be avoided because it could foster contagion across markets. The notional outstanding value of contracts referenced on LIBOR is estimated to be in the range of US$233-303 trillion according to UK authorities; but could be as high as US$800 trillion. EURIBOR is more difficult to estimate. According to end-2011 Bank for International Settlement data, the notional amount of OTC interest rate derivatives only referenced to euro interest rates was US$184 trillion: most of which probably used EURIBOR as the reference.
A greater diversity of benchmark indices “may better reflect the changes and risks in markets” and improve market efficiency. The ESRB doesn’t put forward specific suggests on what bespoke benchmarks should be developed for certain transactions--industry would be best placed to undertake this task. But it would like to see a wider use of references indices which take into account structural changes in bank funding over recent years and indices that are closer measures of risk-free interest rates.
The EC’s consultation on benchmarks closed on 29 November 2012. We expect legislative proposals sometime in the New Year. In the UK, the Government has now accepted the ‘Wheatley Review’ proposals on LIBOR, including:
Some of these changes are currently being implemented, others will take a bit longer to finalise. Any required legislative changes will be incorporated in the UK Financial Services Bill which is likely to come into force in early 2013.
While LIBOR and EURIBOR have different structures, they are perceived in many respects as ‘twin’ rates. It is important that reforms for the respective benchmarks are coherent and consistent, to help minimise contributors’ compliance costs and give users more confidence on the robustness of rates. European regulators may want to prioritise reforms on EURIBOR to keep in-step with the timing of the UK’s reforms.
External links: EC’s consultation on benchmarks (September 2012); ESRB's response to the EC's consultation (November 2012); EC’s amendments to MAD II/MAR (July 2012); the Wheatley Review of LIBOR (interim) (August 2012); the Wheatley Review of LIBOR (final) (September 2012).
The EC’s plans for a FTT were stalled last year when a handful of Member States made it clear that they had specific problems with the proposals, making agreement next to impossible. But in October a coalition of 11 countries indicated they were ready to consider establishing a common system of FTT. Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia and Slovakia favour it, and the Netherlands is still weighing up its options. The 11 Member States called on the EC to re-table its FTT proposals under what is known as the ‘enhanced co-operation procedure’. In response, the EC adopted the enhanced co-operation procedure a few weeks ago and is currently working on finalising its proposals—which will be largely based on its September 2011 text.
The enhanced co-operation process allows nine or more Member States to move forward on a particular area as a last resort if the EU as a whole cannot reach agreement within a reasonable period. All members of the Council may participate in its deliberations, but only those participating in enhanced cooperation shall take part in the vote. Other Member States are free to join the enhanced co-operation at any time.
During recent EU budget negotiations, EU Council President Herman Van Rompuy suggested that the FTT revenues should be used to off-set national contributions. This is not the first time EU authorities have laid claim to the proceeds of a FTT. In its budgetary plans for 2014-2020, the EC floated the idea of using a FTT as a source of revenue, to make it less reliant on funds from national governments.
Proceeds from a FTT could generate around €57 billion over a seven year period if all member states participate, equivalent to about one third of its overall budget. The revenue estimate assumes a 0.1% levy is imposed on the value of transactions involving stocks and bonds, and a 0.01% levy on derivative transactions.
The IMF believes that there are more efficient ways of taxing the financial sector than a FTT, arguing that backward looking charges on financial instruments based on past balance sheet items is more effective. Many commentators, including the ECB, have also warned that the FTT could damage competitiveness of European financial centres unless the scheme is adopted internationally.
What impact a FTT would have on trading across the EU is unclear; the 11 countries have asked the EC to undertake a detailed impact assessment of the proposals. Other countries, such as the UK and Poland, are also keen to see the results of this assessment.
Losing alignment of the single market and creating an unlevel playing field within it poses potential for problems. The EC needs to tread carefully in this area and ensure that its assessment of whether and how to implement a FTT is rigorous.
External links: EU Council Press release (October 2012); Commissioner Šemeta statement (October 2012); EC's proposals authorising the enhanced cooperation procedure (October 2012).
The ECB is starting to envisage what it will do when prudential regulation of all Eurozone banks is heaped on its shoulders from next year under the Single Supervisory Mechanism (SSM).
In a speech to the European Banking Congress, Mario Draghi, ECB president, indicated that there will be a “rigorous separation of monetary and supervisory policies” within the organisation. The ECB will establish a separate Supervisory Board of senior representatives from national supervisory authorities to ensure this separation is robust.
The Supervisory Board will be at the heart of a decentralised system of financial supervision. Draghi indicates that decision-making will be collective “based on a collegial approach”. National supervisors will be “prime actors” in the new framework, and will contribute with knowledge of their national markets.
Centralised supervision will be felt highest for systemically important banks (SIBs) according to Draghi. These institutions will also face daily interactions with their national supervisors. National supervisors will still be largely responsible for the supervision of smaller banks but the ECB will still have overall responsibility.
Draghi rejected calls that the ECB’s supervisory remit should only extend to SIBs. The financial crisis has demonstrated that small banks (e.g. Cajas in Spain; Anglo Irish Bank in Ireland) have the capacity to destabilise the financial system and even sovereigns. Moreover, due to interlinkages and mechanisms of contagion, even smaller banks may turn out to be systemically important.
The ECB will seek to ensure “homogeneous supervision, convergence of practices, a level playing field and therefore a reduction in banks’ compliance costs” under its reign. It sees the single rulebook that the European Banking Authority is developing as key to the success of its approach. But Draghi believes that ensuring convergence of regulation is not enough: “supervisory practices also need to converge”.
Draghi believes that the SSM will not only break the feedback loop between banks and sovereigns, it will also result in more effective monetary policy. The banking system is an important vector of monetary policy. Draghi believes the ECB needs to avoid significant differences in transmission arising from the countries in which banks happen to be located. SSM will help level the playing field and reduce fragmentation.
The ECB has a long way to go in preparing for the changes that lie ahead, but it is probably the best placed institution to take up this daunting role. Clearly, it will need time to prepare for these changes. Draghi called on politicians to agree the legal basis of SSM as soon as possible so that the ECB can begin its preparations.
External Links: Draghi’s speech (November 2012).