Breaking free from the eurozone’s liquidity trap
The eurozone crisis has now reached systemic proportions and the euro has ‘only ten days to save itself’, Ollie Rehn, European Commissioner for Economic and Monetary Affairs, said on 30 November 2011.
Despite new governments in Spain and Italy, yields on ten-year bonds in both countries remains stubbornly high (both above 6%). Other countries, such as Belgium and France, are now experiencing rising borrowing costs amid heightened concerns over the health of their financial systems. Investors have even displayed some hesitancy on German bonds; the government could only sell about two-thirds of a 6 billion euro bond auction on 23 November, as uncertainty about the fate of the single currency continues to make investors wary about eurozone sovereign bond markets.
As yields increase, the underlying price of government bonds reduces. This places additional strain on banks’ balance sheets, forcing them to sell assets, deleverage and withdraw from providing funding on wholesale interbank markets. This, in turn, damages the prospects of economic recovery, weakens public finances and forces banks to raise additional capital (and thus the spiral continues).
This sequence of events is currently being played out in Europe. Financial institutions are scrambling to meet the June 2012 minimum capital-adequacy targets (9% capital ratios) set by EU leaders. Banks in France, the UK, Ireland, Germany and Spain have already unveiled plans to slash a total of 775 billion euros of assets over the next few years. Morgan Stanley estimates that the real figure could be closer to 1.5-2.5 trillion euros in the next 18 months. Banks have already started repatriating funds from Eastern Europe according to the Economist
, which may explain in part the stability of the euro against the dollar in recent weeks, despite the eurozone’s ‘internal convulsions’.
The problems are further exacerbated by strains on wholesale funding markets. Long-term bond issues by financial institutions have been rare in recent months, with US money market funds, thus far the primary buyer of these instruments, abstaining from these markets. Central Banks have tried to avert a liquidity crunch by taking the coordinated action of lowering the pricing on the existing temporary US dollar liquidity swap arrangements because a number of US banks refused to roll-over US dollar denominated debt of large European banks, according to press reports.
This is forcing banks to sell even more assets and tighten lending further in the real economy. Not surprisingly, the OECD said on 28 November that the eurozone is currently in a mild recession, having slashed growth in Quarter 3 2011 to only 0.2%. Based on surveys of purchasing managers in manufacturing and services, eurozone sentiment is also pointing to significant reduction in activity in 2012. A decline is further borne out from figures on industrial orders, which fell by 6.4% in the eurozone in September, the largest decline since three years. Consumer sentiment has now fallen for last five consecutive months.
In the short-term, the ECB is the only institution that can help stop the vicious feedback loop by providing unlimited liquidity for banks for longer terms against a broader range of collateral. This means cutting short-term rates and engaging in ‘quantitative easing’ on a large scale.
Mario Draghi, the ECB chief, indicated to the European Parliament on the 1 December that a ‘fiscal compact’ could result in more ‘aggressive action’ by the ECB in response to the crisis. Given the need for swift action, Draghi hinted that the ECB may be willing to intervene in markets without waiting for treaty changes, suggesting that ‘faster processes are also conceivable’ to create conditions which ease the moral hazard concerns that the ECB would have in acting as lender of last resort.
Preparing contingency plans on the eurozone crisis
UK authorities ‘are making contingency plans’ on the possible break-up of the eurozone and banks should take similar action, according to the Bank of England’s governor Mervyn King.
Despite the Bank of England’s assessment that UK banks are adequately capitalised (particularly relative to their continental peers), King called on firms to limit distributions (i.e. dividends and bonuses) and give ‘serious consideration’ to raising additional capital in the coming months.
A break-up is just one of the many scenarios the governor is keen for banks to consider as part of their contingency planning. The effects of short-term measures to address the crisis, such as massive ECB funding, external help from the IMF, sovereign default or the creation of stability bonds (better known as eurobonds) as outlined recently by the Commission, should be considered by firms.
These short-term measures will only be introduced if European leaders agree to lasting solutions to resolve the crisis. Under such conditions, the eurozone is faced with two probable solutions: a tighter fiscal union amongst eurozone members or some form of euro break-up.
Tighter fiscal union is favoured by most governments and commentators. Despite German reluctance, a fiscal union would probably result in the creation of joint eurobonds to mutualise at least some debt of weaker countries. Fiscal integration is difficult to control via the existing channels of government oversight and therefore would require fundamental treaty changes (which may be difficult and time consuming to agree), such as strict rules around national budgets and the creation of supranational monitoring agencies.
Fiscal union would result in the creation of a two-speed EU, with a ‘federal’ core of the 17 eurozone members and a looser ‘confederal’ outer ring of non-eurozone members, as outlined by French President Nicolas Sarkozy in a recent speech. Although, governments in non-eurozone countries, such as the UK and Sweden support this policy, others are expressing concerns that this could upset the single market for financial services in the EU and isolate non-eurozone countries as the inner circle becomes more protectionist in the future. The inevitable faster harmonisation of regulation and legislation within the eurozone would also further separate both camps, and make it more challenging to achieve efficiency gains or deliver customer benefits by operating across a single market. Notwithstanding these concerns, the break-up of the euro currency would far-and-away exceed any costs associated with tighter fiscal integration. In fact, recent research from UBS suggests that the cost would be ‘so enormous as to be unimaginable.’ The shocks associated with the departure of a member state from the euro would reverberate deeply across the European financial system, causing a capital flight in weaker economies as depositors worry that their savings will be devalued in the near future. Regulators would be forced to impose capital controls to reduce the flight of capital from these territories. If concerns spread to larger countries, the ability of the ECB to create a firewall around troubled countries would be severely diminished.
Analysing these scenarios is important, given the significance of the forthcoming changes. Since the crisis, the authorities have made a concerted effort to enhance the risk management intelligence of senior managers. Scenario analysis and stress tests using quantitative models can be used to estimate quite effectively the impact that lower domestic growth or property prices would have on a bank’s loan book. However, attempting to calculate the impact of a sovereign default, eurozone break-up or a tighter fiscal union is difficult, and fraught with many pitfalls. Supervisors should encourage banks to pool their analysis where possible and establish special forums to facilitate the exchange of ideas between senior management to help create macro-strategies.
If banks prepare now by undertaking robust stress tests and scenario planning, they can place themselves in a better position to navigate whatever the regulatory and fiscal landscape they will face following the eurozone crisis.
EC publishes work 2012 programme
The EC has published its work programme for the year ahead, giving regulators and firms no time to draw breath from a busy 2011. With the publication of big ticket items such as MiFID II and CRD IV, the Commission has managed to keep its eye firmly on its objectives and resist being completely distracted from the sovereign debt crisis. However, the work programme suggests one more big proposal – on crisis management and bank resolution – should still be expected before the end of this year.
Some timelines have slipped (such as Solvency II), but this has largely been due to the realisation that firms needed more time to prepare for the changes. In addition to the publication of a number of key ‘Level 1’ proposals, the Commission, supported by the new European Supervisory Authorities (ESAs), has managed to make significant progress on implementing measures for key legislations such as Solvency II, the Prospectus Directive and AIFMD during the course of year. However, tensions persist in relation to the relative powers of the Commission in light of the Lisbon Treaty, and that of the ESAs: an ongoing debate that will spill-over into next year, along with continuing concerns around the adequacy of the resources.
In early 2012, investor protection in the retail market will take centre stage with the publication of the ‘horizontal’ proposal on Packaged Retail Investment Products (PRIPs), following initial consultation in November 2010, which will focus on providing comparable information to clients on these products. This proposal will complement provisions in MiFID II focusing on marketing and selling practices, and should be accompanied by an equivalent overhaul of the Insurance Mediation Directive (IMD) in respect of insurance-based PRIPs. However, the Commission has not provided any indication as to the release date on the IMD proposal. Concerns are growing that IMD revisions may not be sufficient to ensure equal treatment and protection for retail customers across all forms of PRIPs. The piecemeal approach to the release of these various proposals also creates concerns about overall consistency in approach.
Legislative proposals are expected in mid-2012 amending the UCITS Directive (UCITS V). Although initially tipped to focus on depository functions, manager remuneration policy and administrative sanctions, recent commentary by the Commission has suggested that it may be wider in scope, focusing on other issues – such as ‘complex’ UCITS – which have increased investor protection concerns in recent months.
The Commission’s work programme indicates that it intends to produce a Communication on shadow banking in the second half of 2012. In a recent exchange with the European Parliament, however, Michael Barnier, European Commissioner for Internal Market and Services, said that he is in fact considering the adoption of a legislative proposal in this area. By the end of 2012, the Commission will publish legislative proposals to revise the Institutions for Occupational Retirement Provision (IORP) Directive with a view to addressing the challenges of demographic ageing and public debt in order to maintain a level playing field with Solvency II and promote greater cross border activities.
There are a number of other important regulatory developments in the pipeline for 2012, where the Commission hasn’t indicated a provisional date, including:
- Third Anti-Money Laundering Directive: This revision is in the context of a review of international standards which is scheduled for completion by February 2012. The Commission’s own review has also begun and a report is planned in early 2012. It will be necessary to rapidly implement international standards once adopted into EU legislation.
- Securities Law Directive: legislative proposals reducing the divergence between national substantive laws on book-entry securities with the overall objective of simplifying financial markets operations while enhancing legal certainty.
- Close-out netting: legislative proposals to increase legal certainty and safety of bi- and multilateral netting agreements, but also, as part of an EU framework for crisis management in the financial sector, to empower national authorities to impose a temporary stay on the rights to close-out netting.
- Insurance Guarantee Schemes (IGS): legislative proposals ensuring that IGS exist in all Member States and that they comply with a minimum set of design features.
- Revision to the Financial Conglomerates Directive: The revision seeks to close many of the loopholes in the previous regime and facilitate appropriate supplementary supervision of financial entities in a financial conglomerate. The changes also amend the relevant legislation on banking and insurance supervision, namely the Capital Requirements Directive and the Directive on Supplementary Supervision of Insurance Undertakings in Insurance Groups.
Italy and Poland taken to court over CRD III implementation
The European Commission is taking Italy and Poland to the European Court of Justice for failing to implement the Capital Requirements Directive III (CRD III) by 1 January 2011. CRD III introduced measures on new remuneration policies and practices (i.e. structure of pay, the amount and timing of bonus payments, etc.) and the extension of certain minimum capital requirements for firms. Its requirements relating to remuneration should have come into effect by the beginning of this year.
Poland has already notified the Commission of certain transposing measures which have been adopted, but it has yet to enact all the provisions concerning the extension of minimum capital requirements and has not notified the Commission of the implementing measures adopted by the supervisory authority responsible for remuneration policies. Italy has not notified the Commission about any transposition measures.
The Commission has requested the court to impose daily fines for Italy (€96k) and Poland (€37k). If the court agrees, these daily fines will be payable with effect from the date on which the court hands down its judgment and for as long as transposition remains incomplete.
The speed at which the Commission has taken this action is significant, and clearly signals its commitment to driving through the regulatory reform agenda across the EU. CRD III was principally targeted at addressing imprudent remuneration structures that adversely affected risk management practices, and is a political hot topic, particularly for the public given the ongoing implicit or explicit support provided by national governments to the financial system. However, more difficult tests remain, and the Commission must keep up the same vigour when the time comes to implement more far-reaching regulations such as CRD IV, AIFMD or MiFID II.
ECB release standards for using CCPs
The ECB is keen to put in place governing standards for the use of central counterparties (CCPs), to ensure the safe and efficient use of infrastructure and to limit exposure to risks. The ECB and Eurosystem national central banks invest in a variety of financial instruments in the context of their foreign reserve management role, including certain over-the-counter (OTC) derivatives such as interest rates swaps. While central banks will be exempt from the mandatory clearing of all trading in standardised over-the-counter (OTC) derivatives (from 2012, as per G20 requirements), the ECB and other central banks in the Eurosystem may decide to make use of CCP services in order to benefit from liquidity efficiency.
The principles do not cover aspects of supervision or oversight of CCPs, but relate to ‘user standards’ and should be viewed as an addendum to existing requirements. The standards are applicable to CCPs providing clearing services for financial contracts that are relevant to the Eurosystem’s foreign reserve management, including:
- Adequate status for central banks as CCP participants: CCPs should establish direct access criteria and risk management requirements which are consistent with the risk proﬁle of central banks.
- Segregation and portability: CCPs should offer segregation and portability for the Eurosystem’s positions and assets on individual accounts in order to limit risks in the event of the failure of a general clearing member which is used by the Eurosystem.
- Settlement in central bank money: CCPs should have adequate access and recourse to the central bank facilities available in their jurisdiction. CCPs should use central bank money for cash settlement. CCPs should share information on the availability of central bank services with the Eurosystem.
- Compliance with Eurosystem policies: CCPs should comply with relevant Eurosystem policies at all times. This includes compliance with the Eurosystem’s location policy for non-euro area CCPs with sizeable amounts of euro-denominated business.
- Access to relevant information: CCPs should provide the Eurosystem with all information relevant from a user’s perspective. However, this remains a controversial issue for non-eurozone members.