Including updates on the Single Supervisory Mechanism, Client Money and RWAs


Making good on SSM

Plans to finalise the Eurozone banking union will consume considerable attention, energy and time this year. Policy makers face significant challenges in constructing its three pillars: the single supervisory mechanism (SSM), a single resolution mechanism, and a common deposit guarantee scheme.

Work on building the SSM is well underway. Following the release of the Commission’s proposal in September 2012, the EcoFIN Council’s agreement (14 December 2012) forms the basis for the current trialogue negotiations with the European Parliament. On 31 January 2013, Vítor Constâncio, Vice President of the European Central Bank (ECB), suggested that the Council’s proposals represented a “robust legal framework” for the SSM to operate. It would establish the ECB as the prudential supervisor of more than 6,000 Eurozone banks from early 2014. The ECB would have direct prudential supervisory responsibility for large banks (with assets over €30bn and/or more than 25% of national output). Smaller and regional banks will be overseen by national supervisors, but the ECB would retain the right to intervene in any bank and deliver instructions to national supervisors.

On 12 February 2013, Constâncio underlines that the SSM needs to be one system: any decentralisation of procedures (or powers) has to be clearly delineated. He notes that “to ensure a strong centre, the ECB’s final responsibility for supervision within the SSM is matched by control powers over the system as a whole, as well as by very close cooperation arrangements with national authorities”. If properly constructed, the SSM will create “uniformly high standard[s] of enforcement, remove national distortions, and mitigate the build-up of risk concentrations that compromises systemic stability” according to an IMF paper, A Banking Union for the Euro Area, published on 13 February 2013. Moreover, the design should reduce regulatory capture by insulating supervisors from the implicit and explicit forces of their regulated entities.

However, a number of elements are necessary to support this single structure. First, the propagation of a single rule book for prudential regulation (the Capital Requirements Directive IV for banks and large investment firms) across the EU is necessary. As we have reported previously, the negotiations on CRD IV are lumbering their way through the EU legislative process: it should be agreed in the coming weeks and implemented by early 2014.

Second, the ECB will need to ensure supervisory procedures and practices converge quickly into a common approach. Deputy Governor of the Irish Central Bank, Matthew Elderfield, believes that this integration will not be easy. For example, developing a common framework for risk assessment with common approaches to inspection and supervisory reviews will involve some “important early practical design questions” according to Elderfield who had experience of working in the UK financial regulator when it subsumed a number of smaller regulators back in the early 1990s.

Moreover, the supervisory philosophy (e.g. principles based and rules-based) and risk appetite will need to be forged, covering issues such as level of intrusiveness, interaction with senior management and what early warning indicators are adopted. Elderfield, who for the past three years has been attempting to re-shape the broken Irish regulatory system, believes the new single supervisory mechanism needs to give national supervisors “a clear mandate to be challenging and assertive with banks in ensuring that risks are not just identified but are definitively mitigated in a time-bound manner.”

Third, the “central control” approach throws up a number of organisation and decision-making conundrums. Once the ECB is up-and-running it will have to manage the hundreds of issues and matters for decision and action. During times of stress this volume will surge exponentially. Elderfield believes that the SSM will have to have a “carefully calibrated governance structure”, involving a Supervisory Board that interacts with the ECB Governing Council. Transplanting the ECB’s monetary structure is not appropriate as the interactions with national financial supervisors will be much greater than has been experienced by the ECB with national monetary authorities under the Single Monetary Authority. There needs to be a clear demarcation of labour between national supervisory and “efficient decision-making procedures” according to Elderfield. The IMF echoes the need for clarity on duties, powers and accountability for all constituent parts of the SSM. It believes that agreeing up-front the “elements, modalities, and resources for a banking union can help avoid the pitfalls of a piecemeal approach and an outcome that is worse than at the start”.

Finally, there can be no SSM without a lender of last resort and some safety nets. Generally, countries can use a combination of mechanisms to deal with ailing banks, such as a deposit insurance agency, a rainy day fund paid by bank dues, or an understanding that big banks will bail-out their smaller peers in times of distress. However, at the Eurozone level, the plans also foresee a common financial backstop permitting direct financial intervention by the European Stability Mechanism in order to break the destructive sovereign/bank feedback loop experienced recently. Work on agreeing the Commission’s proposal on national bank recovery and resolution regimes is ongoing: it will become the main priority once the legislation on the SSM and CRD IV are agreed. The Commission intends to table another proposal aimed at establishing a Single Resolution Mechanism (SRM) in the Eurozone by the summer. Further harmonisation of deposit guarantee schemes will follow in the medium term. Constâncio (12 February 2013) believes that the SRM should create a single resolution authority that would govern the resolution systemically important banks operating on a cross-border basis, coordinate the application of resolution tools and reflect an organisational set-up similar to the SSM. The authority should have a comprehensive set of powers and sufficient funding to resolve all banks in the SSM.

Constâncio foresees a phased approach: “First, the writing-down of capital instruments and bailing-in of creditors should be fully exploited. Second, funds accumulated in a European Resolution Fund should be used to provide additional funding needed to realise a least-cost resolution strategy. These contributions should be risk-based and collected ex-ante from all banks participating in the SRM. Third, as a last resort, if the resources of the European Resolution Fund do not suffice, funds could be drawn from a European-level fiscal backstop mechanism.” However, if resources are needed from the European Stability Mechanism, it should be on the basis of a loan to the SRM thus reducing further the possibility of any impact on taxpayers.

The idea of more integrated prudential regulatory oversight was effective in calming markets last year. In particular it demonstrated that politicians finally understood that deep reform of the Eurozone project was necessary to break the negative feedback loop of rising sovereign and bank borrowing costs, reduce fragmentation of markets and stem deposit flight. However building the banking union will not be easy. European policy makers need to remain resolute in making the grand plan of the SSM, and the banking union as a whole, a reality.



Filling in the gaps: EC propose new anti-money laundering rules

Money laundering a still a problem blighting some European banks, as demonstrated by a number of high profile cases last year. Complying with sanctioning regimes internationally is an ongoing challenge for banks.

The current regulation prohibiting this activity in the EU, the Anti-Money Laundering Directive (AMLD3) (Directive 2005/60/EC), is a pretty solid piece of legislation. The EC believes that there are no fundamental shortcomings in the current framework that require substantial change. Deficiencies arise from ineffective supervision and the challenges in detecting illicit wrongdoings when they occur. However, some minor adjustments are necessary to effectively respond to evolving threats of money laundering and terrorist financing. The EC consulted on revising AMLD 3 in June 2012 to kick-start this process.

On 5 February 2013, the EC published legislative proposals for AMLD 4 (COM/2013/045 final) and for a Regulation on information accompanying transfers of funds to secure “due traceability” of these transfers (COM/2013/044 final). Both proposals provide a more targeted and risk-based approach. They also take into account the latest Recommendations of the Financial Action Task Force (FATF) but go further in a number of areas.

The proposed Directive improves clarity and consistency of the rules across Member States by providing a clear mechanism for identification of beneficial owners and customer due diligence requirements. It expands the provisions dealing with “politically exposed persons” (PEPs), to now also include “domestic” (i.e. those residing in EU Member States), in addition to “foreign” politically PEPs and those in international organisations.

The proposal broadens the scope of the AMLD 3 beyond existing “obliged entities” to include the gambling sector more widely (not just physical and online casinos which are already covered in the Directive) and all persons dealing in goods or providing services for cash payments of €7,500 or more (the previous threshold was €15,000). Such persons will now be covered by the provisions of the Directive including the need to carry out customer due diligence, maintain records, have internal controls and file suspicious transaction reports. Tax crimes are also under scope of the proposed AMLD 4, in response to FATCA’s standards which included tax crimes, related to both direct taxes and indirect taxes, as a “predicate offence”.

Both the Directive and Regulation will now pass to the European Parliament and Council to negotiate the final legislation. Even though the proposals are not contentious, given the backlog of work already on their plate, it is unlikely that level 1 text will be agreed until Q1 2014 at the earliest.



Protecting client money

Fall-out from the Lehman Brothers and MF Global insolvencies highlighted the importance of client asset protection regimes. In this context, a common set of principles is necessary to ensure that investors have some degree of protection regardless of which intermediaries they use and in which countries.

On 8 February 2013, the International Organisation of Securities Commissions (IOSCO) published a consultation report on recommendations regarding the protection of client assets (CR02/13).

IOSCO calls on intermediaries to:

  • Maintain accurate and up-to-date records and accounts of client assets that readily establish the precise nature, amount, location and ownership status of the assets and the clients for whom those assets are held. The records should also be maintained in such a way that they may be used as an audit trail
  • Provide a statement to each client on a regular basis, as well as on request, detailing the assets held for or on behalf of such client.
  • Maintain appropriate arrangements to safeguard the clients’ rights in their assets and minimise the risk of loss and misuse.
  • Comply with applicable foreign client money requirements in cases where the intermediary places or deposits client assets in a foreign jurisdiction.
  • Ensure that there is clarity and transparency in the disclosure of the relevant client asset protection regimes and arrangements and the consequent risks involved.

Where the regulatory regime permits clients to waive or to modify the degree of protection applicable to client assets, such arrangements should be subject to the following safeguards:

  • The arrangement should only take place with the client’s explicit, written consent.
  • Before such consent is obtained, the intermediary should ensure that the client has been provided with a clear and understandable disclosure of the implications of giving such consent.
  • If such arrangements are limited to particular categories of clients, clear criteria delineating those clients that fall within such categories should be defined.

The report also sets a number of principles intended to help regulators enhance their supervision of intermediaries holding client assets. In particular, IOSCO maintains the importance of a supervisory regime to oversee intermediaries’ compliance with the applicable domestic requirements. Clients have also a role to play in ensuring that their money is being protected effectively. A more informed client base which demanded stringent safeguards and credible backstops would be the best catalyst for improving client money practices at intermediaries.


Variation in Risk Weight Assets

The Basel Committee published a report on the consistency of banks’ market risk-weighted asset (mRWA) measures on 31 January 2013.

The report noted substantial variation in mRWAs across global banks. In particular, the Committee’s hypothetical exercise showed that there was a “substantial difference” between the lowest and highest mRWAs. They found that this variation was attributable to two main factors: supervisory approaches and modelling choices.

Regarding the former, the Basel Committee noted that national regulators have a lot of discretion to restrict the available modelling options for their banks and/or require individual banks to apply a higher risk weighting to their market risk. Approximately one quarter of the variation was due to this.

Regarding the latter, they found that significant flexibility within models (e.g. whether to measure risk over one day or ten days, aggregation of asset classes, etc) accounted for the remaining three quarters of the variation.

The report highlights three main policy options for reducing the variation of mRWAs:

  • enhancing banks’ public disclosure requirements
  • reducing the flexibility allowed within mRWA assessment models
  • harmonising national supervisors approaches to mRWA assessment.

The report also acknowledges that the Basel standards deliberately allow for some flexibility as regards risk measurement and that a certain amount of variation should therefore be expected.

The findings are not necessarily evidence of gaming by bankers or ‘capture’ of supervisors. In one way, it is good there is heterogeneity in how banks measure risks. The crisis demonstrated the dangers of group think on risk, for example the riskiness of opaque collateral debt obligations or even plain vanilla private/commercial mortgages. However supervisors need to work further to understand the reasons behind these differences and get a better handle on indicators of systemic risk so they can help guide banks through the quagmire of measuring risk.