Including updates on crisis management and resolution, institutional models for macroprudential supervision and ESA's ambitious plans for 2012


Making crisis management regimes workable

Significant legal challenges need to be addressed to ensure the effective operation of a European crisis management system and bank resolution regime, according to a legal working paper from the European Central Bank (ECB).

The severity of the recent financial crisis showed that general corporate insolvency laws are ineffective tools for managing bank failures, because they do not address financial stability and contagion concerns, and only allow regulators and administrators to intervene at a stage that is too late to prevent disruption to the wider market and economy. Moreover, without a clearly defined legal framework in place, governments have found that bailing-out financial institutions is the only workable solution, but at the cost of creating negative consequences as moral hazard.

The creation of a special resolution regime for banks which provides authorities ‘the necessary tools and powers to react to a financial institution under threat of failure’ is therefore essential. In this context, the laws should focus not just on the individual bank resolution, but on macro prudential/ systemic considerations with a view to minimising the externalities of a crisis, such as the interruption of core financial services, contagion to other markets, and institutions and unnecessary fiscal expenditure.

In many cases, public authorities will want to intervene at a pre-insolvency stage and not simply liquidate the ailing bank. The most ‘challenging’ legal issue arising from crisis management is the inevitable interference with the rights of shareholders and creditors when the government intervenes to rescue an ailing bank. Any resolution regime which involves a contribution by creditors to the bank’s restructuring constitutes an interference with their property rights and must satisfy a number of requirements under EU law.

The ECB paper points to several other challenges in designing an effective EU crisis management regime including balancing public and private interests and protecting banking functions in the economy. They also provide a detailed description of both the German and UK special resolution regimes for financial institutions which have been developed following the financial crisis.

This detailed and comprehensive research by the ECB is timely. We expect the European Commission to publish legislative proposals on an EU crisis management and resolution framework shortly. The planned regime could play a major role in improving both financial stability and integration within the EU financial sector, by taking on-board many of the lessons learnt from the 2008 crisis. Ideally, the ECB (in a July 2011 article on EU crisis management) suggests that the new regime should ensure that each individual Member State has effective tools at its disposal, and that, when cross-border bank resolution is necessary, Member States can coordinate the consistent application of these tools.

However, the success of the new crisis management regime in Europe will heavily depend on the practical implementation of the new regime, and the extent to which legislators will be able to disentangle the far-reaching interlinkages between the supervisory and fiscal aspects. It will also be important to coordinate relevant regimes with third countries, especially the United States, in order to enable the smooth resolution of cross-border banks as well.


Institutional models of macroprudential supervision

Orthodox monetary or regulatory policy responses to counteract credit booms are generally insufficient because their affect on the credit bubble lags, so that policy set this year has its initial impact on the economy next year, ‘by which time the bubble will have either grown further or collapsed’ (Gruen et al. 2003). Lord Adair Turner, chairman of the FSA, and others are calling for the use of unconventional tools ‘to break the cycle of booms and busts’ experienced by the global banking system in past decades. In this regard, commentators believe that macroprudential tools could help mitigate the drivers to excessive credit growth and help direct capital to sectors which are favourable to the real economy, while in the long-run, benefiting the health and sustainability of banks. However, the development and implementation of these tools is still at a very early stage, with policymakers still grappling with the issue both at the conceptual level and in practical terms.

In light of these gaps, the International Monetary Fund (IMF) recently published a working paper on institutional models for macroprudential policy calling on governments to ‘rethink’ the appropriate institutional boundaries between central banks and financial supervisors, or the establishment of dedicated policymaking committees. New institutional arrangements have emerged at international, regional and national levels but questions remain regarding the decision-making process within multi-agency macroprudential authorities and the best arrangements for ensuring accountability for implementing actions. The IMF presents a ‘distinct set of stylized institutional models’, examining their strengths and weaknesses. The paper also demonstrates that to be conducive to effective mitigation of systemic risk, institutional models need to:
  • support effective identification of risks through access to information and relevant expertise
  • provide incentives for the timely and effective use of policy tools, and
  • ensure the cooperation across policies in a manner that preserves the autonomy of established policy functions.
Notwithstanding institutional considerations, significant limitations in supervisors’ current analytical toolkit are posing problems in assessing systemic risk. Firstly, supervisors need clarity on what a macro-prudential policy is designed to do. According to a joint report from the Financial Stability Board, IMF and Bank of International Settlements in February 2011, macroprudential policy should focus on ‘risks arising primarily within the financial system, or amplified by the financial system’: it should not substitute for robust micro-prudential standards nor be used to address macroeconomic shocks or imbalances. However, quality data is needed for clarity and currently that is lacking. More progress on developing analytical models and more international cooperation between authorities is needed to ensure that qualitative assessments can complement quantitative analysis.


EBA and ESMA set out ambitious agendas for 2012

Last week the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) published their extensive work programmes for the year ahead. The European Insurance and Occupational Pensions’ (EIOPA) work programme is still under review as certain provisions are finalised. We expect EIOPA to publish their 2012 work programme sometime next month.

Both ESMA and EBA will focus mainly on finalising and implementing several key regulations. EBA’s main priorities will be the Capital Requirements Directive IV (to implement the Basel III global capital standards in European banks) and crisis prevention and crisis resolution arrangements. ESMA plans to drive forward the European Markets Infrastructure Regulation (EMIR) (governing the operation of securities markets - i.e. central counterparties), the Alternative Investment Fund Managers Directive (AIFMD) (regulating the alternative fund management industry), the revision of the Markets in Financial Instruments Directive (MiFID II) (extended market regulation and enhanced reporting and transparency requirements for trading of financial instruments) and Credit Rating Agencies III Regulation (regulating credit rating agencies and reducing over-reliance on ratings).

However, in a number of areas how much they are able to achieve in 2012 will depend on the progress made by the European Parliament and Council on Level 1 initiatives. EBA and ESMA remain committed to introducing a single rule book for financial institutions this year. Also, both indicated that they will focus more on consumer protection in the financial sector throughout this year, through ongoing scrutiny of existing rules and in the case of ESMA, potential use of its powers to ban products.

These regulations will have profound implications for the way financial institutions operate, and in particular, impacting the way firms many operate derivatives businesses. The sheer volume and complexity of the European Supervisory Authorities agenda in 2012 will challenge national regulators and financial institutions’ ability to effectively analyse, respond to, and plan for the substantial operational changes required to implement these measures.