Including updates on structural reform in EU banking, regulatory flux and the Liquidity Coverage Ratio

 

EC probe structural policy in banking

Proposals to structurally reform the EU banking sector could be here as soon as June, as the European Commission (EC) moves to establish its anticipated high-level expert group to examine the structural aspects of the EU banking sector. Michel Barnier, EU commissioner responsible for internal markets and services, outlined that the group will investigate whether the current regulatory reform agenda needs to be supported by future structural reforms in the interest of financial stability and customer protection. Speaking to reporters, Barnier indicated that there would be “no taboo” subjects for the group, which starts its work next month. The Commission intends to examine, in detail, both the US and UK structural reform proposals and how they might work in the context of the European banking system.

The structural proposals in the US are mainly centred on the Volcker Rule provisions of the US Dodd-Frank law which limits the scope of proprietary trading activities which may be conducted by insured depository institutions. The Volcker Rule also limits the extension of the federal bank ‘safety net’ (e.g., the benefits of federal deposit insurance and access to the Federal Reserve Board Discount Window) to hedge funds and private equity funds. The Volcker Rule proposals of October 2011 remain the subject of vigorous challenge, with the period for public comment recently extended to March 2012 (see PwC’s companion US Regulatory Reform Update to keep abreast with changes in this area).

Recently, the UK government endorsed the recommendations of its Independent Commission on Banking (ICB). By 2019, UK banks be required to ring-fence their retail bank operations from their investment banking and trading activities in a separate legal entity, with its own board of directors. Banks will be required to hold 10% capital inside the ring-fence, with an option for regulators to demand as much as 13%. The ICB estimates that these proposals may cost the industry as much as £7 billion.

The EC’s expert group which will examine these and other measures will be chaired by Erkki Liikanen, governor of the Bank of Finland and member of the Governing Council of the European Central Bank. Liikanen brings a wealth of financial and economic experience to this role, presiding over a country with a stable banking system that has successfully navigated the financial crisis pretty much unscathed and without resorting to public bail-out. His career also includes two mandates as a member of the EU commission between 1995 and 2004 and three years as Minister of Finance in Finland.

He will need to draw heavily on the consensus building skills he has amassed during his career when drafting proposals. Adopting common structural policy in banking across the EU will be highly contentious. The UK government may welcome EU structural reforms if they are in line with their own proposals and create a level playing field across Europe. However, if the EU proposals differ significantly, banks will find it complex and costly to do business in multiple countries with different regimes.

Other powerhouses such as Germany and France are keen defenders of their universal banking models and may balk at measures that would require banks to change. In fact, there is little evidence to suggest that structural reforms actually strengthen financial stability, improve efficiency and/or customer protection. The Swiss parliament took this view in September 2011 when it opted for stringent capital adequacy provisions over and above internationally agreed standards (Basel III), instead of adopting deep structural reforms in its banking system.

If Liikanen does propose far-reaching changes, the ‘single rule book’ propagated by the European Supervisory Authorities may be more easily achievable, risk concentration in territories may be mitigated and the Single Market across Europe could be greatly enhanced. However, a one-size-fits all solution will be difficult to achieve due to the inherent differences in the Member States’ legal systems and the diversity of their financial sectors (although further planned fiscal and monetary integration in the Eurozone will likely reduce many of these differences over time).

We can expect the Volcker vs ICB report (vs Liikanen) debate to be a forceful one during 2012, as the stakes are very high for all the players involved.


 

Regulatory flux continues

The pace of regulatory change shows no sign of abating. Last week we outlined the busy 2012 work schedule for EBA and ESMA. This week we are looking at work programmes from the European Commission’s Internal Market and Services Directorate General (DG MARKT) and the Financial Stability Board (FSB).

The 2012 management plan of DG MARKT will have a clear emphasis on stabilising the fragile EU banking system by ensuring prudential standards (Capital Requirement Directive IV) are agreed and recapitalisation plans made in October are fully implemented. There will also be increased attention on boosting the levels of consumer protection and restoring confidence in the retail financial services sector. The current financial and economic crisis has also brought to light many problems with the EU credit markets and has shown the need to ensure that lending decisions are based on sound criteria. DG MARKT will seek to push forward its grand vision of creating a single market for mortgages across the EU.

Specifically, DG MARKT will be:
  • proposing a directive on Insurance Guarantee Schemes to ensure that operational insurance guarantee schemes are put into place in all Member States
  • delivering a legislative initiative for bank recovery and resolution to foster cooperation and coordination among relevant authorities
  • developing a framework for crisis management and resolution for financial institutions other than banks, in particular concerning central counterparties
  • starting preparatory work on the revision of the Payment Services Directive, the E-money Directive and the Regulation on cross-border payments and
  • preparing “level 2” implementing measures for the Solvency II Directive to ensure further integration of the EU insurance market and enhanced protection of policy holders and beneficiaries.
The FSB also delineated its plans for the year ahead at its first board meeting of 2012. In addition to undertaking ad-hoc measures in response to on-going strains in the Eurozone or elsewhere, the FSB plans to focus on the following areas:
  • Addressing systemically important financial institutions (SIFIs): further developing and implementing the SIFI framework, including extending it to domestic systemically important banks.
  • Shadow banking: supporting the Basel Committee on Banking Supervision (Basel Committee) work streams to strengthen the regulation and oversight of shadow banking.
  • Over-the-counter (OTC) derivatives: ensuring agreed market reforms are delivered by the end of 2012.
  • Legal entity identifier (LEI): supporting the development of a unique global identifier for parties by coordinating work among the global regulatory community.
  • Financial reporting: encouraging the development of principles and identification of leading practices for risk disclosures.

 

Liquidity Coverage Ratio

The Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee, met on 8 January 2011 to discuss the global liquidity framework. GHOS members reiterated the central principle that a bank is expected to have a ‘stable funding structure’ to meet its liquidity needs in times of stress. They endorsed the agreed quantitative standards covered under the liquidity coverage ratio (LCR), and also reaffirmed its commitment to introduce minimum standard in 2015.

The LCR comprises of two quantitative standards for strengthening liquidity:
  • a 30-day liquidity coverage ratio designed to ensure short-term resilience to liquidity disruptions and
  • a longer-term structural liquidity ratio to address liquidity mismatches and promote the use of stable funding sources.
Once the LCR has been implemented, its 100% threshold will be a minimum requirement in normal times. But during a period of stress, banks would be expected to use their pool of liquid assets, thereby temporarily falling below the minimum requirement.

The Basel Committee indicated that it will provide further elaboration on this principle by clarifying the LCR rules to state explicitly that ‘liquid assets accumulated in normal times are intended to be used in times of stress’. It will also provide additional guidance on the circumstances that would justify the use of the pool.


 

ESMA publishes annual report on CRA regulation

The European Securities and Markets Authority (ESMA) published its first annual report on the application of Credit Rating Agencies (CRA) Regulation (Regulation No (EC) 1060/2009 and Regulation No (EU) 513/2011) in the EU. The report summarises the work carried out by national competent authorities (NCAs) and ESMA during the application and registration process of CRAs and presents the supervisory actions that ESMA has undertaken in the course of 2011 to ensure that registered CRAs comply with the standards established in the Regulation.

So far, 16 CRAs have been registered and a Japanese CRA certified. During 2011, 2 applications have been refused and 4 withdrawn (no reasons given by ESMA). The assessment of 3 applications is still ongoing.

ESMA highlighted some of its experiences with CRAs thus far:
  • Completeness of CRA applications: NCAs asked several times (on average twice) for additional information from CRAs during 2011 before the applications were considered complete. Generally, applications were not evaluated until full information was provided.
  • Organisation changes: All CRAs were required to undertake organisational changes based on the findings from the assessment process. In many cases they had to increase their human resources in their compliance and review teams. Most NCAs interviewed the independent directors of CRAs. Following such an interview, one large-sized CRA appointed a new independent director in the course of the registration process.
  • Operational requirements: NCAs paid special attention to the compliance of the applicants with the conflicts of interest provisions. CRAs have adjusted their policies and procedures to ensure that ‘conflicts of interest are periodically identified’.
  • Credit rating methodologies and rating process: NCAs scrutinised CRAs’ ongoing monitoring and annual review of ratings, in some cases resulting in changes to their rating processes, such as in relation to operation of the rating committee and various qualitative and quantitative criteria underpinning their models.
  • Supervisory actions carried out by ESMA: When necessary, ESMA has asked CRAs to provide further explanations on their compliance with the Regulation. ESMA has evaluated any changes made during the registration process, and changes in methodologies and the ownership structure. It has also carried out some on-site inspections following desk research.
ESMA believes that the work carried out by the NCAs was of a high standard and sufficiently proportionate for single entity CRAs to promote the entry of small players and competition into the market. The practice of organising supervisory colleges for pan-European CRAs across the EU worked well. In cases where disagreements arose, ESMA moderated to find a solution agreeable to all parties. Generally, the home NCA was given the final decision on applications.

This report is important for several reasons. The role of CRAs in the subprime crisis has been well documented. Raising their standards should make the financial system a less risky place to do business for all market players. Perhaps more importantly, ESMA’s approach and its interaction with NCAs in this Regulation is an indicator of its future supervisory approach. In this regard, the plurality of its approach, its close interaction with NCAs and the scope it gave national supervisors to enforce standards should be broadly welcomed.