Including updates on UCITS IV comes into force, Basel III reforms and the future of financial regulation

 

UCITS IV comes into force

The UCITS Directive has been a key contributor to the significant development and success of the European investment fund industry over the last two decades, turning the UCITS product into a global brand. However, with the rapid evolution of the investment fund market, it was necessary to enhance the regime more broadly.

For that purpose, the recent amendments to the UCITS Directive (“UCITS IV”) introduces a number of modifications in the UCITS regulatory landscape which offer fund managers the opportunity to undertake a strategic reflection on their product range and management structure and introduces compulsory measures to enhance speed-to-market and investor protection. Firstly, the Directive provides a framework for amalgamating assets, be it through the cross-border merger of UCITS irrespective of their legal form, or by allowing master-feeder structures. Secondly, the UCITS IV management company passport will permit the remote establishment and cross border management of UCITS funds and the centralisation of their asset management, administration and risk management operations. Finally, two compulsory measures to enhance speed-to-market and investor protection, namely the: simplification of the cross-border notification process and the replacement of the simplified prospectus with Key Investor Information document (KIID)

On 1 July 2011, UCITS IV came into force in the EU. However detailed implementation rules which are necessary to bring into effect the new aspects of UCITS IV are still missing in many jurisdictions. Luxembourg, Germany, Ireland, Malta, UK and Denmark have transposed the Directive into national law and were ready for the 1 July deadline. France, Austria, the Netherlands, Romania, Cyprus, Italy, Spain, Sweden and Finland are still at the draft legislative stage. Norway, Belgium and Portugal are still waiting on their respective administrations to issue a draft of the law.

The longer the disjointed implementation process continues, the greater the possibility of regulatory arbitrage. It also places firms operating in jurisdictions who have not transposed the Directive at a competitive disadvantage with their more compliant counterparts. The problems associated with implementing Directives, like UCITS IV, uniformly across 27 Members States have influenced the EC’s decision to use mainly “Regulations” in the future which are automatically binding on Member States.

 

Basel III reforms and global systemically important banks

On 26 June 2011, the Group of Governors and Heads of Supervision (“the Committee”), the oversight body of the Basel Committee on Banking Supervision (BCBS), reached broad agreement on the overall design of the Basel III capital and liquidity reform measures.

In terms of defining capital, the Committee recognises that certain deductions in previous proposals could have resulted in adverse consequences on some business models and processes. Therefore, it has capped recognition of the following items at 10% of the bank’s common equity component (the aggregate of the three items are capped at 15%):
  • investments of more than 10% of issued share capital in unconsolidated financial institutions;
  • mortgage servicing rights; and
  • deferred tax assets that arise from timing differences.
It has also agreed to recognise minority interest supporting “the risks of a subsidiary that is a bank” and removing the counterparty credit restriction on hedging of investments in other financial institutions.

In terms of counterparty credit risk, the Committee is planning to modify the bond equivalent approach to calculating the credit valuation adjustment (CVA), eliminating the 5x multiplier on CVA that was proposed in December 2009 and applying a modest risk weight (1-3%) to central counterparty exposures. The new leverage ratio underpinning Basel III will be calculated as an average over a quarter and will adopt 10% uniform credit conversion factors for off-balance-sheet items. For derivative classes, the Committee has agreed to apply the previous Basel II netting plus a measure of potential future exposure to “strengthen” the treatment of derivatives relative to purely accounting based measurements. Bank level disclosure of the leverage ratio and its components will commence in 2015.

The Committee seems to have acknowledged the inherent differences between insurance and banking systemic risk (an issue we highlighted in EU Market Update 20 June, 2011) by adopting the term: global systemically important banks (G-SIBs), as opposed to the orthodox phase used by regulators: systemically important financial institutions. On the 25 June, it agreed on a consultative document delineating measures specifically for G-SIBs, including a methodology for determining systemic importance and the additional level of capital these institutions will be required to hold in the future. Consistent with previous proposals, the assessment methodology for G-SIBs will centre on five broad categories: size, interconnectedness, lack of substitutability, global activity and complexity. Additional loss absorbency requirements are to be achieved with a progressive common equity tier one capital requirement ranging from 1% to 2.5%, depending on a bank's systemic importance. Therefore, contingent capital is unlikely to play a prominent role in banks’ future capital structure. However, the Committee did note that it would “continue to review contingent capital, and support the use of contingent capital to meet higher national loss absorbency requirements than the global minimum.”

 

Quantifying the impact of CRD IV

Following the Basel Committee’s publication of its prudential framework for capital and liquidity—collectively known as Basel III—the EC is proposing amendments to the Capital Requirements Directive (CRD IV) to implement the changes in EU law. The suggested measures, which form an integral part of the EC’s response to the financial crisis, are designed to tighten the definition of bank capital and require banks to hold a larger amount of capital for a given amount of assets and expand the coverage of bank assets. The EC are expected to publish legislative proposals for amending the Capital Requirements Directive (2006/48/EC) and the Capital Adequacy Directive (2006/49/EC) on 20 July 2011.

Since Basel III was agreed, there has been much debate over its impact on banks’ balance sheets and on the financial system’s ability to support broader economic growth. On one side, there are those who argue that there are significant macroeconomic benefits from raising bank equity: higher capital requirements lower leverage and a reduced risk of bank bankruptcies. Another strand of the argument notes that Basel III will result in the higher cost of equity financing relative to debt financing, which would lead banks to raise the price of their lending and could depress loan growth and stunt the already fragile global recovery.

To contribute to the debate, the European Parliament (EP) on 30 June published a report estimating the impact that CRD IV regulations will have on the real economy. This is one of a number of expected impact assessments on CRD IV, including one from the European Commission (EC). Overall, the EP’s report concluded that benefits that accrue from higher capital requirements— namely by reducing the probability and severity of financial crises—will far and away exceed its costs, in terms of higher financing costs for banks and a reduction in lending in the economy. While the new capital requirements will not necessarily reduce the likelihood of bank failures, it will diminish the severity of financial crises when they occur. Interestingly, it notes that capital requirements above 13% are associated with no extra gains in terms of increased economic stability.

A recent IMF working paper supported the EP’s overall assessment, demonstrating that the potential reduction in lending and investment following the implementation of Basel III “is not predicted to substantial”. The IMF’s current models on loan rate and loan demand predict that a 130 basis points increase in the equity-to-asset ratio required by Basel III should reduce loans of the 100 largest banks by about 130 basis points in the long run. While the impact on lending will be marginal, the IMF notes that Basel III could result in incentives for regulatory arbitrage. The additional capital requirements on large financial institutions would “act as a tax”, since the additional cost of equity would lead to higher loan rates or reduced equity returns. If large complex financial institutions cannot mitigate the effect of higher capital costs, they may lose competitiveness and business to smaller institutions. This may result in a fragmentation of the global financial system as shareholders push for large institutions to be broken up.

 

Financial Stability Board (FSB) puts deposit insurance back on the agenda

On 1 July 2011, the FSB announced the launch of a peer review on deposit insurance systems. The review follows a 2009 report by the Bank for International Settlements (BIS) and the International Association of Deposit Insurers (IADI) which sets out international principles and standards for effective deposit insurance, covering issues such as public awareness, membership and coverage, governance and cross-border considerations. The FSB are now keen to take stock of current developments, to draw lessons on the effectiveness of reforms implemented in the wake of the financial crisis and assess compliance of member jurisdictions’ deposit insurance systems and any planned changes against the core principles propagated by the BIS/IADI.

Information underpinning the review will be sourced from financial institutions, industry and consumer associations and stakeholders on their experiences with deposit insurance systems. The review is structured as a questionnaire and focuses on the following issues:
  • Key features of deposit insurance systems;
  • Reforms undertaken in response to the financial crisis; and
  • National implementation of specific BIS/IADI core principles for effective deposit insurance systems.
Feedback to the questionnaire should be submitted by 26 August 2011. The FSB will analyse responses and publish a peer review report in early 2012.

The FSB peer review comes at time when the EU is on the verge of imminent change to its deposit insurance scheme. Following the financial crisis, the haphazard and uncoordinated nature of the deposit insurance schemes across EU Members States was exposed when the Irish government took the unilateral decision to guarantee the assets and liabilities of its banking system in September 2008, forcing a host of other European countries (e.g. UK, France) to take similar measures.

On 12 July 2010, EC adopted a legislative proposal for a thorough revision of the Directive on Deposit Guarantee Schemes. It mainly deals with a harmonisation and simplification of protected deposits, a faster payout, and an improved financing of schemes. The EC’s proposals are currently being negotiated in the EU Council and Parliament and a consensus is relatively close. It intends to publish a legislative initiative on bank recovery and resolution in September 2011.

 

International Monetary Fund (IMF) proposes risk based money laundering assessment

Since first introduced in 2007, the IMF’s Anti-Money Laundering and Combating the Financing the Terrorism (AML/CFT) programme has played a significant part in the international community’s response to money laundering and the financing of global terrorism. Its requirements have been incorporated into Reports on the Observance of Standards and Codes (ROSCs), which provide the basis for AML/CFT the various components (including AML/CFT) of the IMF/World Bank Financial Sector Assessment Program (FSAP). However, in contrast to other standards that form part of the ROSC programme, there is no framework within ALM/CFT for risk based assessment. Despite adopting a number of “unique” burden-sharing arrangements designed to limit the burden on the IMF and other competent authorities, the ALM/CFT assessment has been “time consuming” and “expensive.” However, the risk-focused approach “may or may not result in significant saving”. The IMF overall objective in moving towards a risk-focused approach is to “improve the quality of the assessments” and the “usefulness of the advice” provided to its members.

The IMF plan to adopt a risk-focused approach to ALM/CFT ROSCs will enable partial AML/CFT assessments in the future. These assessments would focus on the areas which represent the greatest risk of money laundering or terrorist financing, targeting resources efficiently and cost effectively. The IMF and the World Bank are also considering modifying the current policy, whereby all countries included in the FSAP are required to include a full AML/CFT assessment. This relaxing of requirements would further align AML/CFT ROSC policy with other comparable standards.

The IMF is also considering developing criteria which will enable competent authorities to assess which AML/CFT issues pose risks to financial stability of members or to external stability in the wider global community. The criteria would encompass the member’s circumstances, vis-à-vis the relative importance of AML/CFT relative to other matters which effect financial stability. It will be used to guide surveillance and determine whether to include AML/CFT issues in a modular financial stability assessment.

By adopting a risk-based approach, the IMF suggest that AML/CFT assessors will need to move from just assessing member’s compliance with a defined set of FATF Recommendations to start developing a deeper understanding of the economies they are examining—including the criminal and underground economies— to help identify the areas that merit detailed examination. Assessors would also have to determine whether measures adopted by assessed countries would be effective in addressing AML/CFT risks. Under such circumstances, the IMF believes that an assessment would need to be preceded by consultation with the relevant member and with other assessor bodies.

 

European Banking Authority (EBA) Chairman delivers speech on the future of financial regulation

On 29 June 2011, Andrea Enria, the Chairman of the EBA, gave a speech entitled “The future of EU regulation” at the British Bankers’ Association’s (BBA) annual conference. Enria considers the need for consistency in the implementation of global reforms. He believes it’s essential that “exactly the same rules” apply across the EU, particularly on the definition of capital and liquidity requirements. To this end, the development of a single rulebook is important, that is, “key technical regulations should be adopted by means of standards defined at the EU level and adopted through EU regulations”, so that they are applicable to all financial institutions. In the past, rules disparities stimulated regulatory arbitrage as financial institutions sought those jurisdictions with the lightest regulations, concentrating risks in certain areas. A single rule book should help reduce, what Enria calls, “the dead-weight costs” associated with cross-border institutions complying with similar rules in a fragmented compliance process across different jurisdictions. However, Enria notes that some degree of “constrained” discretion is required at national level, under ex ante guidance and ex post review by the European Systemic Risk Board.

The effectiveness and fairness of regulatory reform is also discussed and Enria indicates that co-ordinated action is needed in the following areas: the shadow banking sector, convergence in best supervisory practices and co-ordination of crisis management and resolution on a cross border basis. In terms of the shadow banking system, Enria suggests either regulators attempt to bring all off-balance sheet activities that generate systemic risk “under the regulatory umbrella” or enforce a “strict licensing regime”, which allows only banks and other intensively regulated institutions to engage in risk and liquidity transformation activities that generate systemic risk.