Including updates on the proposition to delay the implementation of Solvency II and competition in the European banking system

 

EBA defends its stress test

Growing concerns about the fragility of the Greek economy are leading to much speculation about the European Banking Authority’s (EBA) stress test exercise. While the criteria of the stress test have been toughened this year with negative projections of GDP growth (0.5% contraction) and equity prices (15% contraction), banks consider that the lack of a requirement to build scenarios on the possibility of a sovereign debt default undermines the credibility of the test.

Speaking at the European Systemic Risk Board (ESRB) second ordinary meeting on 22 June 2011, EBA Chairman Andrea Enria refuted this claim stating that sovereign debt risk exposures are adequately addressed in the 2011 stress test.

For exposures in the trading book, stress test participants must apply mark to market under current regulations. In the 2011 stress test, the EBA has also updated the parameters associated with this exercise in line with market movements in those countries most adversely affected by the financial crisis. In the banking book, banks are required to calculate the credit risk of sovereign exposures by estimating probabilities of potential losses of sovereign default as part of the exercise. To address the possibility of some banks underestimating sovereign risks, the EBA has provided additional guidance which sets the floor on the sovereign risk weights—based on publicly available information such as external rating—which banks are required to map to their own internal risk rating scales. Moreover, Enria noted that the banks will provide full disclosure of the size and type of sovereign exposures when the results of the stress test are published later this month.

At the same press conference, Jean-Claude Trichet, Chairman of the ESRB, recognised that the results of the stress tests may still not completely quell negative market sentiment given the situation in Greece. He reiterated the need for Member States to ensure that national level backstop plans are in place for banks which pass the stress tests but are still identified by the markets as being “vulnerable” against the wider risks to the financial system. He believes that most serious threat to financial stability in Europe at the moment stems from the linkages between the vulnerabilities of public finances in some EU countries and the banking system, with possible contagion effects across Europe.

Subsequently, on 29 June 2011, Enria again sought to dispel recent rumours that the EBA will fail as many as 15 banks in the current round of stress tests, saying they were “completely unfounded.” Speaking to the members of the British Bankers’ Association, he said the pan-European regulatory body is still receiving submissions from the 91 banks and it is too soon to speculate on the outcome when “the results have not yet been put together”.

Clearly, this micro-prudential exercise - designed as an ongoing supervisory tool - cannot divorce itself from the severe macro-prudential risk in the system, and market reactions. Specifically including the possibility of sovereign debt restructuring, or even a sovereign default, in prescribed stress test scenarios, however, could have sent a message to the markets which would have made the current delicate efforts to stabilise the Greek situation more difficult. Last year, reliance on banks to effectively quantify private and sovereign risk proved spectacularly unjustified in some cases. This time round, it is up to the EBA to ensure that its peer review process is rigorous - and is seen as such. Its credibility, and the credibility of the European banking system, rests on this. However, the EBA’s current rearguard action to debunk unfounded rumours suggests that convincing the markets is going to be far from easy.

 

EU Council proposes to delay the implementation of Solvency II until 2014

On 21 June 2011 the Council published the latest Presidency Compromise on the Omnibus II Directive. The Omnibus II Directive (see previous PwC EU Market Update June 20 2011) is the Directive which, once approved by the Council and European Parliament, will amend the Solvency II framework directive (Directive 2009/138/EC) and set, amongst other things, the implementation date.

Notably, the Presidency Compromise moves away from a 1 January 2013 start date, suggesting a one year delay until January 2014. The Council’s position states that legal requirements will need to be transposed into national law by 31 March 2013.

The elements of the directive regarding supervisory approvals (e.g. use of internal models, ancillary own funds, use of undertaking specific parameters in the standard formula SCR) would apply from 1 July 2013 but any approvals granted cannot take effect before 1 January 2014. This means that insurers would be able to receive formal regulatory approval in respect of these items in the second half of 2013 prior to the new rules going live.

Insurers would, however, have an obligation to submit implementation plans to their supervisors by mid-2013 providing evidence of the progress made towards the application of Solvency II. The content of these plans are not specified but could reasonably be expected to contain detailed information demonstrating readiness to comply with all of Solvency II’s requirements. Under the Compromise, the current, Solvency I regime would not be repealed until 1 January 2014 and so, during 2013, the current capital and solvency requirements would continue to apply.

This is the first time that any of the EU policymakers has formally suggested a delay in the implementation date. The European Parliament’s position on this issue is not yet clear: the first indication of its views will be forthcoming in the draft report of its Economic and Monetary Affairs Committee which is expected to be released after the Parliamentary summer break. Clearly though, the Council’s position diverges significantly from that of the EC. In a letter to key industry associations on 1 June, Commissioner Barnier strongly reiterated the EC’s intention for the Solvency II regime to go live on 1 January 2013. Important uncertainties around the timetable are likely to remain until later in the year.

Insurers need to consider the impact of the potential deferral of the implementation date on their Solvency II implementation plans but, at the same time, push forward with their preparations against a 1 January 2013 timetable. Any distraction now could prove potentially costly in the long run.

 

Competition in the European banking system

One unfortunate side-effect of the financial crisis is increased market consolidation in many countries as governments have merged financial institutions to strengthen balance sheets overall. On 25 June 2011, an IMF report indicated that responses to the crisis have left “a strong mark on banking competition in many countries.”

Using a derivative of the H-Statistic, a common barometer used to determine the degree of market concentration in a particular industry, the IMF found that bank competition in the euro area had declined marginally following the financial crisis. However, in countries like Spain, where a large credit and housing boom had preceded the crisis, it observed a “significant decline” in competition. The report caveats these findings as preliminary evidence in view of the limited data set and the fact that the structural changes in the aftermath of the crisis may adversely distort the conditions necessary for validity of the H-Statistic.

However, these findings suggest that current trajectory of structural and behavioural developments in the European financial system may ultimately harm users and legitimate market participants. Even before the financial crisis, various studies estimated that inefficiencies resulting from concentration in the European banking system accounted for between 20-30% of firms’ total operating costs.

The European Commission (EC) recently re-emphasised the need for competition regulation to tackle the harmful behaviour of individual market participants. On 23 May 2011, Joaquín Almunia, Vice-President of the EC and the Commissioner responsible for competition, called on competition and financial regulators to work much more closely together in the future. Almunia stressed “whereas regulation tackles broad structural market failures, you need competition policy to tackle the harmful behaviour of individual market participants”. He suggested that competition controls are essential to ensuring that key market structures are not “concentrated in the hands of a few” and operated for their sole benefit”.

National authorities are beginning to grapple with the issue of competition as their financial systems stabilise. In the UK, the Independent Banking Commission recently argued that both structural and behavioural changes are necessary to improve conditions for competition in UK retail banking due to increased concentration in the banking industry and a loss of challengers as a result of the crisis. To spur greater competition, it recommended that Lloyds Banking Group should be required to divest more branches than to number required to satisfy EC conditions on state aid approval and that measures should be introduced to enable customers to switch bank accounts more easily and at reasonable costs.

Given recent developments, regulators have understandable concerns that increasing competition in the financial system can undermine financial stability when banks engage in riskier operations to compensate for the erosion in their market share and profit margins. Foreign banks’ entry into small European economies such as Ireland and Estonia helped stoke their property bubbles and exacerbated their subsequent banking crisis. Other regulators express contradictory views. For example, Almunia doesn’t believe that competition and stability are at odds or that a proliferation of market actors necessarily exacerbates systemic risk. Instead, he has suggested that although increased concentration may raise competition policy concerns, the level of concentration in markets should reflect the search for optimal efficiency and not the actions of “powerful market players that have excluded potential competitors”. Going forward, therefore, the EC will take steps to safeguard against damaging concentrations in terms of cross-border banking activities and other areas of the financial markets.

 

EP publishes draft legislation on EMIR

On 24 June 2011, the European Parliament (EP) published the final report of its Economic and Monetary Affairs Committee (ECON) on the Regulation on OTC derivatives, central counterparties and trade repositories (dubbed ‘EMIR’). EMIR aims to meet a key G20 commitment through ensuring that a significantly large proportion of OTC derivative trades are cleared through central counterparties (CCPs), that these CCPs are authorised, properly governed and supervised, and that OTC derivative trades are reported to registered trade repositories. The report will be debated in the plenary session of the European Parliament on 4 July and be voted on 5 July 2011. It is highly likely that the legislative process goes to a second reading.

Meanwhile, the Hungarian Presidency has had to admit defeat in terms of completing the dossier before the end of its term on 30 June 2011, and has handed it over to the Polish Presidency. On 17 June, the Council published an ‘orientation debate’ document setting out those areas where there is still substantial disagreement amongst Member States. While there is no broad consensus on the vast majority of the proposals in the latest Presidency Compromise (published on 14 June), agreement has not been reached on the supervisory powers and the role of ESMA and the scope of the regulation (i.e. whether it should apply to all or only OTC derivatives). Member States are split in terms of the role that ESMA plays in terms of authorising and supervising CCPs, including its role in the college of supervisors. On scope, they have not agreed as to whether the regulation should specify that all derivatives are subject to a clearing and reporting obligations, and the rights of access of venues of execution to CCPs and vice versa.

There are many detailed points of difference between the ECON report and latest Council compromise which will need to be resolved once negotiations start between the two. The two areas which are likely to be most debated between them are the same issues that have split the Council: the powers of ESMA and the scope. The European Parliament strongly supports increased centralisation of supervisory powers through the European Supervisory Authorities (arguing that this was why they were created in the first place). A similar debate on scope was also undertaken in the ECON committee so it will be a question of how closely aligned the final outcome of the Council’s discussions to the ECON report. On the issue of interoperability between CCPs which looked initially to be a significant deviation between the Council and the ECON position, ECON has now realigned its position to that of the original Commission proposal (and the Council).

At the moment both the ECON report and the Council compromise envisage that draft technical standards in over twenty areas will be drafted by ESMA by 30 June 2012. This would then allow adoption of these technical standards by the Commission in time for the requirements to come into effect on 1 January 2013. A delay in the finalisation of the Regulation text, however, puts significant time pressure on ESMA and may restrict its ability to consult thoroughly on proposals based on the final Regulation text.