Progress on G20 derivative reforms
On 7 June 2011, Alexander Justham, the UK Financial Services Authority (FSA) Director of Markets, delivered a speech to the International Derivatives Expo in London, outlining progress against the G20 objectives on over-the-counter (OTC) derivatives set out in the September 2009 Pittsburgh agreement. He noted that we are now half way through the aggressive timeline for achieving these commitments and that much remains to be done. He said that it is vital that industry engages with all aspects of the reform, not least to ensure that the outcome achieves the primary objective of mitigating systemic risk.
In Pittsburgh, the G-20 leaders agreed to shore up the derivatives markets by requiring central clearing of standardised OTC derivatives and their trading on exchanges or electronic platforms, where appropriate; that all OTC derivative trades to be reported to data repositories to improve transparency; and that non-cleared OTC derivatives be subject to higher capital charges. Justham discussed progress in terms of the first three commitments and touched on associated issues relating to commodity derivatives.
The European Union (EU) is addressing the clearing and trade repository commitments through the Regulation on OTC derivatives, central counterparties and trade repositories (dubbed ‘EMIR’ ). The requirements relating to trading OTC derivatives on organised trading platforms and to commodity derivatives will be covered in the revision of the Markets in Financial Instruments Directive (MiFID II). In the United States (US) all relevant reforms are covered in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Justham also noted the important work being undertaken by the International Organization of Securities Commissions (IOSCO), providing global context for the reforms.
In terms of central clearing, Justham identified three key issues for regulatory consistency: defining products which can be cleared, determining exemptions in terms of both products and market participants, and timing of implementation. He said regulators must not mandate clearing where this would exacerbate systemic risk: there can be no ‘mechanistic’ assessment. With regards to participant exemptions, he noted that some divergence in approach at the local level may be justified, noting growing acceptance in the EU for an exemption for long-term savings institutions, such as pension funds, from clearing requirements (but not from bilateral collateralisation). However, he said that international consistency is essential in terms of both intra-group transactions and products. The FSA believes the best approach for intra-group transactions is bilateral collateralisation on mark-to-market values, and that the European Securities and Markets Authority (ESMA) should follow the US lead in exempting foreign exchange forwards and swaps. He warned that “inconsistencies create arbitrage opportunities, which could be exacerbated if capital requirements do not deliver an incentive to clear via higher capital charges for non-cleared trades versus cleared trades”.
The FSA expects the obligation to report all OTC derivatives to trade repositories to come into force in late 2012 or early 2013. ESMA plans to launch a consultation exercise as soon as EMIR is adopted by the Council and the European Parliament, and will issue proposals for associated technical standards by mid-2012. Justham noted that the main objectives of trade repositories were to enable regulators to monitor systemic risk and firms’ compliance with mandatory clearing requirements. A key challenge is to ensure no gaps in data collection internationally, and that the data can be aggregated across trade repositories, asset classes and jurisdictions. Notably, Justham said that the FSA supports a single global trade repository per product.
With regards to trading regimes, regulators need to focus on three, interdependent ‘limbs’ to reduce the possibility of ‘mis-calibrated market intervention’, namely: (1) definition of an organised trading platform; (2) regulatory requirements for these platforms that are designed to enhance trade transparency; and (3) the products to bring onto these venues and the means for doing this. Currently, Justham noted that in Europe the debate centres around ‘organised trading facilities’ in MiFID II to determine the role of multilateral versus bilateral trading platforms. However, much work is still required to elaborate the detailed regime around these three ‘limbs’.
Justham mentioned IOSCO has done a considerable amount of work in the commodity derivatives area, supported by ISDA. He also said that the FSA supports the revision of the Market Abuse Directive (MAD) to cover attempted (as well as actual) market manipulation. He noted that the FSA is well-known to also support requirements relating to formalised position reporting and management powers for regulators (including position limits). Therefore, the FSA hopes “to see the Commission’s proposals in its MiFID consultation followed though in the draft legislation”.
His parting comments re-emphasised the need for industry engagement saying “we must be under no illusions about the scale of the tasks ahead”. He stressed that many unresolved issues remain and urged “firms to engage actively [..] to ensure that the regime delivered is fit for purpose”. He warned that firms need to fully understand the “importance of preparing thoroughly” for the changes to come.
Separating banking and insurance systemic risk
Last November in South Korea, the G-20 agreed that globally systemically important financial institutions (G-SIFIs) should be subjected to additional supra-national supervision in the future. The G-20 Leaders also endorsed a requirement that G-SIFIs should have a higher loss absorption capacity to reflect the greater risks that these firms pose to the financial system. Work on developing resolution mechanisms is still ongoing; the FSB have established a Steering Group to investigate further.
Understandably, the insurance industry is concerned about the extra compliance burdens its members could face if classified as systemically important. On 6 June 2011, the European Insurance and Reinsurance Federation (CEA), together with five of its 16 member associations, reflected these concerns in a letter sent to the leaders of the G-20 countries about the processes involved in defining G-SIFIs. The insurance associations argued that work on identifying potential sources of systemic risk in insurance should be decoupled from the FSB’s current work programme in banking. They asserted that “sharp differences” exist between the business models in insurance and banking, and that the insurance regulatory model already includes “strong upfront solvency standards” and “robust resolution procedures”. They are calling for detailed analysis to assess potential sources and transmission of systemic risk in the insurance sector, before any methodology for G-SIFIs is applied. The associations consider that it would be a mistake to simply superimpose the methodology for G-SIFI banks on insurers.
If the association’s recommendations are accepted, this leaves the G-20 and the FSB with the tricky task of developing a differing methodology for insurers. The methodology to assist national authorities in assessing the systemically important banks has been broadly agreed by the Basel Committee, based on quantitative indicators for five categories: global activity, size, interconnectedness, substitutability and complexity. This model could form the basis of discussions on the insurance methodology, which would need to involve a “broad community” of policymakers and prudential regulators. The lessons from banking also suggest that firms on the margins, but not classified as systemically important, need to be given particular consideration. Additionally, the methodology needs to be fluid, enabling it to react to changing market conditions.
European Parliament calls for more competition for Credit Rating Agencies
On 8 June 2011, the European Parliament (EP) gave overwhelming support to an own-initiative resolution on further regulation for credit rating agencies (CRAs), in an effort to encourage competition in the sector and the possible harmonisation of CRA’s legal liability under Member States’ civil law. The resolution calls for greater disclosure of information to investors to enable them– and potentially other rating agencies – to do their own risk assessment. The resolution also addresses issues such as the rating of sovereign debt and the over-reliance of firms on external credit ratings. On the latter, it proposes that firms which cannot conduct internal analyses should face restrictions on investing in structured products. For the former, it suggests that CRAs should “explain their methodologies”, particularly if deviating from forecasts of the main international financial institutions.
The resolution calls on the European Commission (EC) to look at the possibility of creating a new, independent “European rating foundation” and/or establishing a network of smaller European rating agencies, in an effort to stimulate competition in a sector which is dominated by three players: Moody’s, Standard & Poor’s and Fitch. The EP believes that opening up the market to a greater number of ratings agencies should increase investors’ choice and provide more accurate ratings, two key planks in the EC’s regulatory reform agenda. CRAs have been criticised in the past for their role in the subprime crisis, because their initially favourable ratings on collateralized debt obligations (CDOs), securitized from subprime residential mortgages and other complex debt obligations, turned out to be much more risky than the CRAs led investors to believe.
However, the EP believes that merely stimulating competition is unlikely to yield the results policy makers are hoping to see. In 2006, the US Congress passed a similar resolution, Credit Rating Agency Reform Act of 2006, which removed the Securities and Exchange Commission’s authority over “nationally recognized ratings agencies,” and enabled smaller credit ratings to register as “statistical ratings organizations.” The Act had similar lofty aims to improve the quality of rating for the protection of investors and in the public interest by fostering accountability, transparency, and competition. However it failed to break the dominance of the three main players and resulted in “rating arbitrage” as clients looked for opportunities to find the most favourable, and not necessarily the most accurate, ratings.. Therefore, the EP is calling on the EC to identify ways to make CRAs liable in civil law for their ratings. In the past, CRAs have not been subjected to the same expert liability as an auditor or securities analyst. This new resolution proposes that CRAs should be required to assess the accuracy of past credit ratings and make the assessments available to competent authorities. Commissioner Michel Barnier, the Commissioner for Internal Market and Services, welcomed the EP’s resolution. He said that the EC is currently working on an impact assessment on these and further proposals for CRAs and intends to issue a legislative proposal later in 2011.
Omnibus II: the Solvency II timetable in jeopardy?
On 1 January 2011, the EU’s institutional response to the financial crisis, the European System of Financial Supervisors (ESFS), became operational. The new institutional architecture includes the three new European Supervisory Authorities (ESAs) – the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA) - working with and through the network of national financial supervisors The new institutional structure was adopted to prevent future financial crises and accelerate the creation of a common supervisory framework within the context of the European single market.
The ESA regulations set out new, common, generic powers for the three Authorities, including the possibility of setting binding technical standards and settling disagreements between national authorities. However, for the ESFS to work effectively, specific powers have to be defined in the context of existing and new EU legislation. For existing legislation, two ‘Omnibus’ directives have been conceived to introduce the necessary changes. Omnibus I introduced changes to 11 existing directives in the financial services area and was adopted in late 2010. Omnibus II, the draft of which was published by the EC on 19 January 2011, focuses primarily on changes required to the Solvency II framework directive (Directive 2009/138/EC). The draft is now being negotiated separately within the EU Council of Ministers (Council) and the EP, with a view to a ‘first reading’ adoption. However, the complexities involved – particularly in relation to the transitional measures which have been introduced relatively late in the process - are leading to fears that these negotiations will be prolonged, putting pressure on the overall timetable for the introduction of Solvency II, and possibly further delays in the ‘go live’ date.
On 9 June 2011, the Council published its most recent compromise proposal. Amongst other things, the text confirmed the need for a “smooth transition” to avoid any unnecessary market disruption. Uncertainty about the transitional measures, and the timeline overall, is already disrupting industry preparations. While the Council is making some progress in its negotiations, the EP has yet to start ‘for real’: its indicative timetable shows the adoption of the initial report in the Economic and Monetary Affairs Committee in November 2011 with the vote in plenary in January 2012.
Omnibus II, which amends the ‘Level 1’ framework directive, has to be adopted (and published in the Official Journal of the European Union) before implementing measures (‘Level 2’) can be finalised. A significant amount of work has already been undertaken to flesh out the Level 2 (and 3) measures, and the EC has indicated that it will publish a draft version of the complete set of Level 2 measures this month which will then be ‘frozen’ pending the outcome of the Omnibus II negotiations. Publishing this 450 page+ opus should enable industry to identify measures that are subject to change as a result of the negotiations. This is an unusual step in the process overall but necessary to ensure the clear understanding of stakeholders of the implications of the proposed implementing measures: not least in terms of the Council and EP which will be delegating powers to the EC, in line with the Lisbon Treaty, for the adoption of the implementing measures.
Concerns still remain about whether all of this will come together in time. However, noises about any delay in the start date cannot be substantiated. In a recent letter dated 1 June, Commissioner Barnier, responding to certain industry association issues, evinced no desire for any slippage in the timetable. In fact, he stressed: “Solvency II will enter into force as planned on 1 January 2013. Where necessary, the Commission will introduce measures to ensure a smooth transition but I am against a delay to the introduction of Solvency II. Solvency II is a much needed Directive and it is critical that all parties ensure that they are ready in time for implementation”. Mapping the implementing measures to the ongoing negotiations on Omnibus II, and monitoring the debates on these issues in both the Council and the EP will enable firms to anticipate the final outcome on many issues in advance of the final adoption of the Omnibus II final text early next year.
Governance of Financial Stability in the eurozone: More power to European Authorities?
On 10 June 2011, the Vice-President of the European Central Bank (ECB), Vítor Constâncio gave a speech on the governance of financial stability at the “ECB and its Watchers XIII” conference in Frankfurt. He suggested that the financial crisis revealed two main findings on financial stability:
- Firstly, financial stability is dependent on a much broader range of sources then previously understood, from both macroeconomic shocks in the real economy, and from the financial sector. Drawing on these lessons, eurozone economic governance (as delineated in the Stability and Growth Pact) is being strengthened to focus more on “fiscal sustainability and reducing government debt levels”. A “surveillance procedure for macroeconomic imbalances” is also being established, which will include a new “Excessive Imbalances Procedure” developed for eurozone Member States.
- The second lesson refers to the channels through which financial instability can spread. The sovereign debt crisis in Europe has its roots firmly in the banking crisis. European banks’ exposure to Spanish, Portuguese, Irish and Greek debt currently exceeds €1.5 trillion. Given the fragility of the European financial system, a significant debt restructuring programme in these countries could have serious consequences on the balance sheets of banks, leading to the need for an injection of scare public funds into these institutions. Countries such as Ireland, by guaranteeing the liabilities of its banking system, have transferred private debts to the public purse. Effective governance needs to address the financial sector, in order ensure that “imbalances, externalities and spillovers” are effectively addressed.
Constâncio suggests that designing effective financial governance requires five different components:
- Macro-prudential supervision on a pan-European level is necessary to enable public authorities to “identify and address systemic risk”. To this end, the European Systemic Risk Board’s (ESRB) analytical toolbox is using early warning models and indicators to identify “emerging vulnerabilities or imbalances” that could result in financial instability. These models aim to identify the variables associated with financial stability, determine their relative importance and assess the financial channels through which risk can spread.
- A more consistent sets of prudential rules across Member States needs to be developed. In this context, the European Supervisory Authorities have been allocated a significant set of competences in designing, enforcing and co-ordinating regulations. The overall aim is to develop “a single EU rulebook” which will be enforced “consistently” throughout the EU.
- A “substantial” reinforcement of financial regulations, specifically within the eurozone, is needed. Constâncio flags the idea of expanding the role of the Eurosystem (ECB and national central banks) in the supervision of banks, in particular of large cross-border banking groups. Another possibility would be extending the EBA’s remit for the eurozone to include the power to take “mandatory decisions” in certain areas addressed to national supervisors and financial institutions.
- Effective crisis management and resolution requires a more centralised framework for resolution within the eurozone, such as the creation of a “Euro Area Resolution Fund” (EARF), which would be funded ex ante by private sector contributions. He believes that such a fund would both reduce the systemic impact of bank failures and help address “burden sharing problems”.
- Involvement of central banks in the stability process is important. One of the most important lessons from the financial crisis is that “ensuring price stability is necessary but by no means sufficient for financial stability”.
Developing new “tools” at European-level (such as a Euro Area Resolution Fund) would drive a much larger and pervasive role for the ESA’s – which are currently configured in a much more modest, policy-setting role. If one looks at the functioning of the US regulatory model, Vice-President Constâncio’s EARF would play an analogous role to the FDIC in bank resolutions, which would represent a massive change in the dynamics of European regulation.
CRD IV: Basel Committee finalises rules for counterparty credit risk and final text rules
On 1 June 2011, the Basel Committee on Banking Supervision published the final text for the capital treatment for counterparty credit risk in bilateral trades and the Basel III rules, which presents the details of global regulatory standards on bank capital adequacy and liquidity agreed by the Governors and Heads of Supervision and endorsed by the G20 Leaders in Seoul. At the same time, the Committee published the results of its quantitative impact assessment study (QIS). The rules text details the Basel III framework, encompassing microprudential and macroprudential elements, which sets higher and better quality capital, better risk coverage, introduction of a leverage ratio, measures to promote the build up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.
To ensure the rigorous and consistent global implementation of the Basel III framework, implementation of the standards will be in phases to facilitate the banking sector moving to the higher capital and liquidity standards without disrupting lending to the economy. With respect to the leverage ratio, any adjustments would be carried out in the first half of 2017 with a view to migrating to Pillar 1 treatment on 1 January 2018 on the basis of an appropriate review and calibration. Both the Liquidity Coverage Ratio (LCR) and the Net Stable Fund Ratio (NSFR) will be subject to an observation period and will include review clauses to address any unforeseen or unintended effects.
On the QIS results, 263 banks from 23 Committee member jurisdictions participated in the QIS exercise. This included 94 Group 1 banks – those that have Tier 1 capital in excess of €3 billion, well diversified and internationally active – and 169 Group 2 banks – all other banks. Bank’s profitability or behavioural responses such as changes in bank capital or balance sheet composition were excluded in the QIS’ assumptions therefore the results are not comparable to industry estimates, which tend to use forecasts and consider management actions to mitigate the impact. After taking into account the changes to capital and risk-weighted assets definition and assuming full implementation as of 31 December 2009, the average common equity Tier 1 capital ratio (CET1) of Group 1 banks was 5.7% vis a vis 4.5% under the new minimum requirement. For Group 2 banks, the average CET 1 ratio was 7.8%. An estimated €165 billion and €8 billion of additional capital is needed for all Group 1 and Group 2 banks to meet the new 4.5% CET1 ratio. Relative to 7% CET 1 level that includes the 4.5% minimum requirement and the 2.5% capital conservation buffer, the Committee estimated that Group 1 banks would have had a shortfall of €577 billion at the end of 2009 while Group 2 banks with CET1 ratios less than 7% would have required an additional €25 billion. Since the end of 2009, banks have continued to raise their common equity capital levels through combinations of equity issuance and profit retention.
The Committee also assessed the estimated impact of the liquidity standards on the basis that banks made no changes to their liquidity risk profile or funding structure as of end- 2009. For Group 1 banks, the average LCR and NSFR were 83% and 93% respectively while For Group 2 banks the average LCR and NSFR were 98% and 103% respectively. Banks have until 2015 to meet the LCR standard and until 2018 to meet the NSFR standard. The Committee likewise finalised its review of the standards for capital treatment for counterparty credit risk in bilateral trades and plans to modify the risk weighting of credit valuation adjustment (CVA) – the risk of loss caused by changes in a counterparty’s credit spread as a result of changes in credit quality. Under the modified CVA, the Committee reduced the risk weighting of “CCC”-rated counterparties from 18% to 10%, which levels the gap between the standardised and advanced methods. The addition of the CVA risk capital charge means that the capital requirements for counterparty credit risk under Basel III will double the level previously required under Basel II.
CRD IV is the legislation implementing Basel III reforms in the EU amending the Capital Requirements Directive (CRD). It also includes proposals on corporate governance in financial institutions, such as the composition of boards, role of regulators and internal risk management at financial institutions. In a letter dated 19 May 2011, a number of finance ministers from EU countries (Bulgaria, Estonia, Lithuania, Slovakia, Spain, Sweden and the UK) stressed that “any deviations” from Basel III in EU regulations (like CRD IV) should be avoided, particularly those elements of the agreement relating to the prescribed levels of capital and liquidity – being minimum rather than maximum thresholds and transition period in the agreement not being binding. Additionally, they disagree with the Commission’s intentions to continue to allow the use of the Financial Conglomerates Directive approach in the deduction of material holdings in insurance entities. They also point out that recasting CRD as a “regulation” would prevent Member States from allowing for flexibility on Pillar 1 requirements such as capital levels or risk weights. The crux of their arguments rests with allowing national authorities’ flexibility in setting higher standards than is currently proposed in the draft CRD IV for them to develop macro-prudential policies that will address financial risks and “challenges” to financial stability.