G20 Los Cabos Summit: a little growth and a lot of Eurozone angst
While jobs and growth were the focus of the G20 summit held 18-19 June in Los Cabos and progress on key initiatives was reported, the real story was the deteriorating Eurozone economic situation. The other G20 leaders seemed able to do little more than lecture Europeans. However, Angela Merkel, who as German Chancellor presides over the Eurozone’s largest economy, gave enough assurances to keep interference from President Obama and the other G20 leaders at arm’s length. The official communiqué
summarising the agreements and priorities agreed at the meeting put strong, sustainable growth (with its corollary of creating jobs and stimulating lending in the real economy) at the top of the agenda. But the looming Eurozone crisis threatens to bring the rest of the global economies back into recession and largely overshadowed other pressing G20 priorities, such as combating poverty and ensuring food security.
Now it is the New World’s turn to stand in disapproval and waggle its finger at aging and defensive Old World. Julia Gillard, Australian Prime Minister, boasted on the last day ‘about the situation of being AAA rated by all the major credit rating agencies’ and being ‘an island of strength in a world of economic upheaval’. Francois Hollande, the new French President, countered that Europe should be left to solve its own problems and that solutions should not be imposed from outside.
International Monetary Fund (IMF) funding considerations reinforced this role reversal. At the summit emerging market countries pledged an additional $26bn to the IMF’s $430bn emergency fund, which will likely be used to subsidise ailing developed countries. The fund is intended to be a second line of defence after EU national or regional resources are drained. This is the first time that the US has not contributed to a recapitalisation fund, showing the growing influence of the emerging markets. Emerging market leaders are disappointed by the slow transfer of official power in recognition of their growing contributions, and are pushing the G20 to implement IMF voting reforms in full by October 2012 to give them a greater say.
Despite distractions like the runaway Spanish bond market auction on 19 June, the G20 leaders still managed to cover a number of key areas:
- the growth agenda (set out under the Los Cabos Growth and Jobs Action Plan) - aiming to strengthen global growth and restoring confidence but monitoring the fragile economic conditions and readiness to implement fiscal action to support domestic demand if required
- Eurozone banking union - Germany, France and Italy promised to ‘take all necessary policy measures to safeguard the integrity and stability’ of the Eurozone and work toward closer integration through pan-European banking supervision, a bank resolution scheme, and insurance for bank deposits
- price stability - balancing price stability with economic recovery, with a strong focus on maintaining stable energy and commodity prices
- regulatory spill-over impacts - monitoring whether or not international reforms (often designed by developed countries with little reference to emerging markets) are having unintended consequences or resulting in commercial biases against certain jurisdictions
- global rebalancing - to continue efforts to rebalance international country account surpluses and deficits and recognizing China’s action to allow the renminbi to trade more based on market forces
- protectionism - recognising that economic conditions are resulting in many jurisdictions retrenching back into narrow self interest, at the expense of fair market practices.
Several reports commissioned in prior summits were published in time for assessment by various working groups, including the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSCO):
FSB: Third Implementation Progress Report on Over-the-counter (OTC) Derivatives Market Reforms (15 June 2012)
G20 jurisdictions agreed at the Pittsburgh summit in 2009 to introduce central clearing requirements, exchange and electronic platform trading, reporting to trade repositories, capital requirements and standardisation of contracts by the end of 2012. Dependencies have evolved during the implementation process, as countries with less developed markets wait for larger countries to develop rules, and larger countries wait on international standards to be set. Now that international standards are largely complete, the FSB insists that all jurisdictions need to promptly develop and implement appropriate frameworks.
Market participants need to take practical steps to ensure that the necessary OTC derivatives market infrastructure is available soon. The OTC Derivatives Supervisory Group (ODSG) has made some strides toward increased central clearing and trade reporting. For example, the world’s fourteen largest derivatives dealers agreed to commence reporting to trade repositories and a significant portion of interest rate and credit derivative trades are now reported. Work establishing trade repositories and in standardising contracts among major market participants is also moving forward.
The FSB estimated that one eighth of credit default swaps and one third of interest rate derivatives were centrally cleared by the end of 2011, levels below the its expectations. The FSB said further progress is needed to increase central clearing initiatives and to improve the reporting of cleared trades.
The FSB found that most jurisdictions are ‘markedly behind’ in implementing the rules requiring standardised contracts to be traded on exchanges or electronic trading platforms. Exchange trading improves transparency, mitigates credit and operational risk, and provides an easier environment for regulators to detection of market abuse. Only the largest countries have started to introduce exchange trading requirements and associated transparency rules. The US is the only jurisdiction which will have exchange trading and pre and post trade transparency regimes in place to meet the 2012 year-end commitment. The EU and Japan are developing proposals, but these will take several years to implement.
The report concludes that progress has been made in international policy development and in operational efficiency in the largest OTC derivative markets. However, all jurisdictions and markets need to aggressively step up their efforts to achieve full implementation of the Pittsburgh OTC derivatives reforms by end 2012.
FSB:Implementing the Principles for Sound Compensation Practices and their Implementation Standards (13 June 2012)
Most G20 countries have implemented the Basel III Principles and Standards (P&S) and progress has been made in implementing the Pillar 3 disclosure requirements on remuneration, but more needs to be done to embed the Pillar 3 disclosure requirements into supervisory guidance.
Most financial institutions have made progress in adjusting compensation practices to align them with the P&S. However, challenging areas remain in aligning compensation to ex-ante risk taking and ex-post performance, and in the identification of material risk takers.
This report confirms the 2011 peer review conclusion that national authorities must sustain implementation efforts. The FSB will continue to monitor full implementation of the P & S and notes that the Bilateral Complaint Handling process will be a critical tool.
FSB: Legal Entity Identifier for Financial Markets: FSB Report to G20 (8 June 2011)
The FSB’s legal entity identifier (LEI) initiative seeks to agree a standard that gives each counterparty to a financial transaction a unique identifier, and to ensure that data essential for identifying both the counterparties and the transaction is reported in an international, inter-operative system. The report sets out 35 recommendations for the development and implementation of a global LEI system and a set of High Level Principles.
The recommendations draw extensively from the LEI Industry Advisory Panel and public participants in workshops and conform to the LEI standards published by IOSCO. The proposed Central Operating Unit (COU) will be the pivotal arm of the global LEI system. The COU will have responsibility for ensuring the application of uniform global operational standards and protocols. It will be established as a not-for-profit foundation and will rely on industry support. Local operating units will offer local registration, validation and maintenance of reference data.
Leaders endorsed the report’s recommendations at the summit. The FSB will create an FSB LEI Implementation Group to prepare a central platform to facilitate the integration of local identification schemes into a central database of LEIs. The report recommends that a global LEI system should commence operations in March 2013.
FSB, with the IMF and the World Bank: Identifying the Effects of Regulatory Reforms on Emerging Market and Developing Economies: A Review of Potential Unintended Consequences (19 June 2012)
The G20 commissioned this report to identify any unreasonable or unsustainable impacts that regulatory reforms are having on emerging market and developing economies (EMDEs), reflecting their increasing prominence, and an awareness that they have differing needs because of the way that their financial markets operate.
While many EMDEs do not expect significant adverse effects, policy measures for Basel III, measures aimed at G-SIFIs and OTC derivative reforms may result in some disadvantages for EMDEs and their financial institutions, while favouring developed market economies and firms. For example, the extraterritorial effects of EU capital requirements and the Volcker Rule under the Dodd-Frank Act in the US may lead to unintended effects and a perceived protectionist bias against emerging markets. Similarly, credit rating agency regulation could result in overstating the risks of operating in EMDEs, leading to higher finance charges and less liquidity.
The report found it was difficult at this stage to distinguish between intended and unintended consequences and to assess materiality, concluding that EMDEs need to engage in ongoing dialogue and cooperation with standard setting bodies and international financial institutions.
The Basel Committee on Banking Supervision: Report to G20 leaders on Basel III implementation (11 June 2012)
The report covers the G20 countries, Hong Kong, Singapore and six other non-G20 European countries. The implementation review process has three levels:
IOSCO: Report on the Credit Default Swap (CDS) Market (16 June 2012)
- Level 1: ensuring timely adoption of Basel III - as of 31 May all members had issued draft regulations except Argentina, Hong Kong, Indonesia, Korea, Russia, Turkey and the United States. The majority are confident that they can finalise regulations in time for the agreed start dated 1 January 2013, but for others it is likely to be a challenge. Progress reports will continue to be published semi-annually.
- Level 2: ensuring regulatory consistency with minimum Basel III standards –whilst all member countries will be assessed over time, the initial focus will be on the home jurisdictions of G-SIBS. Assessments of the EU, Japan and the US have commenced and are expected to be completed in September. Singapore will begin later in 2012 with China and Switzerland starting in early 2013. Australia and Brazil will follow later in 2013. Preliminary findings from the Level 2 review identified areas of divergence between domestic regulations and Basel III minimum standards but these are subject to further investigation. The European Commission (EC) responded to the preliminary findings published in the report. First, the EC defended its decision to apply a ‘maximum harmonisation’ approach. Then it discussed how its decision to apply Basel rules to all banks (as well as investment firms), as well as the features of certain EU markets, justified a number of polices which the report noted posed potential differences from Basel III rules.
- Level 3: ensuring that the outcomes of the Basel III rules are consistent in practice - initially focused on risk-weighted assets. The review will seek to identify areas of material inconsistency in the calculation of risk weighted assets in both the banking book and the trading book. Preliminary conclusions from the detailed analysis are expected in Q4 2012.
The report discusses recent changes and current trends in the CDS market and provides information about trading, pricing and clearing of CDS. The report is intended to inform the ongoing regulatory debate but does not make any policy recommendations.
One of the main sources of risk in the CDS market is counterparty risk generated by the default of large protection sellers. This arises from the highly concentrated and interconnected nature of the market and the evidence of possible under collateralisation of CDS positions. The use of CCPs is seen as a way of mitigating this risk.
Although publicly available information on CDS has increased over recent years, the CDS market is still comparatively opaque and regulators would benefit from better access to information on trade and position data.
Research shows that CDS have an important role in the price discovery process on credit risk. However, the inception of CDS trading, whilst reducing the cost of funding for more highly rated entities, increases the cost for entities of lower credit quality. To date, there is no conclusive evidence on whether taking short positions on credit risk through naked CDS is harmful for distressed firms or high yielding sovereign bonds.
The report states that existing empirical evidence on many aspects of the CDS market tend to be mixed, for example the impact CDS have on the orderly functioning of the primary and secondary markets of the underlying bonds and on creditor incentives.
FSB: Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability, and accompanying summary Scoreboard Status Report (19 June 2012)
The FSB believes good progress has been made in implementing Basel II.5 capital reforms, but noted that there is a long way to go in designing and implementing standards on OTC derivative reforms, measures to reduce the risks of globally systematic firms and institutions, compensation reform and the development of a functioning international LEI system.
The G20’s agenda to reform financial regulation agenda may have been overshadowed by economic uncertainties, but on balance the status reports showed significant progress. The challenges and pockets of delays noted in the reports reflect the difficulties in translating the G20 commitments into final and fixed rules. But what is clear is that these long planned reform efforts are gaining momentum as implementation dates are coming into view. It is inevitable that legislation addressing such complex issues may take longer than expected to develop, particularly when the process involves the additional challenge of seeking consistency and conformity with the evolving body of international standards and best practices.