Banks have been put under sustained regulatory pressure since the financial crisis. Their business models have been turned upside-down and inside-out as politicians seek a path towards a more traditional approach to banking. In Europe we may just be seeing an end in sight for significant new legislation aimed specifically at regulating banks (although the tinkering will go on for years). Over the next year, attention will be turning to non-banking activities and shadow banking. There are already signs that many different political agendas will influence this debate.
The Capital Requirements Directive IV (CRD IV/CRR) is the seminal package of capital, liquidity and corporate governance reforms implementing Basel III in Europe. It passed a significant hurdle on 5 March 2013, when the Economic and Financial Affairs Council (EcoFIN) agreed to its key terms, confirming a provisional agreement reached with the European Parliament (EP) at the end of February (you can see our US colleagues’ reaction to the agreement here). The legislation now enters its final phases with adoption by the EP plenary in April. That will be followed by a legal/linguist expert review, prior to final adoption by the EcoFIN Council (possibly in May) and publication in the Official Journal. This removes one key priority from the Irish Presidency’s list and its focus has already shifted to moving forward with the EU banking union, with the Recovery and Resolution Plan proposal being progressed in parallel with ongoing negotiations on the Single Supervisory Mechanism. Getting CRD IV out of the way will free up some time and resources for legislators to concentrate on other risky areas of the financial system.
Banks have made some strides in moving on from past mistakes. They have begun replenishing their damage balance sheets, refocusing their attention on their core operations and jettisoning more risky investment and shadow banking activities. But they have a long way to go, and keep finding more non-c0re assets that need to be off-loaded. For the latest on bank deleveraging, see our report, European outlook for non core and non performing loan portfolios: A growing non core asset market. This deleveraging process will make banks smaller, less interconnected and less of a systemic headache for supervisors. But as banks shrink, others are filling the gaps.
The European Fund and Asset Management Association estimates that the investment fund assets in Europe increased by 12.4% to €8,944 billion in the last quarter of 2012. Non-banks (e.g. insurance companies and hedge funds) are also gearing up for a greater role in credit intermediation process—particularly in terms of providing long-term credit for businesses. As more money flows into these markets, concerns about the formation of asset bubbles and financial contagion heighten. The presence of these systemic vulnerabilities may force the hand of regulators to make more structural and operational reforms in these markets to protect consumers, the wider financial system and the economy.
In particular, improving risk management practices across financial markets will be a key area of focus for regulators. This month, both the European Banking Authority (EBA) and the International Organisation of Securities Commissions (IOSCO) separately issued principles on exchange traded funds (ETF) and collective investment schemes (CIS) respectively to harmonize risk managements practices in these industries.
ETFs have become a hot topic with various reports (Financial Stability Board (FSB), International Monetary Fund (IMF) and the Bank for International Settlements) calling for increased surveillance of these funds, noting that their impacts on market liquidity and on the financial institutions servicing the funds are not yet fully understood, especially during periods of acute market stress. The FSB are particularly concerned about the potential systemic risks arising from the complexity and relative opacity of some ETFs which have branched out to new asset classes (e.g. fixed income, derivatives, and commodities) with thinner liquidity. Regulators are worried that the leverage embedded in the new breed of ETFs could pose financial stability risks if equity prices were to decline or interest rates increase. The IMF has also suggested growing popularity of ETF products may be contributing to equity price appreciation in some emerging economies.
On 18 December 2012, ESMA published final guidelines on ETF and other UCITS issues. The final guidelines contain a number of changes following feedback to its consultation early in the year. Controversially, the ESMA guidelines confirm all income generated through securities lending arrangements should be given to the fund, except for direct and indirect operational costs. Currently, market practice in many EU Member States is for the UCITS management company or a facilities agent of the securities lending arrangement to take a cut of the revenue generated from securities lending, but this may no longer be possible under the guidelines.
This month, the focus has shifted onto the risk management responsibilities of banks and the interactions with ETFs. On 7 March 2013, the EBA published an opinion which provides guidance on the evaluation of risks that might emerge at bank level through their operational relationships with ETFs.
The opinion discusses good practices relating to:
The good practices are not legally binding, and their implementation will depend on the specific characteristics of the credit institutions concerned as well as on their involvement in ETF operation.
The EBA’s opinion was issued just after the release of the IOSCO Technical Committee’s final report on principles of liquidity risk management for CIS. IOSCO called on CIS operators to ensure that the liquidity of their open-ended CIS allows them to meet redemption obligations and other liabilities. Before and during any investment, they should consider the liquidity of the types of instruments and assets in which the CIS invests and their consistency with the overall liquidity profile of the open-ended CIS. While liquidity risk is a particular concern for open-ended CIS, certain aspects of the principles are also relevant for closed-ended funds (for example, they may need to meet margin calls or other cash commitments to counterparties on a timely basis).
So what’s next? The European Commission (EC) is expected to issue legislative proposals this month focusing on money market funds which may echo issues covered in the recent European Systemic Risk Board Recommendation (of 18 February 2013) advocating, amongst other things, the conversion to variable Net Asset Value (NAV) funds to address systemic concerns of ‘runs’ on constant NAV funds, as experienced by some funds particularly in the US during the financial crisis. As with the developments discussed earlier, this will focus on ensuring financial stability. However, the EC is also planning to launch legislative proposals on long-term investment funds by the summer, in parallel with a wider review of issues relating to long-term finance of the economy. This plays to the sustainable growth agenda which, if a semblance of financial stability remains in Europe, is likely to come to the fore given the economic challenges facing the Union more broadly. We will have to wait and see whether the EC’s proposals strike the right balance between these two important objectives, and whether what comes out of the political machine at the end of the day does likewise.
The low interest rate environment poses unique challenges for insurance companies as they try to appease their high-yield expectant investors on the one hand and ensure they don’t take on too many risks in their investment portfolios on the other. Japan’s financial crisis provides a clear case study of both the plausibility of a prolonged period of low interest rates, as well as the impact of such a scenario on insurance firms. Many Japanese life insurers had built up substantial books of guaranteed business from the 1980s; seven large insurers failed during the 1990s and early 2000s as the effects of the low interest rate environment kicked in on this business.
The European Insurance and Occupational Pensions Authority (EIOPA) has been highlighting for some time the potential solvency risks arising from a prolonged period of low interest rates. Given the current economic pictures and signals from central banks, the low interest rate environment is set to continue for the foreseeable future.
EIOPA believes there are potential solvency risks for most types of insurers arising from a prolonged period of low interest rates. Long term interest rates are of critical importance to life insurers, because these institutions typically have long run obligations to policyholders that become more expensive in today’s terms when market rates are low. Life insurers pursuing a business model where investment returns are used to compensate for weak underwriting results are similarly exposed. Non-life insurers may also be affected in a situation where low yields do not provide sufficient returns to counteract the effects of inflation on longer tailed business.
In response to these concerns, EIOPA published an opinion on 4 March 2013 (dated 28 February 2013). The opinion recommends that national supervisors should:
The report’s appendix sets out a summary of the recommended key tasks and deliverables for national supervisors and EIOPA respectively.