Bankers’ bonuses look likely to be significantly limited from the start of next year, as European politicians reached a preliminary agreement on the Capital Requirements Directive (CRD) IV/Capital Requirements Regulation (CRR) on 27 February 2013. The proposals would cap bonuses at the level of a banker’s fixed salary (i.e. 1:1 ratio of fixed to variable remuneration) introducing the world’s most stringent curbs on bankers’ pay. This cap can be lifted to twice a banker’s fixed salary if a simple majority (66%) of the bank’s shareholders approve. If fewer than half of shareholders vote, then a super-majority (75%) would be required.
The requirements would apply to all senior employees and material risk-takers at banks (collectively known as “identified staff") based in the EU, and even more controversially, to employees of EU banks located abroad.
The proposals are softened slightly by the longer-term compensation discount. Under this provision, banks will be able to discount the future value of shares, options or other non-cash payments that are paid out over a number of years. Up to 25% of bonus/variable remuneration--if payable in a long-term form and subjected to claw backs--benefits from a discounted valuation for the purposes of the cap. When calculating the size of a banker's bonus to determine whether or not it exceeds the new ceiling, banks will be able to the discount the value of such payments. The European Banking Authority (EBA) will set the level of discount, but it isn’t clear yet exactly how the discounted valuation will work.
Another worrying area for banks is the country-by-country reporting requirements that now also look likely to come in under CRD IV. Banks would have to report their profits before tax, the amount of tax they paid, their total number of employees and their aggregate compensation, etc.
Details accompanying this political agreement are scant. We will need to wait for further information to get a complete picture of how these proposals will impact banks.
The Financial Stability Board (FSB) reported to the G20 Ministers and Central Bank Governors on the progress of regulatory reforms on 12 February 2013. Along with the Chairman’s letter, the FSB submitted reports on regulatory factors affecting the availability of long-term finance, and accounting standards convergence.
According to the FSB, medium-term downside risks remain, despite improvements in financial market conditions in recent months. Returning risk appetite raises a number of issues. In particular, the FSB points to a need to guard against mispricing of risk and the value of assets. Secondly, it argues that the need to push through reforms to OTC derivatives and shadow banking has increased. Thirdly, it suggests that historically low interest rates pose challenges for institutional investors with long-dated liabilities and may leave market participants more vulnerable to unanticipated movements in the yield curve.
Availability of long-term finance: At the G20 Finance Ministers and Central Bank Governors meeting in November 2012, the G20 asked the FSB to look at regulatory factors affecting long-term finance. The request was motivated by concerns about inadequate resources being channelled to growth-enhancing long-term finance projects in the post-crisis environment.
Having considered the G20’s programme of financial regulatory reform, the FSB’s general conclusion is that “while there may be some short-term effects, the most important contribution of the financial reform programme is to long-term investment finance to rebuild confidence and resilience in the financial system". As a result, the FSB argues, the reforms should substantially enhance the financial system’s capacity to intermediate investment flows through the cycle at all business horizons.
FSB members’ submissions in this area did not show much evidence that regulatory reforms have had a notable impact on long-term financing thus far. However, and as the FSB points out, this is hardly surprising given that the reform process is still at an early stage.
Accounting convergence: The joint IASB and FASB update on accounting convergence highlights two outstanding issues: impairment of loans and insurance contracts. Of these two issues, the FSB is most concerned about the need for convergence on a new forward-looking expected loss approach to provisioning. It argues that this issue is of immediate concern both for end-users and from a financial stability perspective. The FSB recommends that the G20 ask the IASB and FASB to prepare a roadmap for converging to a common approach for impairment and for achieving the G20 objective of a single set of high quality accounting standards.
OTC derivatives: The FSB has asked member countries to confirm before the G20 September Summit that reforms to the OTC derivatives market are in place. FSB members will provide an update in April on progress of work being carried out to identify and address conflicts, duplications and gaps in the cross-border application of rules. At the Summit, the FSB will also report the findings of a new macroeconomic assessment of OTC derivatives regulatory reform.
Legal Entity Identifier system: The FSB reports that the Regulatory Oversight Committee, the governance body of the LEI system, was established in January 2013. It explains that establishing the Global LEI Foundation is the key next step to launch the system in March 2013.
Shadow banking: Following its consultation on shadow banking, the FSB is refining recommendations relating to securities and repos, and to shadow banking entities other than MMFs, including fund managers and other investment funds. It explains that it will deliver recommendations to the Summit, noting that those measures should be seen as the start of a broader process.
Liquidity: Subsequent to the agreement reached in January, the FSB explained that the LCR will be introduced as planned. Minimum requirements will begin at 60% before reaching 100% in 2019, allowing the global banking system with sufficient time to adjust.
Too-big-to-fail: The FSB explains that the IAIS is making progress and plans to issue an identification methodology for non-bank G-SIFIs for consultation in the second half of 2013.
Basel III: The BCBS has completed an initial examination of the international consistency in the application of the Basel III risk weighting scheme for trading book assets. The analysis indicated that supervisory decisions and variations in banks’ models contribute to the substantial differences in banks’ calculations of market risk: the average risk weighting of assets for most banks in the study varied between 15% and 45%. Banks’ public disclosures are insufficient to enable regulators and investors to understand how much of these variations are owing to different levels of risk rather than other factors.
The FSB finds this situation unacceptable and suggests three policy options:
Resolution regimes: The FSB will shortly conclude the first peer review of FSB members’ implementation of the Attributes of Effective Resolution Regimes that were published in October 2011. The FSB found that significant work remains, so it is developing an assessment methodology to assist countries with their implementation. The methodoogy will be published in the second half of 2013.
By June 2013, resolution strategies should be in place for all G-SIFIs identified in November 2011. In the second half of 2013, the FSB will launch a first round of assessments under the G-SIFI Resolvability Assessment Process to evaluate the progress made.
CRAs: The FSB plans to carry out a thematic peer review, to assist its members in fulfilling commitments under the roadmap for implementing principles for reducing reliance on CRA ratings by early 2014. The findings of the review will feed into a progress report on CRAs for the Summit.
EDMEs: The FSB plans to organise a workshop for emerging markets and developing economies in the first half of 2013 to share lessons on implementing financial reforms. The FSB will report findings from the workshop to the Summit.
The EBA published two discussion papers on liquidity last month as it starts calibrating the standards of the new liquidity regime under CRR.
The first discussion paper sets out the suggested methodology for defining liquid assets under the Liquidity Coverage Ratio (LCR). The LCR requires banks to have adequate stock of high-quality liquid assets that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The EBA’s methodology for defining liquid assets is based on a scorecard, with the objective of producing an ordinal ranking of assets by combining a set of different liquidity indicators.
The discussion paper outlines the scope of the EBA’s forthcoming analysis of defining liquid assets. The EBA will start its analysis by assessing the range of asset classes against the definitions in the draft CRR. It will then perform a detailed quantitative assessment of the liquidity of individual assets, with the objective of producing a ranking of the relative liquidity of the different asset classes. Finally, it will identify the features that are of particular importance to market liquidity. The objective of this last step is to provide the characteristics assets should have to be qualified as highly, or extremely highly liquid. Following the outcome of this analysis, EBA will report to the EC on appropriate definitions of high and extremely high liquidity assets and credit quality of transferable assets for the purpose of the LCR.
In the second discussion paper, EBA sets-out its preliminary thinking on a methodology under CRR for identifying retail deposits that are subject to higher outflows. The proposal presented in this discussion paper is to take into account the likelihood of retail deposits leading to outflows of liquidity during a 30 day period during a financial crisis.
The proposed methodology will follow a two-step approach. The EBA will first outline a list of characteristics for identifying and defining retail deposits that may be subject to higher outflow rates. Next, it will propose an approach for determining the levels of higher outflow rates for retail deposits.
In terms of calculating the associated outflow rates, EBA will take into account the likelihood of deposits leading to outflows of liquidity over a 30 day horizon. The outflows will be assessed under the assumption of a “combined idiosyncratic and market-wide stress scenario". The objective is to ensure a consistent and comparable measure of outflow rates across institutions for deposits that are subject to higher outflows than specified in the CRR.
As with most things in life, the devil is in the detail. How the LCR ultimately impacts banks in Europe (and the real economy) will depend on the form and structure of these harmonised standards and others which are coming soon. Market participants have until 21 March 2013 to respond to both papers.
The European Systemic Risk Board (ESRB) published recommendations on reforms to money market funds (MMF) on 18 February 2012. The ESRB recommends a mandatory variable net asset value (NAV) and minimum amounts of daily and weekly assets that MMFs must hold.
Towards the end of last year, recommendations on MMF reform were published by IOSCO, the FSB, the FSOC and the European Parliament. While broadly in line with the recommendations issued by these bodies, the ESRB’s are the first to promote a mandatory move to a variable NAV. The ESRB’s recommendations are likely to have a significant impact on the EC’s thinking ahead of the legislative proposals on MMF reform that it is due to publish in the coming weeks.
In its own initiative report on MMFs, the European Parliament suggested that regulators should require a conversion to a floating NAV or introduce appropriate safeguards to protect a stable NAV MMF’s performance. In the US, the biggest MMF market, the FSOC recommended a floating NAV, a stable NAV with a NAV buffer and a minimum balance at risk, or a stable NAV with other measures such as more stringent investment diversification requirements. IOSCO recommended that stable NAV MMFs be converted to floating NAV where possible. The FSB endorsed that approach.
The ESRB also recommended imposing explicit minimum amounts of daily and weekly liquid assets that MMFs must hold. It also thinks that regulators and MMF managers should have tools to deal with liquidity constraints in times of stress, for example temporary suspensions of redemptions. Managers should also be made more responsible for monitoring liquidity risk.
The ESRP also called for greater public disclosure. It wants the EC to make it clear to investors that there is no capital guarantee and that there is the possibility that the principal could be lost. The ESRB also recommends that MMFs should disclose valuation practices, particularly the use of amortised cost accounting. As the FSOC highlighted in its recommendations, amortised accounting is often used by MMFs to allow rounding to maintain a stable NAV.
Finally, the ESRB made recommendations on reporting and information sharing. It wants MMFs to report to regulators on any sponsor support that might have an impact on the price of the MMF. It also wants to see MMFs enhance their regular reporting and to share information with regulators more effectively.
The ESRB has asked the EC to deliver an interim report containing a first assessment of its recommendations by 30 June 2013, and a final report on how MMFs have implemented the recommendations by 30 June 2014.
The FSB and the US will watch the EC’s reaction to the ESRB’s recommendations with interest. Imposing more regulation on MMFs may be easier in Europe than the US, where the more mature MMF industry has an effective its lobbying capability. It seems unlikely that the US will pursue a mandatory variable NAV but this latest development will put pressure on the FSB as it considers its final recommendations on shadow banking reform ahead of the G20 Summit in September.
Following consultation with industry, the European Securities and Markets Authority (ESMA) decided that binding measures to regulate the proxy advisory industry are not necessary. Instead, it has put forward recommendations for the development of an EU Code of Conduct.
While recognising the important function they provide, the EC raised concerns about proxy advisors in its 2011 Green Paper on Corporate Governance. Specifically, the EC was anxious about proxy advisors not being sufficiently transparent about the methods applied with regard to the preparation of advice. It was also concerned about conflicts of interest: when proxy advisors also act as corporate governance consultants, and when proxy advisors advise on shareholder resolutions proposed by one of its clients. The EC also was uneasy about a lack of competition in the sector which it thought raised concerns about the quality of the advice and whether or not it meets investors’ needs.
The EC’s concerns prompted ESMA to publish a discussion paper on the topic in March 2012. Like the EC, ESMA acknowledged the usefulness of proxy advisors. However, ESMA voiced similar concerns, particularly around conflicts of interest.
Having reviewed responses to the consultation, and conducting bilateral discussions with market participants, ESMA concluded that it has not received clear evidence of market failure in relation to proxy advisors’ interaction with investors and issuers. Therefore, it believes that introducing measures that are binding on the industry would not be justified. But it does want to encourage the industry to develop its own code of conduct.
As such, ESMA has provided the industry with principles to guide the development of the code. It has also set out its expectations regarding the governance of the code. The recommendations fall into the following areas (1) identifying, disclosing and managing conflicts of interest, and (2) fostering transparency to ensure the accuracy and reliability of the advice.
ESMA made clear that the industry committee that drafts the code of conduct is expected to take into consideration and distinctly address key governance parameters which it sets out in its report. The recommendations include developing a code of conduct that sets clear expectations and is workable for those who subscribe. ESMA also suggests that the committee carries out a robust public consultation of stakeholders in developing the code.
ESMA will review the Code of Conduct in two years, and may reconsider its position if no substantial progress has been made.