Including updates on bank restructuring in Europe, macroprudential supervision and market abuse


Further restructuring by European banks appears inevitable

Further industry-wide reorganisation is expected in the EU financial sector, particularly banking, according to a staff working paper from the European Commission’s (EC) Internal Market and Services Directorate General (DG MARKT). In its 2012 European Financial Stability and Integration Report, DG MARKT envisages:
  • further consolidation of the Spanish Cajas (a collection of savings banks who took a big bet on the Spanish property market), taking into account the new solvency requirements announced by the Spanish Government
  • a new wave of mergers and acquisitions as firms exit State recapitalisation programmes and seek better cross-border consolidation due to regulatory reforms
  • operational restructuring and rationalisation process in the asset management and insurance industries in response to new regulations (Solvency II, UCITS IV, AIFMD, MiFID II)
  • further pressure on banks to improve their cost effectiveness, return-on-equity and capitalisation levels due to CRD IV.
Depending on market conditions, the EC will remove special-aid measures in the financial sector to allow banks to renormalize towards a more efficient, stable and properly regulated business model without the need for State support. However large uncertainties still persist which could prevent this from happening in the medium term. The outlook for continued strong earnings in the banking sector remains uncertain, reducing their attractiveness to private investors/creditors. Roll-over risk remains present for banks and sovereigns, particularly US dollar denominated debt. And the risk of crowding-out of private bank debt by sovereign debt issuance (particularly in Italy) will increase in the recovery, according to the report. Banks (and the economy) are also still being propped up by the government through large capital injections, loans and historically low interest rates and it’s unclear how long these policy measures can/will persist.

The report is not all doom and gloom. Generally the European financial system is in a better place now than a year ago, and risks of a financial melt-down have rescinded in the eurozone as the ECB has taken a more interventionist role in the financial system by, amongst other things, issuing cheap credit lines to struggling banks late last year.


IMF finds central banks are not optimal macroprudential regulators

Monetary policy and macroprudential regulation should be carried out by two separate institutions free from political interference, according to a recent IMF working paper: Central Bank Independence and Macro-prudential Regulation. Drawing from well-established theoretical models, the paper finds that a dual-mandate central bank (i.e. with both monetary and financial stability responsibilities) is not optimal from a welfare perspective (in producing higher output) because of a time-inconsistency problem. Although it may be optimal for a central bank to pursue low inflation targets before a crisis, after a crisis it is better to let inflation rise, at odds with price stability, to repair debt-laden private balance sheets and achieve financial stability. Macroprudential regulation is not useful in the immediate aftermath of a large crisis because it takes too long to feed its way through the system. Therefore, a dual-mandate central bank has only monetary policy to achieve its objectives.

Consistent with prevailing conventional wisdom, the paper concludes that the macroprudential regulator (under whatever guise) and the monetary authority should be politically independent. In fact, a dual-mandate central bank which is politically independent may be optimal if financial crisis are kept small because the benefits of information sharing and the use of central bank expertise may outweigh the welfare losses due to the time-inconsistency problem.

The IMF working paper is useful. Testing the appropriateness of institutional structures in the immediate aftermath of a financial crisis―where it is probably most strained―represents good practice. Moreover, reinforcing the need for political independence of monetary and macroprudential authorities is timely, as European governments toy with the idea of using monetary policy to stimulate investment and employment in the eurozone.

The pan-European macroprudential regulator, the European Systemic Risk Board (ESRB), has been established as a quite distinct and separate body from the European Central Bank and the European System of Central Banks. However, the ESRB’s independence is tenuous. The president of the ECB, Mario Draghi, is also chairman of the ESRB; Mervyn King, the governor of the Bank of England, is its vice-chairman. Moreover, the ECB has formed a unit within its structure to provide secretariat support to the ESRB.

Nevertheless, by its very nature macroprudential oversight requires a regulator to interact very closely with other competent authorities in the area of supervision and monetary policy. Sharing personnel who have the skills to interpret these results and the authority to issue warnings makes sense, drawing from statistical and analytical inputs captured by the ECB and other central banks is necessary, and ensuring that monetary and macroprudential policy are coordinated is essential.

More important matters should also be considered. The IMF paper concludes that assuming small credit shocks, ensuring political independence of institutions should be the “central point” of this debate. Moreover, arguments about where the macroprudential regulator should be optimally located is academic unless it is has a clear legislative mandate with robust powers. The IMF assumes this in their models; let’s hope their models prove to be correct.


ESMA reviews market abuse sanctions across Europe

Member States maintain the right to impose sanctions under Article 14 of the current Markets Abuse Directive (MAD) (2003/6/EC) with no minimum requirements. Unsurprisingly, there are considerable differences in the penalties imposed by national regulators to deal with market abuse due to heterogeneous cultural, legal, judicial systems across Europe, together with differences in the powers and resources available to the national regulators. Ultimately, the European Securities and Markets Authority (ESMA) is keen on developing some “minimum common standards” in this area (regardless of, or in preparation for, the outcome of current negotiations on revisions to MAD). However, some preparatory research is needed beforehand.

On 26 April 2012, ESMA published a report, The Actual use of sanctioning powers under MAD, which looked at the use of administrative and criminal actions across 29 of the 30 European Economic Area Member States over the period from 2008 to 2010. The report focuses on the types of sanctioning powers available to national regulators; the different legal approaches to the relationship between administrative and criminal sanctions; the resources allocated to combating market abuse; and actual use of settlement powers, administrative and criminal sanctions; and the publication of decisions.

At 180 pages, it’s a good reference piece for national regulators to benchmark their current framework against the norm or the best in class; it’s also worth noting the regimes which are most lenient or stringent in the penalties they impose.

According to ESMA, national regulators took into account a large range of factors when determining the type and level of sanctions, including the:
  • seriousness of the violation
  • amount of financial benefits
  • extent to which the defendant co-operated with the authorities
  • financial strength and/or size
  • duration of the violation
  • impact on market and consumers
  • degree of culpability
  • repetitive nature
  • level of responsibility/seniority.
In terms of financial sanctions, two national regulators (Norway and the UK) have no maximum penalty for market abuse cases. Italy has the highest maximum penalty at €25 million; Estonia the lowest at €1,200. In all, 23 national regulators imposed administrative sanctions associated with market abuse during the review period. Ireland, Iceland, Luxembourg and Norway, Sweden imposed no sanctions during the review period, due to difficulties in proving intent of market abuse, the small size of the market, specific legal anomalies, a bias towards criminal sanctions and the small size of the market, respectively.

Around half of the Member States have no specified minimum penalty for insider dealing or market manipulation. Insider dealer and market abuse fines ranged from €1 (Lithuania) to €16 million (Estonia).

Non-financial sanctions were imposed by 11 national regulators during the review period. The types varied but generally included one of the following: reprimands, temporary disqualification and withdrawal of licences (which occurred in Lithuania, Poland and Slovenia).

Criminal sanctions are also important, and the national approaches vary widely. Where national regimes allow imprisonment as a penalty, the range of the minimum length of imprisonment applicable for insider dealing violations varies from 15 days (Slovenia) to three years (Sweden), while the range of the maximum length of imprisonment applicable varies from 30 days (Estonia) to 12 years (Italy and Sweden). Of the four national regulators (Greece, Ireland, Poland, the UK) that have the power to bring prosecutions themselves in the criminal courts. three did so during the review period (Greece, Poland, the UK). Ireland’s national regulator also has this power, but did not use it during the review period.

Imprisonment was imposed by 7 Member States as a sanction for insider dealing and by 7 Member States (but not all the same ones) as a sanction for market manipulation. The length of term ranged from under 1 year to 3 years for insider dealing, and from one year to four years for market manipulation.

Given the EU’s ongoing review of the market abuse regime, one of the key questions has to be whether or not more uniformity of processes and penalties would bring more consistency to the national regimes. A more uniform approach would almost certainly reduce the likelihood of regulatory arbitrage and provide better deterrence against abusive market conduct, which would benefit institutions and investors. However, there are challenging questions around proportionality, particularly in relation to financial sanctions.


IOSCO outlines principles for CIS liquidity risk management

On 19 January 2012, the International Organization of Securities Commissions (IOSCO) Technical Committee outlined some common sense principles regarding the suspension of redemptions for open-ended collective investment schemes (CIS) (see our 30 January 2012 update).

One of the principles in that report related to liquidity risk management. 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 the CIS invests in, and their consistency with, the overall liquidity profile of the open-ended CIS.

IOSCO believes a set of sub-principles is needed to help firms understand how they should actually manage liquidity during the design and ongoing management of a CIS. It has set out 15 principles structured around the lifespan of a CIS.

Starting with the design or pre-launch phase, the applicable entity (generally the fund manager) should create a robust risk management framework taking into account the types of instruments in which the CIS’s assets will be invested. Part of this framework should include appropriate liquidity limits―which are proportionate to the redemption obligations and liabilities of the CIS―and a suitable dealing frequency for units in the CIS. The framework must ensure that the applicable entity has access to data which it can use to calculate risks and disclose information to investors. The framework can be supported by specific tools or exceptional measures to limit redemptions in times of stress, such as exit charges, limited redemption restrictions, lock-up periods or suspensions. Nevertheless, investment strategies should not rely on these measures (which may or may not be allowed under local rules); because they are not a substitute for sound liquidity risk management practices. Moreover, these measures should only be used where fair treatment of investors is not compromised. Managers should not be required to construct a new framework for each new CIS if it already operates a CIS with similar characteristics, according to IOSCO.

After the liquidity risk management process is established pre-launch, the manager must ensure that it is effectively performed, maintained and tested during the life of the CIS. The manager needs to consider investment strategy, liquidity profile and the redemption policy of the CIS. This, again, requires high quality data and also robust governance structures to provide adequate oversight and controls. According to Principle 12, the liquidity risk management process should facilitate the identification of emerging liquidity shortage before it happens. Also, all new investments should be assessed in terms of their likely impact on the overall liquidity of the CIS during the lifetime of the investment. The liquidity “quality” of securities accepted as collateral should also be evaluated on an ongoing basis, according to IOSCO.


G20 finance ministers and central bank governors meet ahead of June summit

The G20 countries hope 2012 will bring modest growth in the global economy, but this remains under pressure in the face of deleveraging and high volatility in European financial markets, according to a communiqué from the G20 finance ministers and central bank governors who met in Washington on 18-19 April 2012 ahead of the main summit in Mexico in June. The participants reaffirmed the need to implement common global standards in financial regulatory reform across member countries and to stick to agreed timetables. The ministers and governors welcomed the progress in extending the global systemically important financial institutions’ framework to important domestic banks and highlighted the importance of regulating shadow banking. They supported the work of the Financial Stability Board to reorganise its legal, institutional and operational framework. And they also endorsed efforts of the International Accounting Standards Board and the Financial Accounting Standards Board to achieve convergence to a globally accepted set of high quality accounting standards, urging them to meet their target of issuing standards on key convergence projects by mid-2013. Recognition was also given to ongoing efforts by the G20 development working group in creating a basic set of financial inclusion indicators which will assist countries, policymakers and stakeholders in focusing global efforts on measuring and sustainably tracking progress on access to financial services globally.