Including updates on materiality in financial reporting, calls for an EU-resolution authority and the need for a smaller banking system


ECB executive member calls for EU-resolution authority and smaller banking system

Current international reforms around resolution standards need to be buttressed by centralising crisis management and resolution responsibilities in global institutions, according to Jürgen Stark, member of the executive board of the European Central Bank (ECB). In a speech to the Transatlantic Business Conference in Frankfurt, Stark indicated that significant challenges remain in establishing effective cross-border resolution schemes, in particular for global systemically important banks. Stark floated the idea of creating an EU-resolution authority which would act as a nexus in coordinating the resolution of cross-border banks and help harmonise regimes across Europe. He pointed to the success of the European Supervisory Authorities — which are taking a similar role in the supervision and regulation of financial institutions — as a model which could be adopted in this area.

Stark lamented the ‘lost momentum’ of the initial impetus for adhering to ‘strict and precise timetables’ of implementing globally agreed financial reforms. Important reforms are expected to be ‘finalised only in years to come’ (e.g. shadow banking); the Basel III framework will be phased in by 2019 with significant legal and regulatory preparation still required — a full ten years after the recent financial crisis had seen its peak.

New rules on strengthening capital and liquidity standards through Basel III are hugely beneficial and should be pushed forward by authorities, according to Stark. The implementation of harmonised global rules on capital requirements will create a level playing field, boost competition and increase the availability of financial services to the real economy. These measures will also protect the financial system against the systemic risks associated with the boom-bust cycle in aggregate growth.

However, regulation is not a panacea and significant restructuring is necessary to make banks stronger. Stark suggests that the banking sector will need to shrink in size (analysts suggest 25-35%) to negate many of the risks it has built-up in the past two decades. Stark believes that the financial system has ‘outgrown in size....lost track of its core functions... and become a major source of risk itself’. However, whether investors will tolerate a lower return on equity (RoE) is debatable as banks retrench to traditional activities.

Universal banks are likely to see a 4-5% point fall in their RoE due to Basel III, taking them from a historical average of 15% to a level nearer their cost of equity. Some business lines will be more affected than others; McKinsey estimate that the top 13 investment banks could see a 65% decline in RoE, as a result of a 25% fall in profits and a 100% increase in Tier 1 capital requirements. Regulators accept a fall in RoE is inevitable but believe banks and investors should not focus on this ratio as their primary indicator of profitability as it encourages short-term — and sometimes — unsustainable returns.

In light of the huge losses borne by investors as a result of the financial crisis and a greater appreciation of the risks inherent in banking operations, investors are likely to demand a large premium when investing in banks shares for the foreseeable future.

However, if supervisors can accelerate reforms and convince market participants that risks have been neutralised, it will make it easier for senior management at banks to implement reforms to their business models — reverting back to lower-risk business practices envisaged by authorities — and investors to stomach lower utility-like returns.


Materiality in financial reporting

The European Securities and Markets Authority (ESMA) has called on the financial community to help shape policy around materiality in financial reporting via a high-level consultation.

Broadly defined, information is material if its ‘omission or misstatements could individually or collectively influence the economic decisions users make on the basis of financial statements’. ESMA wants to break down this definition, asking for feedback on many of its components.

For example, as users of financial information are varied, ranging from suppliers, employees, customers and investors, there is ambiguity on what information is required and whether the firm has a responsibility to cater for all categories of users.

In practice, some users may only require primary statement totals to make informed decisions, while others may need more granularity with notes and explanations accompanying each financial entry. The situation is further complicated as supervisors are unable to specify uniform quantitative thresholds across industries, according to ESMA, as materiality is ‘entity specific’. Even if supervisors were able to do so, the changing nature of markets would require careful monitoring. The eurozone crisis is a good example of how information on ‘riskless’ sovereign debt exposures, previously not seen as being material, is now viewed as being central in terms of judging the context of a financial institution’s accounts.

ESMA is starting to play an increasingly important role in the enforcement and application of international financial reporting standards (IFRS) in Europe through its Corporate Reporting Standing Committee (CRSC) which regularly meets with other European enforcers to exchange views and discuss experiences. Materiality has always been a difficult concept to pin-down and developing workable parameters underpinning the concept is a necessary, albeit, arduous endeavour. ESMA is in a good position to contribute to these debates, which are particularly relevant for financial institutions and their investors.

The consultation period closes in 29 February 2012; ESMA expects to publish a final report on materiality later in 2012.


EIOPA releases guidelines on complaints-handling

All insurers should have a ‘complaints management policy’ in place which is defined and endorsed by senior management and made available to all relevant staff, according to draft guidelines issued by the European Insurance and Occupational Pensions Authority (EIOPA). The policy should outline how complaints are investigated and information is collected and reported to supervisors. Information on the complaints-handling process should be easily accessible to all consumers and the general public at large to mitigate information asymmetries.

To steer a harmonised approach to consumer outcomes, EIOPA wants insurers across the EU to provide a response to each complaint without any ‘unnecessary delay’ and state their decisions using plain language. Opportunities to escalate the complaint should be shared with clients (where available), such as the option to bring the complaint to the national supervisor, ombudsman or any other alternative dispute mechanism.

Insurers should analyse complaints on an ongoing basis, according to the guidelines, to ensure that they identify and address any recurring or systemic problems which could present potential legal and operational risks. Specifically, the guidelines call on firms to identify the root causes of individual complaints and determine whether such causes may affect the provision of other products or services.

EIOPA believes that most of the policies introduced in these guidelines are already in place in many EU countries. In markets where these policies are not propagated, some costs related to changing communication and software technologies and insurance contracts is likely. The benefits expected to flow from the proposed policies will outweigh the costs, as detailed in the impact assessment accompanying the guidelines.

Comments on the draft guidelines can be submitted up to 31 January 2012; EIOPA will then consider feedback received and submit final proposals by March 2012.