Including updates on short selling, Basel III and the new UK regulatory structure


Short Selling Regulation comes into force

Firms are now prohibited from engaging in uncovered (naked) trading of credit default swaps (CDS). This prohibition is part of the Regulation on short selling and certain aspects of credit default swaps (Regulation (EU) No 236/2012) (SSR), which came into force on 1 November 2012. SSR restricts the short selling of bonds, shares admitted to trading on EU markets and CDS, the instruments which provide credit insurance on EU sovereign and other debt. The Regulation also introduces EU-wide transparency requirements and harmonises regulators’ powers to intervene in markets when serious threat to financial stability arise.

SSR applies to all financial instruments admitted to trading on an EU trading venue and broadly follows the European Commission’s proposal in September 2010 which focused on the following areas:
  • increasing transparency of shorted trades
  • enhancing powers for national regulators and the European Securities and Markets Authority (ESMA) to intervene in a consistent and coordinated fashion in volatile markets to restrict or ban short selling
  • reducing settlement risk created by naked short-selling through buy-in requirements within a prescribed timeframe and
  • banning naked short selling of CDS on government bonds.
While the EC acknowledges that short selling and CDS have economic benefits and contributes to the efficiency of EU markets, notably in terms of increasing market liquidity (such as supporting efficient price discovery and helping to mitigate overpricing of securities) it also presents the following risks: transparency deficiencies; the risk of negative price spirals; and the risks of settlement failure associated with naked short selling.

EU lawmakers view SSR as the antidote for these risks, fortifying ESMA’s arsenal in cracking down on short selling and sovereign debt speculation. According to Michel Barnier (2011), EU Financial Services Commissioner, SSR will ensure that sovereign CDS are used for the purpose for which they were designed - hedging against risk of sovereign default - without putting the proper functioning of sovereign-debt markets at risk.

Critics argued that prohibiting traders from buying sovereign CDS as a ‘straight bet’ rather than a means of insuring against risk exposure will further increase sovereign borrowing costs. Some have also raised concerns that naked short selling increases the risk of settlement failure. They worry that at a time of considerable financial instability, short selling could aggravate falling share prices (especially in financial institutions) in a way which could ultimately threaten their viability and create systemic risks.

Many institutions are still getting to grips with monitoring their short selling activities, which can be a complex exercise particularly for global businesses. We expect regulators to remain vigilant in this area, and to start testing firms on the effectiveness of their compliance efforts in the near future.


Unfinished business: global regulatory reform

Christine Lagarde, Managing Director at the IMF, spoke on financial regulation to the Canadian International Council on 25 October 2012.

Lagarde believes that we have seen good progress on regulatory reform since the crisis. She points to agreements on higher capital and liquidity standards for banks and large investment firms (Basel III), the clearing of OTC derivatives contracts and the development of recovery and resolution frameworks, as evidence that we are moving in the “right direction”.

But many countries have not yet delivered on these reforms and many sources of systemic weaknesses exposed during the crisis are still present. Financial systems are still overly complex and interconnected; banking assets are still highly concentrated with strong domestic bank interlinkages; some banks continue to rely excessively on wholesale funding; and many banks are still too-important-to-fail.

Why has it taken so long for regulators to implement reforms? Lagarde believes that financial systems are still under distress and “crisis-fighting efforts are inadvertently impeding reforms”. In many EU countries, it might take banks decades to re-build their damaged balance sheets (some Asian banks are still recovering from the crash of the Japanese property market in the early 1990s). As a result, many borrowers face very tight borrowing conditions for the foreseeable future. This phenomenon is the adverse feedback loop of credit tightening on growth. In Europe, a pullback of cross-border capital flows has driven up funding costs in the periphery for all borrowersfurther compounding their difficulties and extending recovery times. Speaking this weekend, Angela Merckel, German Chancellor, stated that she believes it will take at least five years for the debt crisis in Europe to be resolved.

The global economy is not helping matters. There is no end in sight of the ‘Great Recession’ we have been experiencing since 2007. The IMF projects anaemic global growth at 3.3% in 2012 and 3.6% in 2013; in advanced economies, the forecast is even worse with output projected to expand by only 1.3% this year and 1.5% in 2013. A further escalation of the Eurozone crisis and the fast-approaching U.S. “fiscal cliff” are the key downside risks and sources of this policy uncertainty.

Reforms such as Basle III have “generous implementation timetables” precisely to allow the economy to recover, so there is no excuse for delaying the implementation of this seminal regulation. But maybe even more time is needed that was envisaged back in 2009 when many reforms were agreed, in light of the difficulties in the world’s leading economies?

Lagarde said that there are many vested interests working against regulatory reform which is slowing down progress and this “pushback is intensifying”. Lagarde is troubled by some banks that say the new regulations will be “too burdensome” and are spending huge sums of money lobbying against them. The IMF estimates that the overall costs of regulatory reforms to banks is relatively small and the impact on economic growth is negligible, particularly when compared to the trillions of euros of public funds that were injected into failed banking institutions during the crisis.

Lagarde’s comments about lobbying may have been directed towards the US, where banks have been very active in lobbying and the presidential elections have created uncertainties about future reforms.It shouldn’t surprise policy makers that US banks are seeking to dilute some of the provisions under the Dodd-Frank Act. Reforms coming down the tracks will fundamentally change the banking industry, affecting its structure, culture and profitability. Regardless of which way the election goes, authorities in Europe need to remain resolute in their reform agenda. EU countries have paid a high price for clearing up the mess of the financial crisis and reforms are key to ensuring that banks are in a more solid position to withstand the affects of the next crisis.


Basel III implementation progresses

The Basel Committee published its Report to G20 Finance Ministers and Central Bank Governors on Basel III implementation on 31 October 2012. They found that just under a third of Basel Committee members have issued final regulations on Basel III standards. Japan has conducted a detailed assessment of its final set of regulations. Two further assessments have been conducted on draft regulations in the EU and US, and these jurisdictions now have the opportunity to address the identified gaps as they finalise their rules. But significant effort is still required to ensure that these jurisdictions are ready for the globally agreed start date of 1 January 2013.

At the same time, regulators are evaluating banks' calculation of risk-weighted assets for banking and trading book exposures relevant for the implementation of the Basel III framework and the findings are expected to be published during 2013. This is important and has been exercising a lot of attention of late. The European Banking Authority (EBA) found recently that Pillar II capital requirements under Basel 2.5 are treated differently across Member States. From the most stringent to the most lenient regimes the differences equates to around 300 basis points in terms of capital requirements. It also observed differences within jurisdictions due to the vagaries of banks’ internal risk models. The UK financial regulator, the Financial Services Authority (FSA), conducted three exercises in the last few years where they gave a sample of banks a collection of assets (sovereign bonds etc.) and asked them to calculate how much capital they should hold based on their internal risk models (which are calibrated to Basel 2.5 requirements). The large variation in the results is significant and hasn't improved since the crisis.

This problem suggests that while finalising global rules across 27 Basel Committee members is difficult, ensuring that regulators implement consistent standards and that banks adopt similar risk management methods is a much greater obstacle to harmonisation. A single rule book and supervisory handbook should help in Europe in this regard, but so long as we rely on banks own proprietary internal risk models to calculate capital requirements some element of inconsistency will always exist.


CRD’s impact on SME lending

The EBA believes that risk weights (RWs) and thresholds for SME loans under CRD IV/CRR should not be relaxed to stimulate growth for the 20 million-or-so SMEs in the EU. The EBA undertook a detailed Assessment of SME proposals for CRD IV/CRR, and believes that chipping away at CRD IV/CRR is not optimal as it will “endanger” future financial stability.

The current regulatory framework already incorporates a discount factor for RWs vis-à-vis SMEs (75% RW for exposures below €1 million) while loans in the Corporate exposure class have an RW according to the rating of the borrower (from 20% to 150% depending on the rating--but usually 100% for most unsecured corporate loans). Under CRD IV/CRR, the methodology for calculating capital charges against traditional lending activities has not been subject to major changes other than the introduction of the capital conservation buffer (2.5% of risk-weighted assets, in addition to the current 8% requirement). The tougher capital requirements under CRD IV/CRR are particularly focused on capital market activities, trading business or securitisations exposures, which are now facing a much harsher treatment.

There is little evidence to indicate that SME loans are less risky than other Corporate loans and should be subjected to even more favourable conditions. Based on evidence from the 2007-2009 financial crisis, SMEs had a much larger probability of default than the whole of the Retail or Corporate asset class.

However, the EBA does recognise that lending conditions are deteriorating for SMEs and some temporary measures may be needed in the medium term. The EBA can see some sense in neutralising the affects of the conservation buffer for SMEs, which comes in gradually from 2016. Structural reform to make SMEs less reliant on bank loans would work better. Promoting venture capital, private equity and the use of consistent ratings across SMEs, would open up new, and more stabile, funding lines for SMEs and help get the engine of the EU economy peering again.


The dangers of liquidity regulations

The EBA’s Banking Stakeholder Group published a position paper on New Bank Liquidity Rules: Dangers Ahead on 3 October 2012. The paper focuses on the potential impact of the Liquidity Coverage Ratio (LCR) under CRD IV.

The Stakeholder Group estimates that EU banks will need an additional €1.15 trillion worth of liquid assets to comply with the LCR which is expected to come into force in 2015. Since the crisis, this shortfall has actually widened as banks have focused on replenishing their capital base rather than building-up their liquidity buffers. The Group believes there is a clear risk that banks may direct funding towards LCR-eligible assets in the future rather than providing loans to the SME sector. The Group are concerned that the LCR will ‘crowd out’ further productive investments and ‘sterilise’ €1.15 trillion of liquidity from the real European economy.

We are already seeing this trend. Currently over $850 million worth of deposits from large EU banks are sitting in central bank coffers and thus playing “no role in financing the real economy”. They call on the EBA to consider ways to enhance the set of assets eligible as liquidity buffer to mitigate these concerns. For example, if banks are allowed to use corporate bonds and asset-backed securities as liquid assets, capital markets could pick-up any slack in lending that banks are no longer provide.

The full impact regulations such as the LCR are still not fully understood. Research of this nature will help broaden debates and help the EBA design technical standards that not just buffer the stability of financial markets but help support the important credit intermediation role they play.


The UK’s new approach to financial regulation

The Bank of England and the FSA have issued documents setting out the approach to supervision of the new prudential regulator in the UK, the Prudential Regulation Authority (PRA), and the new conduct of business regulator, the Financial Conduct Authority (FCA), before they assume their responsibilities in 2013. The approach to conduct supervision is contained in a single document published by the FSA (Journey to the FCA) whereas the approach to prudential supervision is contained in two separate documents, one targeted at insurers (The PRA’s approach to insurance supervision) and another for banks and investment firms (The PRA’s approach to banking supervision).

The papers seek to explain the approach to supervision and thus facilitate scrutiny of the proposals. Both the PRA and the FCA plan to have more judgement led, forward-looking approaches, focussed on firms’ business models and the potential risks that their activities pose to financial stability and consumers.

The new regulators will employ a proportionate, risk-based approach to supervision, focusing on those issues and firms that pose big risks to safety and soundness in the case of the PRA, and in terms of ensuring fair and appropriate consumer outcomes in the case of the FCA. This will include forward-looking analysis considering potential future risks alongside existing ones. Each of the regulators will have to rely more heavily on their own judgment to make this approach work.

Both regulators intend to make assessing the suitability of a firm’s business model a core part of the overall supervision process. Firms will be required to demonstrate that their business model is appropriate, viable and sustainable given the nature and scale of their business. An adequate business model should provide clear evidence of adequate contingency planning and outline how the needs of customers and clients can be met without placing them at undue risk or undermining the stability of the wider financial services system.

Firms should consistently embed their risk framework throughout the organisation and not just rely on a separate risk function. In managing risk, firms should understand the extent of reliance on models and their limitations. This area appears to be an increased area of regulatory focus. Additionally, firms need to ensure that their risk management processes are reflective of the regulators focus on forward looking risks, including those present under severe but plausible circumstances which may lead to failure.

UK firms should be considering the implications of the regulators’ new approaches on their businesses’ governance and oversight, compliance, risk management, product development, distribution and, perhaps most importantly, their culture.