Including updates on G20 summit, retail ring-fence and FTT


G20 summit agenda dominated by Greece

The G20 summit in Cannes was largely preoccupied with the continuing eurozone crisis and the Greek government’s ineffective efforts to deal with its debt burden. As prospects of a potential bail-out from China and other countries receded, difficult discussions around increasing the IMF’s firepower to deal with the crisis in Greece, measures to protect Italy through some kind of financial firewall and how to avoid further globalisation of the crisis dominated the main agenda.

Despite the preoccupation with Greece, the final conference Communiqué contains several important signals about the direction of financial regulation. Shadow banking, high frequency trading and dark liquidity were singled out as areas for further work to develop regulation strategies in the coming year. The Credit Default Swaps markets will also be reviewed by the International Organisation of Securities Commissions (IOSCO) in 2012. There was less in the final Communiqué than might have been expected on matters dealing with derivatives trading, reflecting perhaps the challenges of achieving consistent global approaches to issues such as collaterailization and margins requirements.

The Leaders did follow-up on the priorities they set last year by agreeing a package of comprehensive measures to tackle the risks posed by global systemically important financial institutions (G-SIFIs), sending a definite signal that no financial institution should be ‘too big to fail’. They confirmed G-SIFIs will be subject to stringent capital requirements from 2016, more intensive oversight and new international standards for resolution regimes. The Financial Stability Board (FSB) have published an initial list of G-SIFIs, as these firms begin to be segregated from the pack, and may publish a similar list of non-bank SIFIs in future. The FSB will be given an even more prominent role in coordinating and monitoring these requirements, given the cross-border nature of their activities, and will take on a legal personality with greater financial autonomy under the Chairmanship of Mark Carney, Governor of the Central Bank of Canada.

On the much debated financial transaction tax (FTT), President Sarkozy acknowledged it as an initiative being examined by ‘some countries’, reeling off a list of supporters (e.g. Argentina, Brazil, UN and Commission) that now backs its introduction. However, it continues to lack support from the UK and US who remain unconvinced of it merits, scuppering any meaningful progress at the summit.

We also plan to release a further issue of the European financial regulation update on Wednesday (9 November) in response to the G20 summit. We will be analysing what happened at the summit, what was said, agreed and sidelined, reading between the lines, and highlighting the likely ramifications’ for financial institutions.

The broader G20 agenda continues to make progress in other quarters, with the wider developments on the financial transaction tax, retail ring fencing, mortgage regulation and macroprudential policy discussed in more detail below.


European Parliament calls for global retail ring-fence and Tobin tax

On 25 October, the European Parliament (Parliament) agreed by a large majority a resolution on financial and economic governance in the run-up to the G20 summit in Cannes. The resolution covers three big ticket items: retail ring-fence, a Tobin tax and IMF governance.

The Parliament supports the introduction of global proposals to ring-fence retail bank activities of large financial institutions and require them to be capitalised on a standalone basis. Parliament believes a retail ring-fence should make it easier to separate universal banks if they become distressed, without resorting to taxpayer-funded solvency support. It should also insulate vital banking services from problems elsewhere in the financial system and curtail government guarantees — reducing the risks to public finances and making it less likely that banks will run-up excessive risks in the first place.

While the resolution doesn’t provide specifics on what a global or European retail ring-fence would look like, it does suggest that it should ‘mirror’ the Independent Commission on Banking (ICB) final proposals on UK banking reform. Broadly, the ICB recommends that domestic retail banking services should be inside the ring fence, global wholesale/investment banking should be outside, and the provision of straightforward banking services to large domestic non-financial companies can be in or out. Once established, the two sides of the ring-fence will need to be economically independent, transacting with each other on a third party basis. Both sides will need to be separately funded and able to continue operating in the event either side were to fail. Therefore, the ICB have allowed banks some flexibility in how they design their ring-fenced retail banks, making it a lot easier to match assets and liabilities on either side of the ring-fence.

In terms of capital, the ICB proposals recommend that large ring-fenced banks should have a ‘ring-fence buffer’ of at least 3% of Risk-Weighted-Assets (RWAs) above the Basel III baseline of 7%, e.g. Core Tier 1 equity to RWA ratio of 10%. This buffer requirement is supplemented by a maximum leverage of 4.06% and a total primary loss absorbing capacity (PLAC) minimum requirement of between 17% and 20%. Part the PLAC can be made up from contingent capital and bail-in debt.

The ICB proposals have been generally well received by market players and commentators alike and give banks sufficient time (until 2019) to prepare for fundamental changes to their legal structures, governance arrangements, payments, technology and regulatory risk management and reporting in the run-up to the structural split. However, the ICB’s economic case for a retail-ring fence rests on the assumption that it can shift the probability and impact of potential future financial crises. As such, one of the main failures in the recent financial crisis was that retail banks didn’t have sustainable funding structures and prudential lending practices in place to cope with liquidity shocks and loan losses and impairments. Unless that changes, a retail-ring fence may do little to mitigate the probability and severity of a crisis. Not all jurisdictions are supportive of ring-fencing —in September, the Swiss parliament rejected proposals to require its two largest banks to jettison and at least shield risky investment business from their core retail and investment business operations, believing that a ring fence was not necessary to protect financial stability.

The Parliament resolution also highlighted the merits of a Tobin tax on financial transactions (FTT). Despite concerns about its cost and effectiveness, European policy makers believe that it will cleanse the market of high-tech practices which fuel speculation, market noise and technical trading and market volatility. Various other market behaviours and business models are likely to be severely affected as well. The FTT would increase transaction costs, eroding profit margins on high frequency trading and most likely result in a shift towards automated trading based on algorithms that trigger less frequent but higher-margin transactions. This could make EU financial institutions less competitive than their international peers. The FTT will likely displace up to 90% of the derivative trading taking place in the EU if no international agreement is reached to implement comparable legislation elsewhere, according to the Commission own analysis. Thus the FTT’s anticipated benefit of generating additional tax revenues for the EU may not be realistic.

Finally, in its resolution, Parliament calls for the International Monetary Fund (IMF) to be more legitimate, transparent and accountable in the future, given the institution’s increasingly important role in global governance. To this end, Parliament believes that the IMF’s managing director should be elected through a transparent and legitimate process. Also, the resolution calls for a fairer distribution of voting rights, which may decrease the EU’s influence in key IMF decisions, at a time when the eurozone countries are likely to become more reliant on IMF funding to overcome the sovereign debt crisis.


FSB outlines principles for residential mortgage underwriting

Effective due diligence of borrowers’ income capacity and ability to repay are core tenets to sound residential mortgage underwriting practices, according to the Financial Stability Board (FSB). In a consultation paper, the FSB outlined a set of principles outlining minimum acceptable underwriting standards with a view to ensuring that prudent underwriting practices are propagated across all jurisdictions to prevent any concentration of risk in the future, like the subprime crisis in the US where weak residential mortgage underwriting practices transferred risk globally through securitisation and other financial instruments.

Most of the FSB principles seem like basic common sense. Harping back to traditional banking values, the FSB wants banks to carefully assess borrowers’ ability to service and fully repay their loans by examining a range of factors, such as their income and assets, past savings record and allowances for future negative outcomes. The FSB warns that the use of mortgage insurance, where used, does not substitute for sound underwriting practices. Lenders should adopt and adhere to adequate internal risk management and collateral management processes. Supervisors should ensure that lenders adopt prudent loan-to-value ratios (through caps etc.) and require a down payment that is substantially drawn from the borrower’s own resources.

The challenge for firms will be demonstrating that they have sound procedures in place to ensure they comply on an ongoing basis with these principles. Tightening credit risk management frameworks associated with residential lending is a first step, ensuring staff have adequate training to help them make appropriate judgements on borrowers is a necessity. FSB is keen to play its part in making the residential mortgage market more sustainable and safe. Firms have until 9 December 2011 to respond to the consultation.

The European Commission previously released related proposals on residential mortgage credit in March 2011. The EC has been studying various options for legislation at an EU level in relation to mortgage credit over the past decade but historically Member States showed little appetite for greater harmonisation in mortgage practices. The financial crisis, however, has provided the impetus to put forward concrete proposals focusing on the retail property market. Indications are, though, that this may just be a first step and future proposals will consider the mortgage market more generally.

Similar to the FSB’s principles, the Commission are seeking to create a stable residential market in Europe. The proposed EU Directive on ‘Credit Agreements Relating to Residential Property’ (Mortgage Directive) will offer residential mortgage borrowers increased protection, delivered via robust regulations on mortgage advertising, advice, creditworthiness assessments, pre-contractual information, and the right to early repayment. Ultimately, the Mortgage Directive aims to create a ‘more efficient and competitive single market for mortgages.’ Principally, proposals seek to provide greater flexibility in the post-contractual phase of mortgage agreements, allowing customers to make early repayments, switching lenders, and the right to convert a foreign current mortgage into the lender’s national currency. The proposed Mortgage Directive is currently been negotiated between the EU Council and Parliament, and we expect the Level 1 text to be agreed in early 2012 and implemented two years later.


Getting to grips with macroprudential supervision and ‘shadow banking’

The development and implementation of macroprudential tools and frameworks is still at a very early stage, according to a progress report by the FSB, IMF and Bank for International Settlements (‘tripartite authorities’). Achieving a succinct definition of macroprudential policy is still proving difficult, despite significant work in this regard. Broadly, macroprudential policy can be described as one which seeks to limit systemic risk, focuses on the financial system as a whole, and uses prudential tools to target risk. However, consensus has yet to emerge on the category of policy it fits into (i.e. is it a subcomponent of prudential regulation or something different) – which is probably mere semantics to anyone other than the economists.

However, some progress has been made, particularly in the enhancement of systemic risk monitoring (still a very nascent stage), development and introduction of new tools (such as countercyclical buffers for global systemically important banks) and in assessing the effectiveness of existing tools.

The tripartite authorities bemoan the lack of applied research in the area of systemic risk, where no common paradigms exist. The significant limitations in supervisors’ current analytical toolkit are posing significant problems in assessing systemic risk. In addition, the authorities recognised the need for macroeconomic tools to be tried and tested in the field, to evaluate their performance against current expectations so they can be modified and further improved. They further reiterated the need for jurisdictions to develop specific institutional arrangements and government structures for the conduct of macroprudential policy. Open and frank dialogue between national policymakers, with clear division of responsibilities and reporting lines, is essential for effective macroprudential policy, according to the report.

Shadow banking continues to receive considerable attention. Since the completion of Basel III, the global community has been increasingly worried that financial institutions — in search of higher returns — may circumvent new regulatory standards through shadow banking. Supervisors have stepped-up their regulatory focus on the estimated $60 trillion market in recent times, and have formed a number of work streams which will finalise formal regulatory proposals in each area by around mid-2012.

The first such work stream is examining whether or not regulated lenders hold enough capital against their transactions with all players in the credit intermediation chain. The second work stream is tasked with assessing the risks and possible regulatory reforms required in relation to money market funds and to non-regulated entities. Additionally, the FSB is probing the regulation of securitisation, particularly with regard to retention requirements and transparency. A final work stream is investigating the regulation of activities related to securities lending/repos, including possible measures on margins and haircuts.

In its October update, the Financial Stability Board (FSB) also presented a number of recommendations for effective monitoring and supervision of shadow banking. While, the FSB stressed the difficulties and complexity associated with this task and the many unknowns still present, it did outline a general roadmap supervisors could follow. Supervision, firstly, requires carefully analysis of the trends of non-bank credit intermediation (which is unique in each national financial system) that has potential to pose systemic risk, according to the Basel-based institution. To minimise the source of risk inherent in off-balance sheet activities, the FSB recommends that supervisors need to pay close attention to a series of risk factors, such as liquidity transformation, leverage and imperfect credit risk. Moreover, to ensure the definition of shadow banking is sufficiently wide, the supervisor needs to also assess the potential impact that the severe distress or failure of certain shadow banking entities/activities would pose to the overall financial system by looking at other factors, such as the interconnectedness between the shadow banking system and the regular banking system.

Laudably, the FSB called for supervision which is ‘flexible, forward-looking and regular’, emphasising the need to share information among national supervisors given the international dimension of transactions. Recognising that authorities will have to continually adapt to changing market trends and therefore create a regulatory framework which is fluid and dynamic is a good first step in difficult task of effectively identifying and supervising shadow banking activities.