Including updates on Banking liquidity, MiFID II leaked proposals and the ICB report

 

Banks play down liquidity crisis in the eurozone

Banks will not be required to disclose their liquidity positions as part of industry-wide stress tests, deputy chairman of the European Banking Authority (EBA) Adam Farkas said at a recent economic conference. Farkas noted that the nature of liquidity risk assessment from a supervisory perspective is “quite different” from the assessment of capital, and the EBA will not be seeking to achieve the same level of disclosure on both positions.

Farkas’ comments were made in the context of growing concerns about the fragility of the eurozone banking system, following a week banks’ share prices were hit heavily, a downgrading of long-term debt of two large French banks by Moody’s and the continuing problems from the sovereign debt crisis.

These factors are making it more difficult for banks to tap wholesale funding markets. Bloomberg, the Wall Street Journal and Reuters have all reported that some major financial institutions in Europe are now completely cut-off from dollar funding markets, as U.S. institutions pull back capital in response to the region's debt crisis.

Farkas, in a recent press interview, accepted that the supply of liquidity is “currently difficult for a number of banks”. The European Central Bank (ECB) and some banks, for their part, came out last week to forcefully to reject suggestions that they are facing liquidity problems.

However, recent movements by the ECB point to some underlying problems. The ECB said on 13 September that it had allotted $575 million in a regular 7-day liquidity providing operation at a fixed rate of 1.1%; it also indicated that it will be lending an undisclosed amount of dollars directly to two euro-area banks on 15 September. Apart from dollars lent to a troubled Greek bank in August, this is the first time the ECB has pumped dollars into its eurozone banking system for six months. Furthermore, in a coordinated action, five international central banks agreed on 15 September to inject billions of dollars into Europe’s troubled banking system in an effort to avert a global credit crunch. Markets are reflecting heightened concerns; with the premium European banks pay to borrow in dollars through the swaps market close to the highest level in almost three years, according to data compiled by Bloomberg.

In light of these developments, Farkas has called on national regulators to “closely monitor” lenders’ liquidity positions, suggesting the pan-European regulator could start to implement systemic liquidity stress tests of banks, as part of its ever growing arsenal of supervisory measures.


 

Exchange traded funds and systemic risk

Investment management firms largely agree with the Financial Stability Board’s (FSB) call for greater transparency and enhanced disclosure in Exchange Traded Funds (ETFs) that use derivatives (commonly known as “synthetic” ETFs). However, some respondents to the FSB have refuted its contention that securities lending by ETFs posed more risks than other types of securities lending, calling on the international organisation to produce evidence to support its conclusion. More generally, respondents put forward a number of suggestions:
  • exchange traded note structures (particularly credit backed notes) should be subjected to greater regulatory scrutiny than fund structures, as they are typically associated with higher leverage and more exotic exposures.
  • funds constructed using a basket style swap should have the same regulatory requirements as funds constructed using a fully-funded swap. The important distinction under UCITS is that under the basket style swap construction, the collateral is represented by the holdings of the fund whereas the fully-funded swap is collateralised outside of the fund.
ETFs have become a hot topic with various reports (FSB, IMF, BIS) calling on increased surveillance of these funds, noting that their impacts on market liquidity and on the financial institutions servicing the funds are not yet fully understood, especially during periods of acute market stress. The FSB are particularly concerned about the potential systemic risks arising from the complexity and relative opacity of some ETFs which have branched out to new asset classes (e.g. fixed income, derivatives, and commodities) with thinner liquidity. Regulators are worried that the leverage embedded in the new breed of ETFs could pose financial stability risks if equity prices were to decline or interest rates increased. The IMF has also suggested growing popularity of ETF products may be contributing to equity price appreciation in some emerging economies.

The news of massive losses by a rogue trader at UBS, said to be connected to ETF trading, may result in increased regulatory scrutiny in this area. With the full facts as yet not known, it is far too early to leap to conclusions about the risks ETFs may pose.


 

MiFID II leaked proposals: end to vertical exchange silos?

New rules requiring open access to clearing houses have been included in a leaked copy of the MiFID II regulation which has been circulating in the press this week. Article 26 and 27 of the leaked text, which is subject to amendments prior to formal publication by the European Commission (EC) sometime next month, requires open and non-discriminatory access to central counterparties and trading venues, and applies to all financial instruments.

If the leaked proposals are implemented, they will bring an end to the “vertical silos” model which has allowed exchanges to dominate both the trading and clearing of instruments on their platforms by restricting access to their downstream clearing houses.

The inclusion of the two new clauses, which did not appear in the original MiFID II proposals, comes after a similar requirement was dropped from the Regulation on OTC derivatives, central counterparties and trade repositories (EMIR), after the EC decided against proposals to widen EMIR’s scope to all derivatives and make future clearing houses subject to open access rules, following industry consultation.

In another controversial move, the EC is pushing forward with its idea of creating an Organised Trading Facility (OTF), a ‘catch-all’ targeting all forms of trading platforms which are not regulated markets or MTFs. The EC believes this will enhance transparency and level the playing field between various trading venues. According to leaked rules around its operation, investment management firms will not be able to put their own capital to work in the OTF category, which will likely pose significant challenges given the wide variety of ways they currently use own capital throughout their businesses.

The leaked rules also make considerable reference to high frequency trading, indicating that the EC is keen to bring all high frequency traders within the scope of MiFID.


 

ICB report recommends structural change in UK banking

The Independent Commission on Banking (ICB) has called for both structural reforms, including a retail ring-fence, and enhanced loss-absorbing capacity for UK banks, in its final report published on 12 September.

Universal banks will be required to ring-fence retail banks from investment banking and trading activities and establish a separate board of directors for their retail bank. Banks will be required to hold 10% equity inside the ring-fence, with an option for regulators to demand as much as 13%. Investment banks’ capital, and consolidated group capital will have to be held to at least meet the new Basel III requirements.

The rationale behind the ring-fence is to ensure that capital inside the retail bank —which performs vital economic functions like payment services — is not depleted by losses at the investment bank. The Swiss government decided against a ring-fence, possibly recognising that retail banks seeking high returns can always find risky retail investments, as we saw with the subprime crisis in the U.S. Moreover, one of the main lessons from the recent financial crisis was the failure of retail banks to have sustainable funding structures in place to cope with liquidity shocks.

UK headquartered global systemically important banks will be required to hold 17-20% of loss-absorbing capital including bail-in bonds. This far and away exceeds current Basel III requirements, and reflects the UK’s determination to ensure that its banks can effectively navigate systemic crises in the future, without having to draw on public funds. It aligns with Swiss proposals, which require its main banks to hold 19% of their equity in tier one capital, with firms having the option to use bail-in bonds for the final 9% of their capital requirements.

The issue of whether or not Basel III should be a maximum or minimum requirement has been actively debated in Brussels this past summer. Germany and France have been pushing for EU regulations, setting minimum capital requirements of Basel III into the maximum level for all EU banks. Seven finance ministers, lead by the UK, wrote in June to Michel Barnier, the EU Internal Market and Service Commissioner asking the EC to scrap its proposed plans to prevent national regulators from setting tougher capital rules over and above capital requirements laid down by Basel III. They argued that some countries may need to set higher capital levels “in specific circumstances to protect financial stability”, and that allowances need to be made for the varying levels of importance of the financial sectors in different economies and the varying sizes of banking sectors relative to GDP across the EU.

Sir John Vickers, the ICB chair, and his colleagues also delivered a host of measures to stimulate domestic competition in banking, including the creation of a new entity resulting from the Lloyds divestiture, the introduction of measures to reduce barriers to entry and measures to make it easier for customers to switch accounts between banks.

The reforms are expected to cost banks around £6 billion per year or around 0.1% of banks’ assets. The EC and other European countries are likely to be examining these radical reforms and the ICB’s detailed finding closely, to consider whether similar measures in other countries are needed.

Read more on the ICB report