Before the financial crisis financial policy makers were triumphant. They had tamed the business cycle, mastered monetary policy, and defeated financial stability. The situation is now very different. Five years on from a financial crisis, G20 leaders sat down in St. Petersburg to review the progress made in re-building the flawed financial system and resulting regulatory framework they helped create.
Leaders pointed to significant wins in reforming the financial system since the crisis. New global capital, risk management and liquidity provisions as enshrined in the Basel III accord will ensure that banks will be better prepared when the next crisis comes around. Of the 27 Basel Committee member jurisdictions, 24 have implemented Basel II fully according to a recent progress report. The EU and the US are on track to implement the new prudential regime by 1 January 2014. But Basel III isn’t done and dusted. International regulators must still revise a global leverage ratio, currently fixed at 3% (the Fed has proposed a 4% ratio- see our briefing note here), and finalise the second pillar of the new liquidity provisions: the net stable funding ratio. The latter requires banks to maintain a sustainable maturity structure of assets and liabilities and will provoke a major re-think amid growing concerns about its potential impact on lending to the real economy. G20 leaders expect the Basel Committee to finalise its proposals on the internationally harmonized leverage ratio and the net stable funding ratio in line with agreed timelines and procedures or at the very latest by the end of 2018.
OTC derivatives reform is a little less clear cut. The US is leading the pack in implementing the new regime and progress is being made internationally. By the start of 2014 three-quarters of Financial Stability Board (FSB) member jurisdictions intend to have legislation and regulation adopted to require transactions to be reported to trade repositories. Frameworks for central clearing requirements are in place in most of the largest derivatives markets, with concrete rules now starting to go into effect. Moreover, minimum standards are in place for sound risk management of FMIs including CCPs, supporting OTC derivatives markets. But the FSB points to a number of challenges that remain. Regulators should seek to increase market use of central clearing, and minimise opportunities for regulatory arbitrage. They should also renew their focus on the commitment to increase the use of exchanges and electronic trading platforms and to implement finalised capital and margin requirements in accordance with agreed "phase-in" schedules. Countries should adopt resolution regimes for financial market infrastructures (FMIs), including central counterparties, ensuring that recovery and resolution plans for FMIs are developed in line with international guidance.
The FSB and the International Association of Insurance Supervisors (IAIS) identified the 28 banks and nine insurers that are too-big-to-fail and demand heightened prudential requirements to mitigate the risks they create. Living wills or recovery and resolution plans are the favoured method to ensure firms and regulators are equipped to navigate future periods of stress without resource to public funds which, following the crisis, is known to be both fiscally unsustainable and politically untenable. The FSB and national regulators have embarked on this initiative with gusto, requiring large banks (and in the near future insurers and FMIs) to prepare recovery and resolution plans. Strategies to enable too-big-to-fail financial institutions to be wound down in an orderly fashion continue to be tweaked. Recently, the FSB set out its proposed methodology for assessing the implementation of its key attributes of effective resolution regimes for financial institutions. The key attributes establish minimum requirements for effective resolution regimes for financial institutions that could be systemically significant or critical in the event of failure.
While the breadth and speed of reforms is unprecedented, the financial crisis and subsequent economic downturn was the worst since the Great Depression and required a monumental seachange in financial regulation. But the risks of regulatory arbitrage still remain, and may arise through planned or unintentional national differences in rules, policy or supervision. In St. Petersburg, G20 leaders agreed to enhance cooperation and information sharing to ensure that jurisdictions fully implement the agreed reforms in a “consistent and non-discriminatory way”.
The regulatory reform agenda has largely been developed with developed markets in mind. The impact and unintended consequences of reforms on emerging markets and developing economies (EMDEs) requires further work. G20 leaders want the FSB, IMF, the World Bank Group and standard setting bodies to examine the effects of evolving regulatory reforms on EMDEs as a part of its overall implementation monitoring frameworks.
Policymakers’ staying-power in introducing tough reforms will be tested next year as the full effects of Basel III and OTC reforms start to bite on the financial system and real economy. We have already heard noises from regulators that liquidity buffers built up following the crisis can be reduced. G20 leaders will also continue to monitor and assess the impact of financial regulatory reforms on the robustness of the financial system, stability and on economic growth, and on the availability of long-term finance for investment.
It doesn’t make sense to impose requirements on financial institutions that might damage the economy or impede recovery. But neither does it make sense to create conditions that could allow the next financial crisis to happen.
The European Commission (EC) tabled its proposed Regulation on money market funds (MMFs) on 4 September 2013. Caught in the headlights of pan-EU regulations for the first time, the new regime introduces a host of requirements for MMFs from risk management to data collection.
Essentially, the proposed Regulation is designed to ensure that MMFs can better withstand redemption pressure in stressed market conditions, by enhancing their liquidity profile and stability. The idea is that this should help to secure their important financing role for the economy. MMFs would be obliged to hold at least 10% of their assets in instruments that mature on a daily basis and an additional 20% of their assets in instruments that mature within a week.
The EC is concerned about the interconnectedness of MMFs and the banking sector. According to the EC, nine out of the 10 largest MMF managers are sponsored by commercial banks. The EC also worries about the concentration of MMF assets. It says that the 200 largest MMFs account for more than 86% of the aggregate assets MMFs hold.
The EC’s proposal addresses concerns raised by a European Systemic Risk Board (ESRB) recommendation issued on 20 December 2012. The ESRB recommended moving to a mandatory variable net asset value (NAV) which it believes would reduce shareholders’ incentive to withdraw funds when a fund experiences a modest loss. The ESRB also recommended imposing explicit minimum amounts of daily and weekly-maturing liquid assets.
The EC has responded explicitly to the majority of the ESRB’s recommendations, although it hasn’t adopted a mandatory variable NAV. But arguably the same policy objective will be achieved through the specific capital requirements placed on constant NAV (CNAV) funds. Key proposals in the Money Market Fund Regulation (MMFR):
The number of MMFs in Europe and the US has radically reduced in the past couple of years, and the market is likely to shrink further if the EU’s proposed regulatory requirements are adopted. While the EC’s proposals may change, the current proposals would have a significant impact on the MMF industry, particularly on CNAV funds. The MMF industry believes the proposal will effectively kill off CNAV MMFs. The International Money Market Funds association suggests that a requirement to hold a capital buffer of 3% is “simply uneconomic” so, if the proposals were implemented, CNAV providers would convert their fund to variable NAV. The proposals have already come under heavy criticism from the European asset management industry. So we are likely to see affected industry players lobbying hard to get the buffer removed or reduced.
The next step in the legislative process is for the European Parliament and Council to consider the EC’s proposal and to issue responses. But EU financial services lawmakers face a formidable workload this autumn: 29 legal texts are being negotiated or are expected to be tabled by the EC in the near future. The MMFR is not on the Council’s priority list, and while big ticket issues such as banking union remain unresolved, negotiations on MMFR may not reach the key first reading milestones before the elections in May 2014. If this happens, the proposal faces an uncertain future.
At the 2011 Summit in Cannes, G20 leaders agreed to focus on the shadow banking system, and asked the FSB to develop policy recommendations. At the September 2013 G20 Summit in St Petersburg, they approved the FSB’s final policy recommendations on shadow banking.
On 29 August 2013, the FSB published three documents:
The FSB’s Securities Lending and Repos paper includes a public consultation on the proposed regulatory framework for haircuts on non-centrally cleared securities financing transactions. The consultation closes on 28 November 2013.
The FSB’s overarching aim for shadow banking is to extend regulation and oversight to all systemically important institutions, instruments and markets. Its strategy to achieve this aim has two principal elements: creating a monitoring framework to track financial sector developments outside the banking system and developing policies to strengthen oversight and regulation of the shadow banking system. The FSB has been working with the Basel Committee and IOSCO to formulate policies.
Work on shadow banking has been conducted through five work streams. These work streams and their latest status are set out below.
The success of the G20 initiative to regulate the shadow banking sector is largely dependent on regional and national regulators’ appetite to put into practice policy frameworks developed by the FSB and other supranational bodies. By being closely involved in development, and by getting ahead of the curve on implementation, the EU has so far shown itself to be highly willing to support the new policy frameworks. But despite the numerous peer reviews planned for 2014, achieving broad international harmonisation will take some time. Therefore, the risk for the EU is that the implementation of these measures may pose a threat to financial services competitiveness and economic growth in the face of inaction elsewhere in the world.