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15 September 2008

Financial Regulation in the EU: the current state of play

15 September 2008

Graham Bishop

(A version of this article is appearing in this month's Financial Regulator, published by Central Banking Publications)

The EU’s community of financial regulators suffered a profound shock a year ago but that is now giving way to meeting the demand that “something must be done”! So plans are developing rapidly – but the question needs to be put: can these plans eliminate the risk that something similar might happen again? If they can, will they do so in practice? Or is there something in the current structure of the financial system that pre-disposes it to gaming the rules to the point where they become ineffective in practice no matter how theoretically perfect?

Some of the problems
However, ECB president Trichet said recently that “Three broad factors have reinforced one another in a way that almost nobody could have foreseen … namely, the abundance of liquidity, a complex financial system, and some financial agents’ incentives.” But other commentators could respond that the profusion of “Financial Stability Reports” from central banks did point out some weaknesses but did not produce calls for specific, forceful action. This author is not clear that any regulators were sufficiently convinced that they took any measures to force behavioural change beforehand.

With the benefit of the easy wisdom of hindsight, the IOSCO final report on the sub-prime crisis contains devastating and wide-ranging criticisms: “many institutional investors and investment banking firms had inadequate risk modelling and internal controls in place, relied heavily (or even exclusively) on external credit ratings for their risk analysis, had inadequate balance sheet liquidity even when adequately capitalized… concerns have been raised regarding the role fair value accounting principles and its role in providing adequate information about the strength of financial firms facing illiquid market conditions. Also, some financial firms appear to have inadequate human and technological resources to model their financial positions using fair value accounting principles under illiquid market conditions.”

Trichet has echoed some of these trenchant criticisms and pointed out that the purpose of the financial system “increasingly fell victim to a game for fees, very short term apparent profits and arbitraging regulation,” He identified “the trend towards short-termism and the profound asymmetry in the response which is given to booms and busts,” as particularly adverse from a financial stability stand point. Trichet also criticized the “shadow banking system” which rested on a poorly understood system of credence (provided by rating agencies) and the (false) perception that the only way for asset prices was upward, and warned that “the challenge for us today lies in preventing the system from feeding on itself through a spiralling process of leverage.” Elaborating on the issue of incentives, Trichet commented powerfully about “some financial agents’ incentives that were aligned against prudent practices”.

The key problem to emerge is the lop-sided balance of risks to the banks and rewards to the executives where there is no mechanism to claw these rewards back if the products turn out not to produce the forecast flow of profits. But an individual bank cannot impose new principles on its employees without risking an exodus. So public policy may need to respond – but correspondingly that can only work if applied across all major financial centres – and not just in the UK or the EU.

Compensation structures are now moving to the forefront of regulatory discussion and FSA Chief Executive Sants added some practical bite: “Asymmetrical structures where traders receive immediate reward and do not bear the consequences of losses are a risk to shareholders” He recommends deferred compensation with claw back and the increased use of share options as a possible way to tackle this problem. “I do believe the regulators need to consider the risk of such structures when judging the overall risk of an institution…The assessment of remuneration structures is part of our supervisory approach and we will emphasise this more in the future.”

Is the discussion of incentives masking a more basic question about the ethics of the financial system? Many of the participants at the bottom of the chain must have realised that they were exposing a significant portion of these mortgagees to the probability of personal ruin. Correspondingly, they must have known that the probability of the projected cash-flows was debatable. As the products flowed up the chain, an increasingly highly-educated group of finance professionals (including lawyers and accountants) should have realised the potential problems inherent in the products they were distributing. Why did their ethical values allow them to shut their eyes – at best – to this? The answers will have profound implications for their willingness to accept the letter (let alone the spirit) of any regulatory changes that ensue.

Some policies to solve the problems

The drive to legislate solutions to the “turmoil” is being pushed rapidly forward ahead of the 2009 deadlines of EP elections and a new Commission. The French Presidency of the EU is setting the pace and will concentrate on the implementation of the roadmap for financial stability, an agreement on “registration” of Credit Rating Agencies, and the amendment of the Capital Adequacy Directive. But supervision of cross-border financial groups also features on the list.

These priorities seem to chime with Commissioner McCreevy’s wish-list. Changes to the Capital Requirements Directive will be proposed in early autumn and will require colleges of supervisors for all cross-border banking groups. President Trichet supported the latter though insisting that closer ongoing co-operation should be pursued not only between supervisors, but also between supervisors and central banks. But he argued to the European Parliament that the recent financial market corrections did not provide any convincing evidence for the setting up of a new authority for EU supervision.
What proposals are really on the table?
As many ideas are floated about an “SEC for Europe”, it is worth being clear what the existing structures really are. As an example, CESR was created by a 2001 Commission “Decision” to:

o Improve co-ordination among securities regulators: developing effective operational network mechanisms to enhance day to day consistent supervision and enforcement of the Single Market for financial services

o Act as an advisory group to assist the EU Commission: in particular in its preparation of draft implementing measures of EU framework directives in the field of securities

o Work to ensure more consistent and timely day-to-day implementation of community legislation in the Member States.

So the legal basis of the Level 3 Committees is relatively weak and clearly no stronger than that of the Commission itself. Correspondingly there are no powers to pursue fraudsters/ market abusers and send them to jail. Such ultimate powers of criminal sanction reside at the national level, and are seen as lying at the heart of national sovereignty.

The European Commission issued a consultation paper in May 2008, stating:
o A radical overhaul of existing Decisions is not needed
o There should be a clearer framework for supervisory cooperation/convergence
o Strengthening the requirement to take decisions by Qualified Majority Voting (QMV) may have to be “enshrined” in the Decisions setting up CESR etc.
o It is essential to mandate the Committees to make the “colleges of supervisors” for cross-border firms cooperate, and explicitly so for conglomerates

The European Parliament – as ECON – debated a report on Lamfalussy follow-up in June. The key elements were:
o ECON asked for comprehensive reform – and “requested” the Commission to respond by late 2008 with formal proposals
o There should be mandatory colleges of supervisors for major cross-border firms
o The 3L3 Committees should be made “supervisory agencies” (with a presidium) and cooperate with the ECB

The 3L3 Committees responded in September with their own reactions:
o They see the Commission Consultation as a “ratification” of their current practices
o Independence remains a basic pre-requisite
o The focus of reform should be on general tasks, long-term objectives and available tools so removing the risk that their mandates might be reviewed each year
o They approve of the push to enhance cooperation/convergence at EU level

However, these ideas have to be set in the context of the developments amongst the Member States as their agreement is needed for any substantial action. As always, they are likely to guard jealously their powers and prerogatives. In particular, the “turmoil” has made them fully and publically aware of the potential budgetary costs that can fall on the taxpayer/elector if financial regulation does not do its job properly. The Council of Finance Ministers (ECOFIN) has had several formal discussions and has agreed the following conclusions:

ECOFIN meeting of 4 December 2007
o The Lamfalussy Process should be improved at all levels but without changing the political balance between Council/Parliament/Commission
o They should consider including an EU dimension in national supervisors’ mandates
o For cross-border groups, there should be colleges of supervisors with common guidelines
o They request the L3 Committees to use QMV where necessary
o By the end of 2008, the Commission should consider EU funding of the Committees and provide for voluntary delegation of competences. By end 2009, the Commission should define a set of powers for the Committees.

ECOFIN meeting of 5 April
o They agree that the legal status of the Committees should not be changed [so Parliament’s pleas will fall on deaf ears at Council]
o Any progress will depend on resolving “burden sharing” when things go wrong

ECOFIN meeting of 14 May
o They endorsed the introduction of a “European Dimension” for national supervisors [but that does not mean that they will bind themselves to do it in reality!]
o Specific tasks should be given to the Committees to foster cooperation/convergence; providing non-legally binding guidelines [so is there a substantive change? Perhaps not immediately, but the process of building “conventions” of acceptable behaviour may well generate a “common law” approach to creating a body of precedents that will effectively be binding. ]
o “Direct budgetary net costs” of a crisis will be shared “among affected states on the basis of equitable and balanced criteria” [but that basis is not yet clear!]

The private sector has also stepped forward with its own contributions and comments:
o A joint initiative of eight industry associations strongly objects to the Commission’s alternative proposal to amend the CRD to address incentives in the “originate-to-distribute” model. The new proposal aims to prohibit European investment in obligations where the originator or sponsor fails to retain a 10% interest in positions having the same risk profile. Apart from criticizing several fundamental flaws of the proposal they argued it will increase costs and damage the competitiveness of Europe.[The speed of the consultation illustrates the risk that the 2009 deadline for legislation may produce serious “unintended consequences”]
o The Finance industry is consulting on its Good Practice Guidelines which focus on promoting sound, consistent and appropriately granular implementation of the CRD disclosure requirements relating to securitisation. Commissioner McCreevy pointed out that it will be very important to verify the effectiveness of these initiatives.
o The IIF Final Report on Market Best Practices proposes Principles of Conduct together with Best Practice Recommendations on issues such as risk management, compensation policies, valuation of assets, liquidity management, underwriting and the rating of structured products as well as boosting transparency and disclosure.

Some problems that do not seem to be addressed
o Regulators’ staffing: How can public regulators keep up with the turnover of their best staff attracted to the other side of the fence by high salaries? As the EU moves toward colleges of international supervisors for the biggest and most complex groups, the regulatory skills of the college members will be enormously valuable to the firms they regulate, so the incentives to switch sides will be tempting! Perhaps the senior regulatory staff should be on a 2-3 year contract so they know at the outset that they must stay for that period but would then be free if they wished to move.

o But another intriguing strand of thinking is emerging that is far more fundamental to the structure of the financial system. BaFin’s Sanio called it the doctrine of “too connected to fail” – epitomised by Bear Stearns. CEPR’s Buiter also believes that, post the rescue of Bear Stearns, even some hedge funds may be deemed to big, or too interconnected, to fail. Perhaps regulators need to pay more attention to the mushrooming of these inter-connections in the last decade or so, recalling that Drexel Burnham was liquidated in a week in the 1980’s as its assets were nearly all reasonably marketable securities, rather than a web of derivative contracts. In effect, society is providing comprehensive default insurance to the users of these firms – but not charging an appropriate premium. Do the EU’s policy prescriptions deal with this at all?

Finally, the speed of the legislative reaction should be a source of concern. Commissioner McCreevy has talked of the need to avoid a “knee jerk” reaction, but has then proposed timetables for action that seem risky and based only on the timetable for the current Parliament and Commission to complete measures. The essence of the Lamfalussy Process is to consult stakeholders at the pre-legislative stage and then all the way through the process to ensure that all players accept the societal legitimacy of the resulting rules. First, that should minimise the risk of the “law of unintended consequences” emerging later. Second, it will raise the chances that ethically-minded participants will respect the spirit of the new rules, rather than just seeking to game them and by-pass the intent.

The verdict on the EU’s attempts to head off future problems may not be available until after the next crisis. The current holes in the dykes may be effectively plugged, but are market participants really motivated to stop drilling new ones?


© Graham Bishop

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