The single supervisory experiment

The EU banking union proposals for centralised supervision of the largest EU banks represent a significant new step in the evolution of the single market for financial services. It will pose many challenges for the ECB supervisors and national regulators, and for the banks under ECB supervision. Getting it working well is critical to preserving the financial stability of the EU and the reputation of all EU financial centres and banks.

The Maastricht Treaty established the blueprint for European Monetary Union (EMU) in 1991. It was phased-in over a nine year period, guided by the European Monetary Institute, to ensure that Member States had sufficient time to prepare for the transition. The Single Market 1992 programme, launched by a Commission White Paper in June 1985, was a chief catalyst for EMU. Politicians realised that the internal market's potential could not be fully exploited while high transaction costs linked to currency conversion persisted. Many economists denounced what they called the "monetary trilemma", pointing out that free movement of capital, exchange-rate stability and independent monetary policies were incompatible in the long term.

The 1991 plan foresaw monetary union alongside economic union. The Stability and Growth Pact of 1998/99 set tight preconditions and the ongoing rules for membership of EMU which unfortunately were either not met by certain members at the outset or subsequently ignored. So EMU 2.0 comprises proposals for a reinforced economic and fiscal union, a political union and a banking union.

The banking union figures a single supervisory mechanism (SSM), a single resolution mechanism (SRM) and a common deposit guarantee scheme at its heart, centralising key supervision and resolution powers. It addresses the 'financial trilemma' perceived by economists today which recognises the impossibility of achieving financial stability and financial integration while maintaining national financial policies. Given our recent sovereign debt crisis and the need to remove the negative feedback loop between banks and sovereigns, this new system will not have the luxury of a lengthy transition. The ECB will get a host of supervisory powers immediately the legislative text enters into force. The ECB is expected to be fully operational as the hub of the SSM early in 2014.

Building the SSM

Work on building the SSM is well underway. Following the release of the EC's proposal in September 2012, the Council's December 2012 agreement forms the basis for the current trilogue negotiations with the EP. Vítor Constâncio, Vice President of the ECB, believes that the Council's proposals represent a "robust legal framework" for the SSM to operate, establishing the ECB as the prudential supervisor of more than 6,000 Eurozone banks from 2014. The ECB will have direct prudential supervisory responsibility for large banks (with assets over €30bn and/or more than 25% of national output). National supervisors will still oversee smaller and regional banks, but the ECB can intervene in any bank and give directions to national supervisors.

Constâncio underlines that the SSM needs to be one system. He notes that "to ensure a strong centre, the ECB's final responsibility for supervision within the SSM is matched by control powers over the system as a whole, as well as by very close cooperation arrangements with national authorities". If properly constructed, the SSM will create "uniformly high standard[s] of enforcement, remove national distortions, and mitigate the build-up of risk concentrations that compromises systemic stability" according to an IMF staff discussion note published on 13 February 2013.

However, this single structure needs a number of supporting elements. First, the EU needs a single rule book for prudential regulation, implementing the CRD IV for banks and large investment firms. Negotiators made a breakthrough in the trilogue negotiations in February. As long as both the Council and EP endorse the provisional agreement soon, we should see the regime launch on 1 January 2014 (or 1 July 2014 at the latest).

Second, the ECB need to ensure that different supervisory procedures and practices converge quickly into a common approach. Matthew Elderfield, the Deputy Governor of the Irish Central Bank, believes that this integration will not be easy. For example, supervisors will need to develop a common framework for risk assessment with common approaches to inspection and supervisory reviews. They will have to resolve some "important early practical design questions" according to Elderfield, who worked for the UK financial regulator when it subsumed a number of smaller regulators back in the early 1990s. Moreover, the ECB must determine its supervisory philosophy (e.g. principles based or rules-based) and risk appetite, including its level of intrusiveness, interaction with senior management and what early warning indicators are adopted, among other features. Elderfield has been working to re-shape the Irish regulatory system for the past three years. He believes the new SSM needs to give national supervisors "a clear mandate to be challenging and assertive with banks in ensuring that risks are not just identified but are definitively mitigated in a time-bound manner."

Third, the ECB will face organisational and decision-making challenges in implementing its "central control" approach. Once it is up-and-running, it will have to manage hundreds of matters for decision and action. During times of stress this volume will increase considerably. Elderfield believes that the SSM will need a "carefully calibrated governance structure", involving a Supervisory Board that should interact with the ECB Governing Council. Transposing the ECB's existing monetary structure is not appropriate into the supervisory context because the interactions with national financial supervisors will be much greater than the ECB has previously experienced with national monetary authorities under the Single Monetary Authority. The ECB will need to clearly delineate who takes decisions and when to ensure "efficient decision-making procedures" according to Elderfield. The IMF echoes the need for clarity on duties, powers and accountability for all constituent parts of the SSM. It believes that agreeing up-front the "elements, modalities, and resources for a banking union can help avoid the pitfalls of a piecemeal approach and an outcome that is worse than at the start".

Finally, centralised supervision also requires the centralisation of resolution powers and safety nets. Generally, countries use a combination of mechanisms to deal with ailing banks, such as deposit insurance schemes, a rainy day fund paid by levies on the banks, or requiring big banks to bail-out their smaller peers that are in distress. However, at the Eurozone level, the plans anticipate permitting direct financial intervention by the European Stability Mechanism. Work on agreeing an EU bank recovery and resolution regime is ongoing: it will become the main priority once the legislation on the SSM and CRD IV are agreed. The Commission intends to table another proposal to establish a SRM in the Eurozone by the summer. Further harmonisation of deposit guarantee schemes will follow in the medium term. Constâncio believes that the SRM should create a single resolution authority that would govern systemically important banks operating on a cross-border basis, coordinate the application of resolution tools and reflect an organisational set-up similar to the SSM. The authority would have a comprehensive set of powers and sufficient funding to resolve all banks in the SSM.

Constâncio foresees a phased approach to resolving distressed banks that would start with writing-down capital instruments and bailing-in creditors. Next, funds accumulated in a European Resolution Fund should be used to provide any additional funding needed to realise a least-cost resolution strategy. These contributions would be risk-based and collected from all banks participating in the SRM. Finally, if the resources of the European Resolution Fund are insufficient, further funds could be drawn from a European-level fiscal backstop mechanism. If resources are needed from the European Stability Mechanism, it should be on the basis of a loan to the SRM, thus reducing the impact on taxpayers.

Will it work?

The EU managed to calm markets last year by putting forward the idea of imposing more integrated prudential regulatory oversight. In particular it demonstrated that politicians finally understood the need for deep reform of the Eurozone project to break the negative feedback loop of rising sovereign and bank borrowing costs, reduce market fragmentation and stem deposit flight.

Non-Eurozone governments recognised this and gave their broad support to the banking union proposals when it was first announced. However as the dust has settled many have voiced concerns about how a powerful Eurozone supervisor may diminish their influence over the future direction of financial regulation in Europe. While non-Eurozone countries won a major concession on agreeing "double majority" voting rights at the EBA in December, further points of contention are almost certain to emerge.

The EMU project demonstrated the complexities of harmonising policies across 17 Member States with different business cycles and economic systems, even with the benefit of comprehensive planning and preparation. The challenges this time round are compounded as policymakers need to ensure that SSM doesn't upset the integrity of the single market for financial services across the EU. While non-Eurozone countries are free to participate in the SSM, it's unlikely that many will join at this stage.

If policy makers get the foundations right, an EU banking union will be better placed to weather future financial storms. If they don't, the idea could crumble and policy makers could be forced to re-lay its foundations.

Regulation

Capital and liquidity

Enhancing long-term investment finance

The FSB submitted a report, Financial regulatory factors affecting the availability of long-term investment finance, to G20 Finance Ministers and Central Bank Governors on 8 February 2013. The G20 are concerned about inadequate resources being channelled to growth-enhancing long-term finance projects in the post-crisis environment.

The FSB believes that while there may be some short-term effects, the regulatory reform agenda should substantially enhance the financial system's capacity to intermediate investment flows through the cycle at all business horizons. Principally, current reforms tabled will improve confidence and resilience of financial markets—the two key ingredients in promoting long-term investment finance.

FSB members' submissions did not show much evidence that regulatory reforms have had a notable impact on long-term financing thus far. However, as the FSB points out, this is hardly surprising given that the reform process is still at an early stage.

Access to long-term finance is an important component to kick-start the economic recovery. The FSB will keep this area under scrutiny in the near-future by monitoring the effect of financial reforms on an ongoing basis to identify any factors that may disproportionally impact the provision of finance so that they can be addressed. The FSB will also work with relevant parties to identify regulatory factors that may impede the effectiveness and efficiency of financial markets.

Defining liquid assets under CRR

The EBA published a discussion paper on Defining Liquid Assets in the LCR under the draft CRR on 21 February 2013. The LCR requires banks to have sufficient high-quality liquid assets that can be converted easily and immediately into cash to meet their liquidity needs during a 30 calendar day liquidity stress scenario. The proposed methodology for defining liquid assets includes a scorecard, which will rank assets by combining a set of different liquidity indicators.

The EBA's analysis to define liquid assets will start by assessing the range of asset classes against the definitions in the draft CRR. It will then perform a detailed quantitative assessment of the liquidity of individual assets, with the objective of producing a ranking of the relative liquidity of the different asset classes. Finally, it will identify the features that are of particular importance to market liquidity. This last step should identify the characteristics assets should have to be qualified as highly, or extremely highly liquid.

Following this analysis, the EBA will report to the EC on appropriate definitions of high and extremely high liquidity assets and credit quality of transferable assets for the purpose of the LCR. The consultation closes on 21 March 2013.

Bonus cap nears reality

The EP and Irish Presidency of the EU Council announced in a press release that it had reached a breakthrough on CRD IV negotiations on 27 February 2013. The breakthrough proposes a 1:1 cap on bonuses based on an individual's fixed salary. This cap can be lifted to 2:1 if a simple majority of the bank's shareholders approve. If fewer than half of shareholders vote, a super-majority would be required.

The requirements would apply to all senior employees and material risk-takers at banks (collectively known as "identified staff") based in the EU, and to employees of EU banks located outside the EU.

The proposals are softened slightly by the longer-term compensation discount. Under this provision, banks will be able to discount the future value of shares, options or other non-cash payments that are paid out over a number of years. Up to 25% of bonus/variable remuneration - if payable in a long-term form and subjected to claw backs - benefits from a discounted valuation for the purposes of the cap. When calculating the size of a banker's bonus to determine whether or not it exceeds the new ceiling, banks will be able to the discount the value of such payments. The EBA will set the discount level, but it isn't clear yet exactly how the discounted valuation will work.

Politicians also agreed that country-by-country reporting requirements should come into force under CRD IV. Banks would have to report their profits before tax, the amount of tax they paid, their total number of employees and their aggregate compensation etc.

The UK government fought hard against the cap, believing it will damage the competitiveness of the City of London and the financial services industry in Europe more generally. Although it appears to be fighting a losing battle at the moment, the agreement isn't yet final, so the UK may still get the opportunity to chip away at some of the contentious provisions as CRD IV continues its slow progress.

See our detailed analysis for more information.

ESRB makes recommendations on funding credit institutions

The ESRB adopted a Recommendation on the funding of credit institutions on 18 February 2013 (though dated 20 December 2012), which it would like to see implemented by year end.

The ESRB wants banking supervisors to intensify their assessments of credit institutions' outstanding funding and liquidity risks, as well their funding risk management within the broader balance sheet structure. It is also encouraging supervisors to assess the impact of credit institutions' funding plans on the flow of credit to the real economy. The EBA will coordinate the assessment of funding plans at the EU level.

The ESRB also called for supervisors and firms to make improvements on asset encumbrance risk management. Credit institutions should put in place risk management policies that define their approach to asset encumbrance. They should have procedures and controls in place to identify, monitor and manage the risks associated with collateral management and asset encumbrance. The ESRB wants supervisors to closely monitor the level, evolution and types of asset encumbrance as part of their supervisory process. It has asked the EBA to issue guidelines on transparency requirements, harmonised templates and definitions to facilitate the asset encumbrance monitoring.

Finally, it wants EBA to issue guidelines on best practice in the covered bond markets, to facilitate greater harmonisation.

Client money

Protecting client money

On 8 February, IOSCO published its draft recommendations regarding the protection of client assets (CR02/13). CR02/13 highlights the risks posed where a client, knowingly or unknowingly, waives or modifies the degree of protection applicable to its assets and where an intermediary places assets in a foreign jurisdiction. The principles proposed by IOSCO largely reflect existing practice and will not significantly change existing EU requirements.

The principles suggest intermediaries should:

  • maintain records of client assets that readily establish the precise nature, amount, location and ownership status of the assets and the clients for whom they are held, and establish an audit trail
  • provide regular statements to each client detailing the assets held for them
  • maintain appropriate arrangements to safeguard the clients' rights in their assets and minimise the risk of loss and misuse
  • comply with applicable foreign client money requirements over client assets in a foreign jurisdiction
  • ensure clarity and transparency in explaining the client asset protection regime to clients
  • the possibility to waive or modify the level of protection should occur only with the client's express written consent, once they have been clearly informed of the implications.

CR02/13 also maintains the importance of a supervisory regime to oversee intermediaries' compliance with the applicable domestic ('home') requirements irrespective of where the assets are placed: regulators should ensure they receive appropriate information on assets placed in foreign jurisdictions from the intermediaries concerned or with the help of local regulators where appropriate. CR02/13 is open for feedback until 25 March 2013.

Corporate governance

FSB reviews risk governance

The FSB published its Thematic Review on Risk Governance on 12 February 2012, containing the findings of the FSB's peer review.

The FSB found that since the crisis, national authorities are improving their regulatory and supervisory oversight of risk governance at financial institutions, although more work remains to be done. National authorities need to strengthen their ability to assess the effectiveness of a firm's risk governance and risk culture to ensure risk governance through changing environments. In addition, supervisors need to change their approach to ensure they have a view across all aspects of a firm's governance structure to assess their risk governance frameworks.

The FSB also looked at firms' progress towards improving risk governance, and discovered that their best practices often exceed regulatory requirements. It believes firms are motivated by a need to regain market confidence rather than just meet regulatory requirements.

However, the FSB also found significant gaps in firms' risk governance. In particular, it recommended that firms should continue to work towards defining the responsibilities of the risk committee and strengthening their risk management functions. Nearly half of the surveyed firms did not meet all of the evaluation criteria in these areas.

The FSB set out several recommendations aimed at ensuring the effectiveness of risk governance frameworks, encouraging firms to target areas where more substantial work is needed. While the review focused on systemically-important banks and broker-dealers, the recommendations apply to other types of financial institution, including insurers and financial conglomerates.

The recommendations call on national authorities to set requirements relating to the board independence and composition, specifying the relevant types of skills that the board should have.

National authorities should also provide guidance on the key elements that are incorporated in effective risk appetite frameworks. The FSB Supervisory Intensity and Effectiveness group, in collaboration with relevant standard setters, agreed to finalise this work by the end of 2013.

Corporate governance standards bed down

The EBA published details of compliance with its Guidelines on the Assessment and Suitability of the Management Body and Key Function Holders on 11 February 2013.

With the exception of France, all EEA states either comply or intend to comply with the guidelines. The French regulator did not notify EBA of its intentions.

Q&As on CRD III remuneration reporting

The EBA published two sets on questions and answers (Q&As) on its data collection guidelines under CRD III on remuneration practices on 28 February 2013.CRD III requires national supervisions to collect information practices from firms so the EBA can benchmark remuneration trends.

In the Q&As on guidelines on the remuneration benchmarking exercise, the EBA considers which institutions are subject to data collection, reporting frequency and submission dates and how to define the amounts to be reported.

In the Q&As on guidelines on the data collection exercise regarding high earners, the EBA confirms that EEA branches of non-EEA institutions are in scope and must submit remuneration data to their national supervisor.

Dodd-Frank Act

SEC issues interim final rule on security-based swaps exemptions

The SEC published an Interim Final Rule on the Extension of the Exemptions for Security-Based Swaps on 4 February 2013. The extension became effective upon publication and will remain in effect until 11 February 2014.

SEC Order and Comment Request on security-based swaps

The SEC released an Order and Comment Request on extending temporary exemptions under the Exchange Act on 7 February 2013, including extending the definition of 'security' to include security-based swaps and extending the expirations date of its earlier Order Granting Temporary Exemptions until 11 February 2014.

CFTC Final Rule on Clearing Requirements effective

The CFTC Final Rule on Clearing Requirements under Section 2(h) of the Commodity Exchange Act became effective on 11 February 2013. The Final Rule was published on 13 December 2012.

To view the complete article, please click here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.