ICFR Regulatory Round Up: Economic Growth Crucial for Progress on Financial Regulation in 2011
December 2010
ICFR Regulatory Outlook 2011
The current battle between the financial markets and European Union (EU) politicians over the value of the debt of some of its members and the future of the Euro itself has moved Europe back to crisis mode at the end of a year that should have been about regulatory implementation. Re-regulation this year has been influenced by regulatory capture, shifting political priorities, worries about growth and growing tensions among the G20 members. The real work of implementation will begin in 2011, including the inauguration in January 2011 of the new European supervisory authorities. Implementation will continue to be subject to debate about the economic impact of the new rules and the costs of the uncertainty surrounding their implementation and enforcement. This will also encompass ongoing worries about the fragility of the recovery, and the need to have a fully functioning financial system to be able to handle the refinancing of significant amounts of maturing government and bank debt in the next 12 to 18 months.
As we close 2010, we see a raft of consultations and regulations, including: rule-writing assigned to the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) by the US Dodd-Frank Act; details on global regulatory standards on capital adequacy and liquidity from the Basel Committee on Banking Supervision (BCBS); a review of the Markets in Financial Instruments Directive (MiFID) in Europe, as well as papers on issues of remuneration, crisis resolution, and the passage of the Alternative Investment Fund Management (AIFM) Directive.
The above mentioned will be overlaid with the new objectives of France’s twelve-month tenure of the G20 – an extended tenure to permit the G20 to re-establish some momentum. It is absolutely critical that attention to new goals does not diminish the energy behind solutions to open regulatory issues such as cross border crisis resolution, and the development of tools and measures for macroprudential supervision. It is also vital – if the G20 is to maintain its credibility with the members included by enlargement of the G7 – that due attention is given to the issues of the new member states.
In our 2009 Regulatory Round Up, we pointed to four major challenges ahead for 2010. These were: i) achieving consensus among countries at very different stages of recovery and financial development; ii) how to turn off the tap on extraordinary support measures and contain fiscal deficits without choking off the nascent recovery, while differentiating among economies with very different growth, trade and fiscal positions; iii) navigation between a certain amount of ‘post-crisis denial’ on the part of the financial system, and the popular anger that still wants to see financial institutions and their staff punished; and iv) the hard graft of trying to ‘right-size’ the regulatory changes to come.
At the risk of saying ‘we told you so,’ most of these issues have yet to be resolved. The divergence in speed and strength of recovery between the new economic powers and the West increased current account imbalances; this has led to exchange rate pressures and imposition of capital controls or taxes on capital inflows in some emerging economies to try to stem the tide. This will remain a core issue for the ‘new members’ of the G20 club in 2011. These flows were exacerbated by a second round of quantitative easing (or QEII) to strengthen a limp recovery in the US and Europe and head off fears of a double-dip recession. At the same time, several European states took significant steps to rein in fiscal deficits, some at their own volition, such as the United Kingdom, and others: Ireland, Greece, and Spain, largely at the demand of the financial markets. Continued popular anger about bank bailouts saw the imposition of taxes on bankers’ bonuses and proposals for financial transaction taxes, or FAT taxes, in selected countries, albeit not consistently. This was a clear demonstration of the difficulty in finding consensus across jurisdictions as the distance from the epicentre of the crisis grew. Such difficulties exist because the crisis affected different countries to different degrees, and because there is increasing recognition that different situations warrant different responses.
As the ICFR predicted, banks sought to maximize the potential costs of Basel III when the Institute for International Finance issued its study in June. Coming as it did, when signs of recovery were still weak, and before the Bank for International Settlement’s (BIS) own study on the subject, this work had a very significant bearing on the BCBS’ deliberation. In spite of general agreement about the need for regulatory change, there remains considerable uncertainty about the impact of transition costs on economic growth and credit expansion. This has been a significant factor behind the long lead-in time for implementation of the proposals.
The degree to which fiscal issues and ongoing banking problems in some eurozone members would continue to preoccupy markets, politicians and the European Central Bank (ECB) was for those in Europe the seminal issue of the year. Although the ECB seems to have brought some stability to the European sovereign debt crisis, much still needs to be done to reach agreement on a more permanent mechanism for a resolution of these country-specific debt problems. Two controversial solutions include E–bonds and greater fiscal harmonisation, both contentious issues. Any faltering in economic activity could exacerbate strains here.
Regulatory change in 2010
The European legislation creating the European Systemic Risk Board (ESRB), and the three European regulatory authorities: the European Banking Authority (EBA), the European Securities Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) replacing CEBS, CESR and CEIOPS respectively, and the omnibus US Dodd-Frank Wall Street Reform and Consumer Protection Act of July 2010 were the core legislative acts of the year in countries most affected by the crisis where 70% of financial market transactions occur. The bodies resulting from the reform of European regulatory architecture and the creation of the ESRB, all scheduled to launch in January of 2011, as well as the creation of the European Financial Stability Facility (EFSF), were achieved far more quickly than might have been expected given the legislative process in the EU. Moreover, it is arguable that such regulatory integration might never have happened at this speed without the crisis.
In July, the UK Treasury issued a consultation on changing its regulatory architecture, featuring a revised tripartite model with two supervisory authorities: the Prudential Regulation Authority (PRA), a supervisory authority in charge of the prudential regulation of individual firms, and the Consumer Protection and Markets Authority (CPMA), an authority responsible for consumer protection and the conduct of financial markets. In addition, the Government proposed to include a Financial Policy Committee (FPC) under the authority of the Bank of England. The FPC would be responsible for maintaining financial stability by monitoring and addressing systemic or aggregate risks and vulnerabilities that threaten the financial sector as a whole. The PRA will be responsible for identifying risks and vulnerabilities to which the financial system is exposed and taking corrective actions to protect the broader economy. The CPMA will focus on consumer protection, promotion of integrity and efficiency in financial markets and regulating the conduct of participants in wholesale markets and market infrastructures such as investment exchanges. Informed by responses to the consultation, the Government will present more detailed policy and legislative proposals for further consultation in early 2011 with the intention of having the new structure fully in place by the end of 2012. The difference in timing between the UK and EU structural changes has done little to enable UK regulators to play a leadership role in EU regulatory deliberations.
In addition to these three major initiatives, the EU also passed the AIFM Directive in November, issued a green paper on financial institutions governance, a parliamentary study on cross border crisis resolution and, on 8 December, a public consultation on the review of the MiFID. The key common issues among the major regulatory works of the year are, thematically:
Systemic Risk: There is a clear imperative to encourage regulators to look across financial institutions and systems in search of signs of future asset bubbles, risk concentrations or other potentially dangerous trends. In most cases, responsibility for this has been assigned to the central bank, though in the United States, the Financial Stability Oversight Board (FSOB) is composed of heads of most regulatory agencies and chaired by the Treasury Secretary. These new boards are charged with developing a set of indicators to identify and measure risk, in much the same way that central banks have a series of indicators they look at to determine appropriate monetary policy. However, the analogy stops here, as there is far less grounded economic work in appropriate indicators. It is rather like searching for the famous Rumsfeld ‘unknown unknowns.’ These groups also need to develop tools to take action on the information they do find, though the authority to do so varies by institution. What is currently entirely lacking is any coordination mechanism across jurisdictions for these boards. One of the challenges for 2011 and beyond will be putting in place consistent global, macro-economic policy tools backed by adequate data resources.
Over-the-counter (OTC) Derivatives: In both the US and the EU, major efforts are underway to force OTC derivatives to clear through exchanges and/or to list, depending on the jurisdiction. Efforts to harmonize rules between the EU and the US exist, but it is likely that technical difficulties will continue which add to counterparty and system costs.
These efforts greatly enhance the systemic importance of the central clearing counterparties (CCPs). It will be important to watch the unintended consequences of risk concentrations and margining at CCPs. While regulators are aware that these institutions are now systemically important, as more counterparties use CCPs for an increasing volume of their transactions, CCPs may come to be the arbiter of credit quality and price for key securities. This autumn, two step changes in collateral requirements for Irish government securities led to knock-on effects on prices as market players dumped stock rather than pledge more collateral. Obviously, in the worst case, this can have a vicious downward spiral effect on prices, as further margin calls are made as price declines, causing further dumping of stock. With a limited number of CCPs around the world, and most transactions clearing through them, the credit and margining functions in these firms may soon hold the keys to the value of many marketable securities. In addition, discussion continues on the interoperability of CCPs. It is possible that financial centres without central clearing capabilities could be disadvantaged in future, leading to a balkanization of clearing by country and product.
Hedge Fund regulation and the AIFM Directive: The US and the EU have both imposed significant regulation and reporting requirements on hedge funds. Under the AIFM Directive, this includes authorisation, capital, operational risk, depositories, valuation mechanisms, risk management, liquidity, leverage, conduct of business and marketing for these funds. EU regulation will take effect in 2013. In the US, hedge funds will be required to maintain records subject to SEC inspection on most of these issues. In addition, Dodd-Frank limits the ability of the banks to own hedge funds. Few efforts, if any, to take similar actions outside the US and EU have occurred, leading many to suggest that the combination of growing wealth and lighter regulation in Asia will lead some asset managers to re-focus their businesses toward Asian markets.
Structural change in the banking industry: The Dodd-Frank Act limits bank ownership of hedge funds and private equity firms as part of what is called the Volcker Amendment. Its original intent was to limit proprietary trading at the banks, which would have led to a dramatic reshaping of the business of some of the major financial institutions. Ultimately, these restrictions were significantly limited in the final Act. Currently, there is some discussion under the new Congress of reviving debate on this subject. In the UK, the Independent Commission on Banking (UKIBC) is investigating how to ensure financial stability and competition, and considering reform options including: a split between retail and wholesale banking, narrow banking, and limits on proprietary trading and investing. The degree of attention this receives varies by country as a function of the degree of recovery in the economy, in employment, in capital investment and wealth distribution.
Securitisation and Credit Rating Agencies (CRAs): These two issues are related insofar as many of the efforts to directly regulate the CRAs relate to their activities in rating asset-backed securities. In both the US and the EU, the SEC and ESMA respectively have been given direct responsibility for the authorisation and supervision of the CRAs. In addition, Dodd-Frank instructs agencies to attempt to remove ratings from regulation wherever possible.
There are significant new disclosure requirements on data used for the initial rating and surveillance of securitisations, and discussions of rotation of agencies on these transactions. In both jurisdictions, originators will be expected to hold some percentage of the securitised assets on their balance sheets unhedged, to encourage them to take due care in the securitisation of assets. Moreover, the BCBS is increasing risk asset weightings for securitisations held by banks.
EU remuneration and bonuses: Treatment of this issue varies enormously by jurisdiction. In the EU, rules will go through the Committee of European Bank Supervisors before the year’s end and are likely to be in line with initial wording of the Capital Requirements Directive 3 (CRD3), which requires significant payment in deferred shares. In the US, It will be interesting to learn whether the high level of Troubled Asset Relief Program (TARP) repayments and the new House majority will take some pressure off this issue.
What should we expect in 2011?
The economic and financial market backdrop will continue to be a key factor in shaping the policy framework over the coming year. The recovery from the downturn has been sharper than expected – in part due to the buoyancy of the emerging economies, some of which have seen output exceed pre-crisis trend growth. However, the rebound has also owed much to the substantial boost from expansionary fiscal and monetary policy. These in turn have left the legacy of heavily impaired balance sheets, especially for some of Europe’s smaller economies, as well as a very flat yield curve. Although there has been some increase in certain longer dated interest rates, these remain relatively low by historic standards. The consensus forecasts global growth in the next couple of years of a slightly lower degree than that seen in 2010, but which will remain at rates above the 1999-2008 average of close to 3%. However, this growth is likely to remain unevenly distributed. Unemployment rates in many parts of the developed world are expected to remain elevated.
Should growth falter, this may discourage some authorities from pursuing a vigorous application of new regulatory measures for fear of crimping the supply of credit: should growth be more robust, this may give regulators an opportunity to press ahead with some measures. The non-financial corporate sector is seeing in many sectors a build-up of cash. If confidence in the outlook builds, there may be a greater demand for investment or even more mergers and acquisitions, rather than the current trend towards share buy-backs. Moreover, there will a substantial amount of bank bonds to be refinanced over the next couple of years, in addition, of course, to the huge amount of public debt. All of this requires a working financial system and a considerable degree of cross border capital mobility.
One element of financial intermediation which has tended to remain in the doldrums has been securitisation. The extraordinary monetary policy measures which have been introduced, including the extensive quantitative easing, has led to continued mispricing of risk. If robust growth encourages monetary authorities to implement exit strategies rather sooner than markets currently expect, the re-pricing of risk may occur more quickly than many expect. Importantly, this may expose less well founded business models in the financial sector which are currently being sustained by widespread central bank liquidity provision. We must also watch for a heated debate over the effect of the proposed effects of Basel III measures on the stable funding ratio and the liquidity coverage ratio.
Clearly one focus of regulatory attention will be the development both of practical resolution mechanisms as well as progress on macro- and micro-prudential tools and data resources. While to date these efforts have been largely focussed domestically, it will be critical to consider effective cross border crisis resolution if markets are to be prepared for future crises. In 2011, we may also see more attention on extension of the regulatory perimeter – that is, addressing the concerns concerning shadow banking, and also more examination of competition issues within banking systems. This will be a central theme of the UK’s IBC, but other countries will be tempted to think about this as well. Should the provision of credit to some segments of the economy continue to be weak, we may see more initiatives for financing SMEs or other groups excluded by the formal financial system. In the emerging world, the ongoing focus will be concentrated on fostering a financial system which is capable of keeping pace with the growth of the real economy, and which can provide the breadth and depth of financial instruments necessary to meet the growing range of needs of borrowers and savers. We can expect more debate over governance issues associated with such rapid financial evolution in these markets. The question of whose job it is to make structural and exchange rate adjustments necessary to normalize global imbalances is not set for resolution in the near term – and may continue to paint a contentious backdrop for future G20 meetings.
Issues we expect to be relevant in 2011 include:
Systemically important financial institutions (SIFIs): Debate continues on how best to ensure that such institutions do not cause future financial disequilibrium. The Financial Stability Board (FSB) has published a series of recommendations, but it remains to be seen whether higher capital requirements will be required of these institutions, and notably, whether the list of which institutions are SIFIs will become public. Such a move, explicit by publication or implicit by the publication of continuously tougher capital norms, could have significant, unintended consequences for competition and business.
Corporate governance of financial institutions: The BCBS, the EU and the UK have all been publishing on this issue. The topic is notable for its absence from the US agenda. Basel Committee principles include: i) the role of the board, which includes approving and overseeing the implementation of the bank's risk strategy; ii) the board's qualifications; iii) the importance of risk management, compliance and internal audit functions, together with the need to identify, monitor and manage risks on an ongoing firm-wide and individual entity basis; and iv) the board's active oversight of the compensation system's design and operation, including careful alignment of employee compensation with prudent risk-taking.
US Government supported entities: Notable by their absence from the Dodd-Frank Act are the US government supported entities Fannie Mae and Freddie Mac, which have needed an estimated $150 billion in financial support since the crisis. An initial conference on the topic was held at Treasury this autumn, with suggestions that legislation would be tabled in 2011. Given the magnitude of the problem, and the costs of rectifying it, it would be extremely surprising to see any inclination for a bipartisan solution to this intractable issue in the next Congress.
The ICFR will continue to monitor these and other issues that appear on our ICFR Regulatory Radar™. In particular, we will continue to monitor progress at the international level. While we recognise that it is always easier to resolve issues at the national level, many regulatory issues need collaborative solutions that are consistent, if not identical, across borders. We will also continue to watch for the unintended consequences of regulatory change. A key issue on our own agenda will be the impact of regulatory measures on long-term savings and investment.
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