11 January 2012

December 2011 Financial Services Month in Brussels

During the Christmas ‘holidays’ of 2011, I researched (and then created) my on-line Foundation Course on ‘The Creation of an EU Financial Regulatory Framework’. This forced me to look back through the history of the EU and why we have arrived at a Single Market for all – and a Single Currency for many – EU States. That exercise reinforced my belief that the EU is at a historical turning point – something that may last for quite some time rather than be a particular day. However, the Summit Meeting on December 9th will certainly loom large.

At moments of great importance: the media reports live, the markets react in minutes, legislators act months or years afterwards but society only catches up a decade later. Will the December 9th Summit of the Heads of State/Government of the EU (HOSG) be seen as the moment when society finally woke up to the scale of the problem? It is widely said that a momentous change to economic governance in the euro area has been proposed. The doubters ask: Will society accept it? This author’s answer is: Yes – it should! And it probably will - as the message sinks in that spiralling levels of public debt (proportionately, tripled during my career!) have to be halted. Otherwise, investors simply will not buy the new debt – and that will halt the spiral in a dramatic fashion.

During that Summit, one of the EU’s major members finished up being out-voted 26:1. My comment afterwards was that “Britain jumps off economic and political cliff”. During the subsequent Christmas holidays, not much has happened except that parts of the British political establishment have started to try to row back from that situation. At the Cannes G20 Summit in early November, the British Prime Minister seemed very willing to sign up to “We will implement our commitments and pursue the reform of the financial system…” But a month later and on the 20th anniversary of the Maastricht Summit, the same person demanded exceptions for the UK that would make this more difficult. During the months ahead, there will be many debates on financial market measures that will be settled by QMV. The ability of the UK to fight its corner will be watched carefully.

However, the 9th December Summit had much broader implications for financial regulation. The central thrust was to improve budget discipline by incorporating a debt brake mechanism in national constitutions. The euro area HOSGs reiterated that the Greek PSI decision should be regarded as exceptional – but the genie is well and truly out of the bottle now! Europe’s accountants were moved to comment that: “The times that sovereign debt was regarded as risk-free are over”, and they will be signing the balance sheets in the future that may have to reflect impaired assets. A private sector that has learnt the hard way that political leaders can change their minds on the value of such huge assets will be looking for actions sustained over a decade. A few simple phrases in a communiqué from the current office-holders will convince few holders of government debt.

The practical ramifications of the sovereign debt crisis continued to develop with the EBA’s formal Recommendation, and the final figures, on banks’ recapitalisation needs. The recommendation required an exceptional and temporary capital buffer against sovereign debt exposures to reflect market prices as at the end of September. Unfortunately, Italian government bond yields, as an example, jumped by around 20 per cent between that date and the year-end when the accountants will be preparing the balance sheets. Presumably, there will be pressure to maintain the buffer even at the new level of yields.

This process is a baptism of fire for the EBA. With cross-border banks and cross-border assets, the case for a Single Rulebook is manifest. But the pressures for national solutions are enormous - the Italian Banking Association even threatened to sue the EBA, and the issue of maximum harmonisation of bank capital standards in CRD IV is at the heart of the UK’s specific problem with the EU. The pressure may explain partly the calls from the ESAs for a change to their funding structure in order to remove the 60 per cent reliance on the national regulators. 

AFME, ICMA and ISDA published a fascinating paper analysing the impact of European sovereigns' collateral policies as they do not normally provide collateral - yet their bank counterparties must do. Under the current Basel III proposals, the only way to reduce the CVA charge is to purchase single-name CDS. Preliminary estimates using data provided to AFME and ISDA by the “G14” group of dealers indicate that the notional amount of CDS required to hedge these dealers’ sovereign-related CVA would have been roughly $70 billion as of March 2011. By comparison, the net CDS outstanding on the entire European sovereign market as reported to the DTCC was roughly $143 billion. Such hedging may therefore account for as much as 50 per cent of the open interest in CDS for the European sovereign community. Has the law of unintended consequences struck again?

Is a similar thing about to happen to defined benefit (DB) pension schemes? The arguments rage about the application of Solvency II capital standards to such schemes but Con Keating put it particularly succinctly about the employee members of a company’s pension scheme: "The Commission appears to regard both pension schemes and insurance companies as financial institutions and seems to be believe this merits equal regulatory treatment. It does not. A corporate treasury may provide financial services to other members of its group, but we do not require it to operate and be regulated as if it were a bank, precisely because it is not offering these services to the public. Indeed, the identification of an occupational pension scheme as a financial services enterprise is erroneous."

The European Commission’s long-awaited audit reforms were published before Christmas. "The proposals will clarify the role of the auditors and introduce more stringent rules for the audit sector, aimed in particular at strengthening the independence of auditors, as well as greater diversity into the current highly-concentrated audit market." Proposals include mandatory rotation, mandatory tendering, European supervision (by ESMA) creation of a Single Market for statutory audits by introducing a European passport for the audit profession. The FT reported that the heads of several midsized audit networks have issued a last-ditch appeal to the European Commission not to dilute sweeping proposals aimed at reducing the dominance of the four biggest accountants and improving audit quality.

Graham Bishop

© Graham Bishop