02 April 2013

March 2013 Financial Services Month in Brussels

The complexity of the Cyprus problem has been clear for some time as the sheer scale of the size of the 'home' supervised banking system become apparent.

The solutions chosen have both regulatory and political importance. Since the G20 decided - in November 2008 - on a radical overhaul of financial regulations, politicians have been exceptionally clear that taxpayers should not support banks – except perhaps temporarily and only in the most extreme situations. Accordingly, in June 2012 the European Commission published a proposal for the Recovery and Resolution Directive. Article 38 explicitly provides for the bail-in tool to apply to all liabilities apart from the €100k protection offered by the Deposit Guarantee Scheme. The same general approach is used by the FDIC in the US, so should not be a surprise to commentators.

However, the political error of the Eurogroup lay in allowing the new and inexperienced Cypriot Government flexibility in choosing how to raise the required money from bank depositors. That Government chose a solution that seemed bound to create the maximum amount of opposition. Was this a deliberate game by Cyprus? History will reveal, but the gamble by the two key Cypriot banks on buying massive quantities of Greek Government bonds – under the EU’s ludicrously favourable capital adequacy regime - backfired on a historic scale. It not only broke the bank, but also the country. The consequences of the resultant destruction of the island’s major industry will play out over many years. It may be very difficult for the euro area to avoid an eventual second 'PSI’.

The longer-term political significance is two-fold: (i) the idea that 'Europe' will ever take over the legacy liabilities of banks that have been allowed to fail by their 'host' government’s ineptitude is rightly dead. (ii) the Eurogroup is unlikely to allow itself to be 'gamed' in the future. With its panoply of new economic governance powers, the Commission will come under strong pressure to propose measures that represent a clear 'collective' control of such a situation. Another step has been taken towards the political union of the euro area.

The consequence for Europe’s banking system will also be profound. The system has been examined by several High Level Groups (most particularly those led by De Larosière and Liikanen) and found seriously wanting. So there must be a separation of powers, and the Green Paper on Long-Term Investing foreshadows the nature of the division that will happen – probably during the term of the next Parliament and Commission. Moreover, bank depositors will be far less relaxed about assuming that they will be rescued from any folly by the managers of their deposit. The EU financial system will be far more brittle in the future.

The barrage of new banking regulations continued with final agreement on CRD IV and CRR. However, the media storm on 'bankers’ bonuses’ highlighted the loss of the UK’s influence. As the FT put it: “UK opposition to a new cap on bankers' bonuses was swept aside, as the rest of the EU discarded a convention that the UK would not be directly overruled on an industry of vital national importance”.

However the 'bonus’ storm did obscure the failure to change the biggest single distortion of the EU’s financial system – the 0% risk weight for euro area governments borrowing in euros. That remains a clear privileging of governments in their access to financial markets - thus binding banks and their sovereign ever closer together in the future.  As the ECB acquires it supervisory powers, a key question is whether it will find a way to force banks to avoid over-reliance on the debts of their 'legacy government’. Will this require a CRD V?

In a world where investors must choose swiftly between the obligations of various governments, the transparency and comparability of government accounts should be a key tool.  Sadly, such an obvious tool is absent at present but the Commission has now begun to assess the suitability of the IPSAS for the Member States. Unfortunately, the overall conclusion was that IPSAS cannot easily be implemented in the EU Member States as it stands currently. But the IPSAS standards represent an “indisputable reference” for the future development of a set of European Public Sector Accounting Standards - 'EPSAS’. ACCA welcomed this, as it is urgent that Member States should publish financial reports which are accruals-based, reliable, consistent and timely. FEE also welcomed the report on the suitability of IPSAS: “We strongly believe that a single set of high quality standards would greatly contribute to stability and sustainability of public finance”.

At least there was a step forward with trialogue agreement on the creation of the Single Supervisory Mechanism. Commissioner Barnier said: "This is a first fundamental step towards a real banking union which must restore confidence in the eurozone's banks and ensure the solidity and reliability of the banking sector”. ECON Chair Bowles pointed out that "Parliament has a central role in approving the Chair and Vice Chair, neither of whom will be able to take up their duties until the Parliament has exercised this right. Essentially, we will have a veto over these roles.” Emboldened by such success, and in creating legislation to curb the bonuses of bankers, ECON voted for corresponding bonus caps on fund managers. As Rapporteur Giegold put it: “The rules as voted today would be an important step towards ending the gambler mentality in the investment fund sector”. But UCITS V is much broader as its aim is to improve investor protection, including through strict liability on depositories.

Debate on UCITS brings the EU closer to the thorny boundary with shadow banking. ESMA’s Maijoor argued that “Shadow banking links investors and borrowers in complex ways. The various forms of intermediation  typically provide leverage and maturity transformation, and include  various complicated interactions involving money market funds and  other institutional investors, special purpose vehicles, banks, as well  as leveraged investors. All of these are linked with one another through the stages of securitisation, repo funding, securities lending, tranching, and prime brokerage. Not surprisingly, our statistical knowledge of shadow banking, at present, remains far behind our insight into other financial activities.” He argued that “the contribution of shadow banking to the financing of real economic activity remains contested. Much of the financing flows remain within the financial system, and their positive impact on real investment finance may be indirect.”

At each stage of the post-Crisis reform of the financial system, the European Parliament has entrenched its co-legislative power. So a draft report to ECON Committee calling for a wholesale restructuring of banking may turn out to have a great influence in due course. Rapporteur Arlene McCarthy (S&D, UK) urged the Commission to present a proposal for the mandatory separation of retail and investment banking activities. This non-legislative report responds to the Liikanen expert group's findings and argues that banking needs a culture change, which piecemeal legislation will not achieve on its own. The Robert Schuman Foundation/Ackermann explained that the EU Banking Union is sound in theory, but difficult in practice. So the initial design of the banking union will be the result of what is politically possible and not necessarily what is required to put Europe's financial system on a firmer footing. A 'sorting out' will undoubtedly pre-occupy the next Parliament/Commission.

Graham Bishop

© Graham Bishop