28 October 2004

Forum Notes

Notes of meeting held at Scotland House, Brussels

The outlook for the next stage of the Financial Services Action Plan and the complex legislative, competitive and prudential issues surrounding efforts to create a pan-European clearing and settlement system were the focus of GrahamBishop.com’s European Finance Forum.

The Post-FSAP Agenda
John Purvis, MEP for Scotland, launching the discussion on the FSAP, said that MEP’s were taking on board the importance of the process of implementation now most of the legislation was passed. He echoed the view, expressed clearly in the Expert Groups report in April, that in so far as possible, legislation should be used only when absolutely necessary in the next stage of the FSAP and that voluntary agreements, codes of conduct and self regulation should be the way forward.

Attention was drawn to the important Financial Services Committee report on the future of the FSAP in June which should be seen as an indicator of the way governments are thinking. Mr. Purvis pointed out that the Parliament itself would also be producing a report on the future of the FSAP, partly to try and influence the thinking of Mr. Charlie McCreevy, the likely new Internal Market Commissioner. A draft would be prepared by 23rd November he suggested, with a vote in EMAC in January and plenary in February.

Returning to the Expert Reports, he said the Expert Banking Group had highlighted the fact that it is now the retail business which has made the least progress towards pan-European integration, and expressed the hope that cross-border consolidation might help here.

One participant pointed out that, partly because of the difficulty of restructuring, and in particular laying off staff, there have been few cross border mergers. The Banco Santander Central Hispano’s bid for Abbey National stands out because of its rarity. Graham Bishop added that this deal had exposed the difficulty which small shareholders face in, for example, selling their shares or in coping with the taxation of dividends in such transactions.

Robert de Bruin (for the Greek Banking Federation) said that retail markets would only become more closely integrated when mortgage loans could be moved across border. But there are obstacles to this, not least varying notary systems in different countries.

National differences between property laws and legal systems which were not designed for integrated capital markets are also barriers. Mr Purvis pointed out that Italian banks are protected from foreign takeover and he asked is this permissible. But it was suggested that one reason why retail banking markets are not integrating is that customers simply prefer to deal with national banks with whom they have been working for years and whom they trust, and that this “home bias” distinguishes retail from securities banking.

Other issues which will have to be watched in the months ahead in the banking sector are Basel II and the Capital Adequacy Directive which will eventually be implemented by national supervisors.

Accounting Standards
The meeting also heard a detailed and enlightening explanation of the Commission’s stance on the controversy surrounding International Accounting Standard 39. In view of its complexity, we have decided to include key extracts from the record of the Accounting Regulatory Committee meeting of 1 October 2004.

1. VOTE ON IAS 39
Result of the vote on a Proposal for a Commission Regulation adopting IAS 39 Financial Instruments: Recognition and Measurement with the exception of certain provisions on the use of the fair value option and certain provisions relating to hedge accounting, in accordance with Regulation (EC) N° 1606/2002 of the European Parliament and of the Council
A qualified majority of the Member States represented (=92 votes) in the Accounting Regulatory Committee voted in favour of the draft Commission Regulation proposing the endorsement of IAS 39 Financial Instruments: Recognition and Measurement with the exception of certain provisions on the use of the fair value option and certain provisions relating to hedge accounting. Three Member States (=15 votes) abstained; four Member States (=17 votes) voted against the proposal

2. DISCUSSION
In his opening remarks the Chairman stated that:
• The partial adoption of IAS 39 represents an exceptional situation due to the inability of the main actors outside the Comitology procedure to co-operate sufficiently and in time.
• The partial adoption of IAS 39 is a temporary solution. On the basis of information received from the IASB Chairman, the Commission expects a final solution with the following timetable:
a) On the full fair value option – carve out number 1 –
Banking supervisors and the ECB oppose the current full fair value option contained in the present IAS 39. This stance has led the IASB to reconsider the fair value option, which led to an Exposure Draft issued in April 2004. Comment letters have been received by the IASB in September 2004. The Chairman of the IASB has declared that this issue will be dealt with as a matter of urgency and that he hopes for a final decision to be taken by the IASB in December 2004. Under these circumstances, the Commission would hope for a final adoption of a revised fair value option in April 2005.
b) On the portfolio hedging of core deposits – carve out no 2
The Commission urged both the IASB and the banking industry to intensify work to find an acceptable solution. The Commission expects that the working group between the IASB and European Banks will without delay examine the proposal for an interest vote margin hedge and will conclude its technical work in April 2005 to the Board. Accordingly, the IASB might be in a position to solve the issue of hedge accounting in autumn 2005. Based on that information, Commission expects to endorse revised IAS39 around the end of next year.

• Compared to the initial proposal, presented at the last ARC meeting of 8 September, the changes in the new proposal are as follows:
a. On the full fair value option – carve out number 1 –,
The justification based on procedural grounds is maintained whilst putting more emphasis on the legitimate concerns of the European Central Bank and the prudential supervisors represented in the Basel Committee. Companies are not allowed to apply the full fair value option and Member States are not allowed to introduce it either, as this would conflict with Article 42a of the Fourth Company Law Directive.
b. On the portfolio hedging of core deposits – carve out no 2
The relevant provisions are no longer rejected on grounds of substance, such as the criteria of understandability, relevance, reliability and comparability. Instead, it is considered that the provisions in question are nor completed nor ready for an agreement
c. IFRS 1: In addition, the problem of the “first time adopters” will be dealt with in the Regulation itself (Article 1 (2) and not only in a recital so as to provide for more legal certainty for companies and auditors.

3. EXPLANATORY MEMORANDUM
The Chairman summarised the Explanatory Memorandum of the Commission Services as follows:
• A partial endorsement is legally possible as far as a standard deals with accounting subjects which are entirely autonomous, distinct and separable.
• In the present case, two carve outs are envisaged which are limited to what is strictly necessary and which do not make other provisions of IAS 39 meaningless.
• The full fair value option is distinct and separable since it was added into the already existing IAS 39 in December 2003. In addition, such an option granted to a company under an accounting standard is by nature separable from the mandatory part.
• On portfolio hedge of core deposits, a specific accounting issue has been addressed and the technical feasibility of the carve out proposed, has been assessed by EFRAG which considers this to be workable.

4. DECLARATION
The Chairman also invited Member States to consider supporting the vote on the draft regulation by an additional political declaration recalling the exceptional situation in which the Commission and Member States currently are and outlining when a final solution on the carved out provisions could be found. As one Member State declared not being willing to sign up to the declaration, the Chairman concluded that only the Commission will present a declaration when the Regulation is adopted by the Commission.

5. QUESTIONS FROM MEMBER STATES
Responding to questions from Member States, the Chairman explained that:
• As Article 42a of the Fourth Company Law Directive is mandatory, there is no contradiction with the principles laid down in IAS 8, para.10 according to which the management has, in the absence of any specific standard, to adopt the appropriate accounting policy. Companies have to respect the Directive in this respect.
• The Commission will further consider the problems for insurance companies. The Insurance Accounting Directive offers a way out for unit linked contracts in the insurance sector, as set out in the Explanatory Memorandum.
• Companies can apply the provisions on hedge accounting under IAS 39 which have been carved out. As explained in the Explanatory Memorandum Member States may also require companies to respect the provisions on hedge accounting, which have been carved out;
• As for the acceptance of IAS 39 with the envisaged two carved outs by the US SEC, the Chairman pointed out that he intends raising the issue in the US. In practice, this should not be an issue as US-GAAP currently does have a full fair value option and as a European company listed in the US is also entitled to apply the carved-out provisions on hedge accounting.
• Companies would have to make clear in their financial statements and in their accounting policies that they are in full compliance with IAS as adopted by the European Union. On this basis, an auditor can provide an unqualified opinion.
• The Commission will closely follow the progress being made in the working group set up by the IASB in respect of the proposal on the interest rate margin hedge.

Clearing and Settlement
Moving to the third part of the seminar, Theresa Villiers MEP said that on the future of Europe’s clearing and settlement structures she and the Parliament were very much in a tentative, listening, learning and consulting mode because many of the issues were new to Parliamentarians, and not just to the new MEP’s.

She said that she was not convinced that a Directive was needed and that the Commission should retain an open mind. She welcomed the Commission’s decision to carry out an ‘impact assessment’ to find out more about how the market is working, where the problems are, and what would be effective and proportionate remedies.

She suggested it, would be important to try and determine the extent to which competition policy can play a role in helping to develop competitive clearing and settlement systems. Do we need legislation on top of this, she asked.

The barriers identified in the Giovannini Group in 2001 are the key areas to be tackled. She worried that moving swiftly to a Directive might actually distract participants from tackling barriers which could be removed without legislation. She pointed to the danger, seen in the process which led to the Investment Services Directive, that political horse trading and last minute compromises can produce unexpected results when the legislative procedure is thrown into gear.

She identified several key questions.
1) Is there competition in the pre and post trade arena? Are users happy with the quality of competition?
2) Are the Commission’s proposals on governance too intrusive?
3) How should we deal with the issues of accounting separation and un-bundling. A key is the need for pricing transparency, especially where providers are also offering value added services. Is the Commission in danger of being too intrusive? I have an open mind on this, she said.
4) She suggested that the Commission is right to look at tax as it affects the structure of the market and the way the market functions. But too radical an approach on tax by the Commission could also complicate the situation and delay progress
5) The laudable aim of reforming and harmonising laws on the holding and transfer of securities could itself slow down the process of tackling the Giovannini barriers.

Graham Bishop pointed out that, within a Lamfalussy type directive for clearing and settlement, the Level 2 details could be so commercially sensitive that market participants might want them in the Level 1 legislation, raising the risk that the legislation would become too complex.

Henny Kapteijn of the EFRP doubted whether the benefits of competition in clearing and settlement would actually flow through to asset managers and investors. They participate through a chain, including for example custodian banks, and might not see significant cost savings. The most investors could hope for might be greater simplicity and less risk. But whether less risk would result was also in doubt. It is important, for example, that when investors are dealing for direct real time settlement, transactions should be settled in central bank money, not least because this would help to reduce costs, particularly costs of collateral.

The big gain for investors from better clearing and settlement should be to improve their risk position, she maintained. If there is not access to central bank money investors are forced to use commercial banks as intermediaries but the banks are not transparent and are making large amounts of money out of managing their customers’ cash.

With competitive clearing and settlement she worried that, from a risk perspective, the environment facing investors could get worse, not better. She maintained that, ideally, large investors should themselves have direct access to central bank accounts, but in fact some central banks are cutting off non-banks’ accounts. However, it was pointed out that who should have access to central bank money was a very complex and controversial issue. In this context, Graham Bishop expressed unease at the length of time it was taking to get Target II up and running.

Theresa Villiers concluded by suggesting that one thing which policymakers would indeed pay close attention to was the issue of the impact of changes on global competition and the need for legal certainty and therefore legal convergence with the biggest financial market jurisdictions. She worried too about the risk of overlapping regulations and said that it was vital to ensure consistency.

Graham Bishop expressed concern about the process of transposing directives into national law. Pointing out that October 12 was the day on which governments had committed themselves to transpose, and thus implement, the Market Abuse Directive, he said that only one country, Germany, had done this. Were a similar approach to be taken to implementing laws relating to clearing and settlement, he said, it would be a nightmare. But Paul Arlman argued that this was the first such directive to be implemented and that it was worth taking an extra six or twelve months to ensure that implementation went smoothly.


Date of next meeting: Currently scheduled for 7th December at Scotland House

© Graham Bishop