29 April 2008

April 2008

Graham Bishop's Personal Overview

The turmoil in financial markets continues to dominate the EU financial services agenda. But we are entering a new phase as policymakers are now laying down the roadmap of legislative responses. However, the plot is also thickening as observers begin to question the ethical foundations of modern finance – a shortcoming that cannot easily be rectified even if very detailed regulations are imposed. Unless market participants accept their moral validity, such rules will quickly be “gamed” and rendered ineffective in the next crisis. Correspondingly, the warnings against an excessively rapid response are rising – but the impact may be diminished when the source of the call is seen to be a self-serving financial industry.

Perhaps the most trenchant criticism of the conduct of private financial markets was launched by ECB President Trichet in a speech at New York University. The purpose of the financial system “increasingly fell victim to a game for fees, very short term apparent profits and arbitraging regulation,” he said. He identified “the trend towards short-termism and the profound asymmetry in the response which is given to booms and busts,” as particularly adverse from a financial stability stand point. Trichet also criticized the “shadow banking system” which rested on a poorly understood system of credence (provided by rating agencies) and the (false) perception that the only way for asset prices was upward, and warned that “the challenge for us today lies in preventing the system from feeding on itself through a spiralling process of leverage.”

The FSF final report laid out a global roadmap of regulatory response: Authorities should establish international colleges of supervisors for each of the largest global financial institutions by end-2008; supervisors must set capital and liquidity buffers at levels that take account of the potential for risk management failures to occur and that limit damage to markets and the financial system when they occur; Basel II capital requirements for certain complex structured credit products should be raised and additional capital charges for default and event risk in the trading books of banks and securities firms be introduced.

The G-7 Ministers and Governors called for rapid implementation of this report and identified four immediate priorities for implementation within the next 100 days, in order to begin to address the current financial crisis. Ministers also called on the Basel Committee, IOSCO, the IASB, and the Joint Forum to accelerate their work in order to conclude their efforts by end-2008 and for the recommendations of the FSF to be fully and effectively implemented. In the short term, Finance Ministers and Central Bank Governors call on firms to fully and promptly disclose their risk exposures and strengthen their risk management practices. Standard setters should initiate urgent action to improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value accounting. Also, the BIS and IOSCO should revise their liquidity risk management guidelines and the code of conduct for CRAs. The G7 endorsed the FSF proposals to, by end-2008, strengthen prudential oversight of capital, liquidity, and risk management, enhance transparency and valuation, changing the role and uses of credit ratings, strengthen the authorities' responsiveness to risk and implement robust arrangements for dealing with stress in the financial system.

For the EU, Commissioner McCreevy disclosed the Commission proposals for changes to the CRD and the strengthening of supervisory convergence. Speaking before the EP ECON, Committee McCreevy said that the proposal should be adopted by early autumn with a view to come to an agreement by April 2009. Proposals for changes to the CRD will include new rules to limit the risk stemming from large exposures, a harmonisation of the definition of hybrid capital, capital requirements for default risk in the trading book, and a definition of the significance of risk transfer. On fair value and mark to market measurements, the Commissioner noted that “there are some real accounting issues and anomalies to examine, such as the consolidation of special purpose entities or the measurement and information disclosed on risk exposures.” The BIS published a working paper: The financial turmoil - assessment and policy considerations and the OECD called for fundamental reform of financial markets.

The IIF will also recommend a suite of best practices to be embraced voluntarily, perhaps in the context of a “code of conduct” to reform banking practices. The EFR supports the IIF interim report recommendations and calls for an efficient market-based solution by the Industry. The EBF said that policy makers should not rush conclusions on the effectiveness of recently-adopted capital rules before they are fully implemented and IBfed questioned the effectiveness of the full fair value approach to accounting. It also argued that, “Anything other than general and high level recommendations in response to the turmoil could produce negative unintended consequences for the financial system as a whole”. However, even a senior official, BIS General Manager Knight, warned against an oversimplification of the underlying causes of the turmoil.

*********

Clearing and settlement is never far from the top of the agenda. So Commissioner McCreevy had to warn the industry that “endless foot-dragging is not acceptable”, he recognized that there is ‘movement in the right direction’. “There are, of course, still some teething problems, in particular in the area of access and interoperability”, he said. ECB President Trichet has warned that, the EU market is characterised by fragmentation and high costs. “This gap for Europe must be closed,” he said, adding “(it) clearly demonstrates that concrete actions are needed to make Europe significantly more competitive and a more attractive place for issuers and investors.” He said that the TARGET2-Security (T2S) project therefore provides borderless core infrastructures for real-time settlement in central bank money. Seven Central Securities Depositories have signed an agreement to establish a joint venture called “Link Up Markets” to improve efficiency and reduce costs of post-trade processing.

Credit rating agencies have suffered a demonization during the “financial turmoil” but CESR’s consultation revealed a need for transparency, not regulation. Most respondents supported the CESR proposal to increase transparency of CRAs, although the required level and extent varies among respondents. The BBA and LIBA for example underline that ratings are not a substitute for investors’ own risk assessment and CRAs should not be held responsible for inappropriate decisions by investors. The French AFG reminds that regulators and legislators at national, European and international levels, have to think about their own responsibilities in the development of ratings in recent years, through the importance they have given to the ratings themselves. Yet Handelsblatt reported that Commissioner McCreevy will present proposals for more transparency in credit rating agencies in June as well as plans for an external, independent supervisor. The spokesman said the possibility cannot be ruled out that McCreevy will make legislative proposals to regulate the industry.

In a slightly surprising turn of events, hedge funds seem to have had some support during April. In a public hearing at the EP, Banque de France Deputy Governor Jean-Pierre Landau noted that the hedge fund industry withstood the recent events much better than expected. Dan Waters from the UK FSA underlined that hedge funds pose no systemic risks. Hedge funds have been neither a catalyst, nor a driver of the crises. The supervision of these funds takes place indirectly through the banking sector, and the review of current events provide no indication why this should be changed. MEP Piia-Noora Kauppi concentrated on the positive role hedge funds play in the European economy and proposes several non-legislative measures to meet enhanced transparency requirements.

The accounting rules for bank’s off-balance sheet interests are “irretrievably broken” argued the FT. Accounting standard setters are already under pressure for their support of marking assets to current market prices and the Financial Stability Forum has asked the IASB and its US counterpart to consider the issue as a matter of urgency. But banks expressed severe doubts over IASB proposals for full fair value accounting. The IBFed said full fair value measurement of financial instruments would overstate the extent to which instruments are held for trading or managed on a fair value basis within the business and the extent to which deep and liquid markets exist, says in a concept paper on accounting for financial instruments. So the aim should be for the accounting standards to accommodate the various business models and circumstances, in which financial instruments are used. A mixed measurement model provides investors with better information for evaluating financial institutions. Where an entity does not manage instruments on a fair value basis, amortised cost is the more appropriate way to estimate future cash flows.

Nonetheless, the onward march of IFRS seems inexorable. The European Commission report on third countries GAAP equivalence took the view that Japanese and United States GAAP both meet the criteria of equivalence to IFRS. Chinese GAAP will continue to be accepted, but since it moved to IFRS for the first time in 2007, more information on its implementation is needed.

Making payments within the EU may seem technical but it is the realisation of a true monetary union. So the progress of SEPA and credit card developments is critical. A survey by Logica showed that less than a third of the banks questioned were in a position to know exactly when the Payment Services Directive will be transposed into national law. Ther were several developments in the cards field and MLex reported that the ECB is plotting the break-up of the payments 'duopoly' and warning against a sharp drop in card in interchange fees.

The Commission’s decision against Mastercard's cross-border MIF did not conclude that all MIFs are illegal per se, according to Commissioner McCreevy. If banks intend to create a new EU debit card player “a possible MIF that is compatible with EU competition law is crucial”, he continued. Meanwhile, leading French and German banks are reported to be hoping to decide within months whether to set up a European debit card payment network that would be a rival to schemes operated by MasterCard and Visa. That underpinned, Visa Europe’s comment that “We believe the best way forward would be to reach a new agreement with the Commission”. However, another front may be opening up as Mlex also reported that the European Commission is looking into standards-setting for payments cards by banks and banking associations after Eurocommerce lodged a fresh complaint challenging co-operation in agreeing technical requirements.

**********
Graham Bishop

© Graham Bishop