27 May 2008

May 2008

The nature of the political reaction to the financial turmoil seems to be transmuting, away from the somewhat mechanical issue of identifying and rectifying regulatory weaknesses towards a more fundamental questioning of the workings of capitalism.

Graham Bishop's Personal Overview

The nature of the political reaction to the financial turmoil seems to be transmuting – away from the somewhat mechanical issue of identifying and rectifying regulatory weaknesses and towards a more fundamental questioning of the workings of capitalism. Some former top politicians even wrote to Commission President Barroso and called for a ‘European Crisis Committee’, saying this crisis is a failure of poorly or un-regulated markets that shows that the financial market is not capable of self-regulation. “The problem is a model of economic and business governance based on under-regulation, inadequate supervision and an undersupply of public goods.” The current financial crisis is no accident and was not impossible to predict, the group says - referring to several warnings issued during the last years.

But others could respond that the profusion of “Financial Stability Reports” did not produce calls for specific action and the ECB’s Trichet said recently that “Three broad factors have reinforced one another in a way that almost nobody could have foreseen … namely, the abundance of liquidity, a complex financial system, and some financial agents’ incentives.” This author is not clear that any regulators were sufficiently convinced that they took any measures to force behavioural change beforehand. But the co-legislators are certainly proceeding with their detailed reactions:
o ECOFIN approved policy and procedures for improving the EU's arrangements for financial supervision and financial stability. It set out steps to develop a European dimension into the mandates of national supervisory authorities, improve the functioning of EU committees of supervisors and the supervision of EU-wide financial groups. The Council also agreed on EU arrangements for financial stability and on future work on deposit guarantee schemes, and approved updated roadmaps for further work on the Lamfalussy process, the EU financial stability arrangements, and actions to be taken in response to the recent turbulence on financial markets.
o ECON chair Pervenche Beres called for concrete proposals for change: “This crisis is a major market failure and calls for strong responses from all the EU policy makers”. ECON has published a report “Lamfalussy follow-up: Future Structure of Supervision”. With the draft report on hedge funds and private equity, ECON will prepare recommendations for immediate legislative initiatives on and beyond the reform of the EU regulatory and supervisory framework. The ECON study “Financial Supervision and Crisis Management in the EU” targets macro-level supervision, in particular to act at EU level with cross-border, cross-sector supervision of big financial institutions. Jörgen Holmquist (DG Markt) informed ECON of some of the forthcoming proposals from the Commission: changes to the CRD may include an update on the large exposures regime, harmonisation of hybrid capital rules, quantitative restrictions or qualitative provisions with regard to securitisation, and changing the legal basis for the colleges of supervisors. Foreshadowing a clash between ECON and ECOFIN on the call for more integrated European regulation and supervision, he noted that “few, if any, Member States consider this to be a viable option at the moment.”

However, Wellink (Chairman of the BCBS) pointed out the obvious problem: As the internationalisation of banks may be presumed to continue, further steps are needed to ensure effective and efficient cross-border banking supervision in Europe. But the way to a more integrated pan-European supervisory structure is far from clear. In the near term, banking supervision in Europe should continue to build on the existing institutional structure. For cross-border banking supervision so-called colleges of supervisors should be established for all major cross-border groups, he explained.

ECB President Trichet added his voice to the discussions: Augment transparency and reduce pro-cyclicality as the broad lines of actions. Recent financial turbulences were the first “real magnitude” stress-test of today’s global financial system “The sharpness and speed of the contagion to unrelated market segments revealed vulnerabilities with a nature and complexity that had not always been well understood.” Trichet underlined that only a global response to the present turbulences can be effective and re-iterated the strong consensus at international community level on implementing the FSF recommendations with determination and in line with the recommended timeline. He also called on the IASB and other relevant standard-setters to take urgent action to improve the accounting and disclosure standards for off-balance sheet entities and to enhance guidance on fair value accounting, particularly on valuing financial instruments in periods of stress.

Compensation structures are now moving to the forefront of regulatory discussion and Sants (FSA) is adding some practical bite to President Trichet’s comments on incentives: “Asymmetrical structures where traders receive immediate reward and do not bear the consequences of losses are a risk to shareholders” He recommends deferred compensation with claw back and the increased use of share options as a possible way to tackle this problem. “I do believe the regulators need to consider the risk of such structures when judging the overall risk of an institution…The assessment of remuneration structures is part of our supervisory approach and we will emphasise this more in the future.”

But another intriguing strand of thinking is emerging that is far more fundamental to the structure of the financial system. BaFin’s Sanio called it the doctrine of “too connected to fail” – epitomised by Bear Stearns. CEPR’s Buiter also believes that, post the rescue of Bear Stearns, even some hedge funds may be deemed to big, or too interconnected, to fail. Perhaps regulators need to pay more attention to the mushrooming of these inter-connections in the last decade or so, recalling that Drexel Burnham was liquidated in a week in the 1980’s as its assets were nearly all reasonably marketable securities, rather than a web of derivative contracts.

Credit Rating Agencies remain in the limelight and CESR has urged the Comission to form an international CRAs standard setting and monitoring body composed of senior representatives of the investor, issuer and investment firms’ communities. Interestingly, CESR recommends that this body is formed at an EU level if international regulatory involvement cannot be achieved in the short term. However, the SEC’s Cox said that they will consider proposed new rules to strengthen the rating agencies' accountability and transparency, and make their industry more competitive within the coming weeks. As financial regulators are drawing up a new code of conduct for the industry, several leading ratings agencies have told them that guaranteeing the quality of information used to assign credit ratings on structured finance securities would be “overly burdensome and redundant.”

The Commission launched a consultation on insurance guarantee schemes, examining the need for, and role of, an IGS as a last resort protection mechanism, and examines the cost of establishing such a scheme. The report is based on the main findings of the OXERA report on insurance guarantee schemes which provides a detailed description and comparative analysis of the existing EU IGS for life and non-life insurance. The consultation paper asks inter alia whether to introduce a single EU-wide IGS that covers all relevant policies written and purchased within the EU. Solvency II continues to stir strong reactions and the CEA is concerned by some parts of the draft advice on supervision of insurance groups which would significantly undermine the efficient operation of the Group Support Regime. The CEIOPS draft advice appears also to impose more stringent supervisory requirements on groups operating under the GSR on elements which are not specifically related to the functioning of the GSR regime. The likelihood that insurers would use group support in practice would be significantly reduced. This draft advice is in direct contradiction to the Framework Directive Proposal, CEA underlines.

The ECON draft report on hedge funds and private equity finally appeared and the Rapporteur has asked for a limit on leverage for hedge funds and the establishment of a public register of structured products in the EU. Its recommendations are grouped into four categories (financial stability and better functioning financial markets, transparency, excessive debt, and conflicts of interest). Among many other elements, the Rapporteur called for conventional funds including UCITS and pension funds/IORPs to comply with capital requirements, and to strengthen the capital requirements for prime brokers; the Commission to establish an EU Public Credit Rating Agency and a European supervisor. However, it was made clear that the whole draft report including the recommendations made in the annexes can be subject to amendments and the report was harshly criticised by members from the EPP and ALDE.

Accounting issue remain at the forefront of attention and IFO Institute’s Sinn attacked IFRS as a bad accounting system, recalling the merits of Germany’s previous system of marking to the lowest of market or book values. However, the FT reported that the IIF is leading the pressure to relax controversial accounting rules with a new plan aimed at breaking the “downward spiral” of huge write-downs, emergency fundraisings and fire-sales of assets. The proposals on “fair value” accounting by the Institute of International Finance, an alliance of 300-plus companies chaired by Josef Ackermann, Deutsche Bank’s chairman, would enable financial companies to cushion the blow of financial crises by valuing illiquid assets using historical, rather than market, prices. Under the plan, which has been obtained by the Financial Times, banks that decided to keep assets on their balance sheet would also be freed from the requirement to hold them to maturity and would be able to sell them after two years. SEC Chairman Cox said that the apparent pro-cyclicality of fair value accounting will be reconsidered and a variety of experts told the SEC’s Advisory Committee on Improvements to Financial Reporting the jury is still out on the absolute merits of fair value accounting for financial statements.

Infrastructure developments continue apace: The ECB reported the final migration to TARGET2, which has now fully replaced the decentralised technical platforms. Three Eurosystem central banks – the Banca d’Italia, the Banque de France and the Deutsche Bundesbank – jointly provide the single technical infrastructure, called the single shared platform (SSP) of TARGET2, and operate it on behalf of the Eurosystem.

Six companies - Icap, TradeWeb, Eurex, MTS, BGC Partners and Bloomberg - are bidding to provide a new electronic trading platform for European covered bonds. According to a Bloomberg report, the European Covered Bond Council (ECBC) met the companies to assess the bids as the Council wants to improve liquidity in the covered bond market with a central trading platform.

The FT reported that LCH.Clearnet and DTCC are in merger talks about a possible deal that would create the first transatlantic provider of post-trade services. The FT said the two sides had talked ‘intermittently’ over the last nine months, but the negotiations were by no means likely to result in a deal.

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Graham Bishop

© Graham Bishop