28 January 2008

January 2008

Graham Bishop's Personal Overview

The opening month of 2008 did not offer any relief from the problems that appeared in late 2007. Indeed the shock loss reported by Société Générale suggests there will be a further bout of introspection on the minutiae of risk controls. However, there is still a busy agenda of Single Market issues that should be finished off during the term of this Parliament and Commission – a deadline that is focussing attention increasingly.

ECON’s Hearing on Financial Supervision and Crisis Management produced some illumination comments on the current market turbulence. ECB President Trichet discussed the turbulence in the financial markets and said banks themselves needed to draw lessons about their own risk management mechanisms, and that the Basel II framework might need refinement. All players in the 'originate to distribute' model of credit securitisation needed to check that the right incentives were in place to assess and monitor risks. “Further measures are necessary on the harmonisation of regulatory requirements at the EU level, “A closer link between the financial stability assessment of central banks and the supervision of major cross-border banking groups undertaken by the colleges of supervisors would be helpful.” Alexandre Lamfalussy talked of the “mind-boggling complexity” of some financial instruments that had led to an over-reliance on the credit rating agencies, with “market participants not doing their homework.” Slovenian Finance Minister Bajuk said that the Level 3 committees needed to be strengthened, and that faster progress was needed In its spring meeting in March 2008, the European Council will review the developments and situation on the financial markets and the whole financial stability dossier will be the main topic of an informal ECOFIN meeting to be held in Slovenia in April.

The agenda of the co-legislators on these issues is also unfolding: The Slovenian Presidency work programme for ECOFIN includes the follow-up of the current review of the Lamfalussy regulatory process and the enhancement of the EU’s arrangements for financial crisis management, as well as the launch of a new three-year cycle of economic reforms under the EU’s Lisbon strategy for growth, in particular with regard to financial services. So the March ECOFIN review transparency of the situation in the financial sector, improving evaluation and risk management standards, as well as consider the work of ratings agencies. Financial stability issues will also be dealt with at the informal ECOFIN meeting in April. But ECOFIN “broadly supports” the initiatives identified by the Commission for retail financial services so that will be transmitted to the spring meeting of the European Council.

Returning to Single Market business, the European Parliament adopted the Consumer Credit Directive at its Plenary Session and chose to apply it within limits of €200 and €75,000. As this compromise had been worked out with Council, it only now needs formal adoption by Council, but the reservations remain. For example, the EBF noted the adoption of the CCD after some six years of intense discussions but fears that the text generates doubts as to whether this directive will really help build a more integrated and competitive consumer credit market in Europe. The consumer credit providers – represented by Eurofinas- were more forthright: “Regulatory fragmentation will persist.”

Echoing some of the sentiments of the ECB, the Bank of England warned about Basel II as the way banks are regulated threatens to make the financial sector even more vulnerable to recessions. The Bank argues that the updated Basel rules will make the financial sector more reliant on credit rating agencies for assessing how much risk to apply to its assets and liabilities. Because these agencies' ratings tend to rise and fall depending on the state of the economy, the Bank warned that the new regime threatened to make the banking system more "pro-cyclical" - in other words prone to booms and busts.

The role of the rating agencies was examined at another ECON Public Hearing. Ms BERÈS noted that rating agencies had been used by some as scapegoats for the current crisis but she felt they could only furnish the results for which they had been mandated. But she also stated that the role of the rating of a structured financial product was different from that of the rating of a debt. She described the question of a conflict of interests as an important element and raised the question of a code of conduct. Standard & Poor's foreshadowed some of Lamfalussy’s sentiments, stressing the limited role of ratings, as they only provide an opinion on the probability of a failure and do not address liquidity. The entire rating process was carefully catalogued by AMF in their report.

Meanwhile, the trigger of the specific European angst – Northern Rock – was in the news continuously in January as the UK Treasury proposed a financing structure, raising funds from investors in the financial markets backed by a mixed pool of assets and a government guarantee. Northern Rock would pay a fee for this guarantee in addition to the fees for the existing guarantee arrangements which will continue. Any proposal relying on this financing structure is likely to involve state aid, which would require approval by the European Commission, and will submit a restructuring plan to the Commission by 17 March. But Mlex highlighted that Northern Rock is not the only such institution the regulators are dealing with as competition decisions are due soon about German bank IKB. Sooner or later, the Commission must ensure competition is preserved and state aid rules are applied – but how to view a potential nationalisation in state aid terms as Northern Rock will be competing for loan business with competitors who do not benefit from such government backing? The Treasury Committee of the UK’s House of Commons issued a scathing report on its investigations into the fiasco and the “Conclusion and Recommendations” should be compulsory reading across the EU.

A group of hedge funds - the whipping boys of 2007 –published best practice standards for hedge fund managers. The voluntary standards include adoption of independent valuations for portfolios and robust governance of funds. Compliance with the hedge fund standards will be voluntary and will operate on a ‘comply or explain’ basis. For the Financial Stability Forum, Mario Draghi welcomed the Hedge Fund Working Group’s best practice standards and highlighted that these standards should be seen as the beginning of a process that might converge with initiative of the US President’s Working Group.

Asset managers were challenged by both Commission and Parliament to develop new ideas in pension delivery which could provide some level of guarantee to retirement incomes but which do not restrict investments to the fixed income market. The Commission is keen to hear of new ideas for the development of defined contribution pension products which would allow a mixture of investment strategies over the life of the product but which still provide some form of guaranteed income at retirement. But this also requires an improvement in the financial literacy of citizens if they are to understand such products.

DG Competition’s decision on Mastercard’s interchange fees continues to reverberate even though the Commission made clear that it did not conclude that all MIFs are illegal per se. “The reason we found this MIF illegal was because MasterCard could not demonstrate that its MIF contributed to objective efficiencies, or that it benefited consumers.” Commissioner Kroes was also worried that market participants appear to have interpreted the SEPA Cards framework in a way that a card scheme is only SEPA compliant if it covers all 31 states of the SEPA territory.

Looking beyond the EU, the Commission has now formally adopted a Regulation enabling it to present concrete proposals on which third country GAAPs should be accepted as equivalent with effect from 2009. The Commission will also be entitled to allow third country issuers to use their GAAPs in the EU for a transitional period ending in 2011 at the latest, provided these countries are converging with IFRS or the respective third country intends to adopt IFRS. This Regulation sets out the grounds on which third-country Generally Accepted Accounting Principles can be found equivalent to International Financial Reporting Standards (IFRS) which are adopted by the EU.

The importance of these developments was underscored by a visit to London of top representatives from the entire Japanese securities industry to promote the Japanese market as a whole to overseas investors. Japan is in the process of introducing a series of specific policy measures which are intended to strengthen the competitiveness of its financial and capital markets and so make them more attractive to foreign investors.

A number of reform and deregulation measures have already been implemented in the Japanese financial and capital markets since the Japanese version of Big Bang financial system reforms that started in the late 1990s. The breadth of the discussions at the joint ICMA/JSDA seminar on regulatory policies, stock exchanges’ strategies, accounting standards and the legal framework for investment showed that these measures can give a momentum to future growth in Japan’s financial and capital markets.
Post script: Policymakers grappling with the ripples reaching European shores from the US sub-prime tsunami should delve into Peter Norman’s book “Plumbers and Visionaries” to understand the reasons for the financial structures in the EU. But the appeal of the book is wider. Anyone entering the securities business today will find that its will give them the history of the “plumbing” companies interwoven with the political, economic, financial and technological events that moulded the capital markets at the time. The general reader should not find it difficult to follow the story, which is grippingly relevant to current economic circumstances.

************************

Graham Bishop

© Graham Bishop