04 January 2016

The Importance of being `Equivalent’

The Fed has just raised interest rates; the crisis must be over; so we can bin all the crisis “governance” stuff! Or can we? No. The lessons learnt in the heat of the crisis are now hard-coded into the genetic structure of global financial regulations and cannot just be ignored if they happen to be an inconvenient truth. They may be particularly inconvenient for British advocates of leaving the EU and converting British financial regulations into a system based on the general principles laid down by international bodies. Recently, Commissioner Hill pointed out this `inconvenience’ – graphically and clearly.

Lehman Brothers failed in September 2008 and the entire financial world trembled at the edge of the abyss. Politicians reacted and the G20 (rather than G7/8) was suddenly elevated to become the central global player. In November 2008, the G20 leaders met in Washington and adopted Common Principles for Reform of Financial Markets including the commitment “…we will implement reforms that will strengthen financial markets and regulatory regimes so as to avoid future crises…. However, our financial markets are global in scope, therefore, intensified international cooperation among regulators and strengthening of international standards, where necessary, and their consistent implementation is necessary…”

The British government of the day was instrumental in turning these concepts into a detailed global, action plan at the April 2009 London Summit. “we also agree to establish the much greater consistency and systematic cooperation between countries, and the framework of internationally agreed high standards… This will be done in close coordination at international level in order to achieve as much consistency as possible across jurisdictions.”

The European Union is a formal member of the G20 so it is the main mechanism for the final step of converting this still rather high-flown political rhetoric into detailed legislation that binds financial institutions operating on the Union’s territory. Then-Commissioner Barnier often began speeches by referring to the EU fulfilling its commitments to the G20. EU legislation can take the form of Directives, which then have to be transposed by national governments into their own domestic law. The Commission then checks that it has been transposed accurately and completely – following up with enforcement proceedings if needed. However, in the spirit of creating a `single rulebook’, an increasing amount of detailed legislation is being put into force by Regulation, as they take direct effect throughout the EU.

Many of these legislative actions are now binding on financial institutions as the transposition periods have elapsed e.g. CRDIV/CRR, Solvency 2. Others – such as MiFID/MiFIR – may come into force with a delay. But it is these precise legal texts that will be enforced by national supervisors and courts – not some general international principles such as Basel 3, even if they are quite detailed.

Since the dawn of the Single Market era in 1992, the EU has struggled with the problem of the extra-territorial reach of other states’ financial regulations – especially those of the United States.  But the G20 meetings of 2008 and onwards recognised fully that a single commercial entity might be operating globally and must be properly overseen and regulated to avoid the risk of contagion. But such a firm might have subsidiaries and branches in many states, so the question is `whose rules’?

To avoid a nightmare of practicalities, the answer from the EU was that it would accept the operations of financial institutions providing they were subject to rules that are “equivalent” to those of the EU. This concept gives effect to the G20 spirit of close co-ordination and consistent implementation. The EU cannot abandon this approach without abandoning its commitment to the whole G20 process.

“In certain cases the EU may recognise that a foreign legal, regulatory and/or supervisory regime is equivalent to the corresponding EU framework… Typically, equivalence provisions require verifying in an assessment that a third-country framework demonstrates equivalence with the EU regime when it comes to:

1.      having legally binding requirements,

2.      having effective supervision by authorities,

3.      achieving the same results as the EU corresponding provisions and supervision (outcome-based analysis).”

The third, outcome-based analysis, may be the one that is highly inconvenient for Brexiteers if they genuinely intend to move UK regulations away from slavishly following evolving EU rules. In a remarkably frank intervention, Commissioner Hill spoke at a recent “FT Future of Europe Breakfast”. He was particularly firm and clear on some Brexit issues that are key for the future of the City of London. “Some say that if there is Brexit, there is no risk because the UK will get the same access (or even better). This is a complete and fundamental misunderstanding of how the rules work. They are misleading about the consequences for business models. People need to be honest… you cannot have your cake and eat it… I do not believe there is a respectable argument that you can leave and have the same access as now…”

These are powerful words for the Commissioner – a former Leader of the House of Lords – to use in the heart of the City at a time when the Brexit debate is strengthening and the future of the City of London is fast becoming a key element in the negotiations. Be “equivalent” or be “out”.

© Graham Bishop