In my article for this week's European financial regulation update I suggest that the attention of financial regulators will be turning to non-banking activities and shadow banks in the future as they step-in and fill the void left by hamstrung banks.
Article in full:
Banks have been put under sustained regulatory pressure since the
financial crisis. Their business models have been turned upside-down and
inside-out as politicians seek a path towards a more traditional
approach to banking. In Europe we may just be seeing an end in sight for
significant new legislation aimed specifically at regulating banks
(although the tinkering will go on for years). Over the next year,
attention will be turning to non-banking activities and shadow banking.
There are already signs that many different political agendas will
influence this debate.
The Capital Requirements Directive IV (CRD IV/CRR) is the seminal
package of capital, liquidity and corporate governance reforms
implementing Basel III in Europe. It passed a significant hurdle on 5
March 2013, when the Economic and Financial Affairs Council (EcoFIN)
agreed to its key terms, confirming a provisional agreement reached with
the European Parliament (EP) at the end of February (you can see our US
colleagues’ reaction to the agreement here).
The legislation now enters its final phases with adoption by the EP
plenary in April. That will be followed by a legal/linguist expert
review, prior to final adoption by the EcoFIN Council (possibly in May)
and publication in the Official Journal. This removes one key priority
from the Irish Presidency’s list and its focus has already shifted to
moving forward with the EU banking union, with the Recovery and
Resolution Plan proposal being progressed in parallel with ongoing
negotiations on the Single Supervisory Mechanism. Getting CRD IV out of
the way will free up some time and resources for legislators to
concentrate on other risky areas of the financial system.
Banks have made some strides in moving on from past mistakes. They
have begun replenishing their damage balance sheets, refocusing their
attention on their core operations and jettisoning more risky investment
and shadow banking activities. But they have a long way to go, and keep
finding more non-c0re assets that need to be off-loaded. For the latest
on bank deleveraging, see our report, European outlook for non core and non performing loan portfolios: A growing non core asset market.
This deleveraging process will make banks smaller, less interconnected
and less of a systemic headache for supervisors. But as banks shrink,
others are filling the gaps.
The European Fund and Asset Management Association estimates that the
investment fund assets in Europe increased by 12.4% to €8,944 billion
in the last quarter of 2012. Non-banks (e.g. insurance companies and
hedge funds) are also gearing up for a greater role in credit
intermediation process—particularly in terms of providing long-term
credit for businesses. As more money flows into these markets, concerns
about the formation of asset bubbles and financial contagion heighten.
The presence of these systemic vulnerabilities may force the hand of
regulators to make more structural and operational reforms in these
markets to protect consumers, the wider financial system and the
In particular, improving risk management practices across financial
markets will be a key area of focus for regulators. This month, both the
European Banking Authority (EBA) and the International Organisation of
Securities Commissions (IOSCO) separately issued principles on exchange
traded funds (ETF) and collective investment schemes (CIS) respectively
to harmonize risk managements practices in these industries.
ETFs have become a hot topic with various reports (Financial
Stability Board (FSB), International Monetary Fund (IMF) and the Bank
for International Settlements) calling for increased surveillance of
these funds, noting that their impacts on market liquidity and on the
financial institutions servicing the funds are not yet fully understood,
especially during periods of acute market stress. The FSB are
particularly concerned about the potential systemic risks arising from
the complexity and relative opacity of some ETFs which have branched out
to new asset classes (e.g. fixed income, derivatives, and commodities)
with thinner liquidity. Regulators are worried that the leverage
embedded in the new breed of ETFs could pose financial stability risks
if equity prices were to decline or interest rates increase. The IMF has
also suggested growing popularity of ETF products may be contributing
to equity price appreciation in some emerging economies.
On 18 December 2012, ESMA published final guidelines on ETF and other
UCITS issues. The final guidelines contain a number of changes
following feedback to its consultation early in the year.
Controversially, the ESMA guidelines confirm all income generated
through securities lending arrangements should be given to the fund,
except for direct and indirect operational costs. Currently, market
practice in many EU Member States is for the UCITS management company or
a facilities agent of the securities lending arrangement to take a cut
of the revenue generated from securities lending, but this may no longer
be possible under the guidelines.
This month, the focus has shifted onto the risk management
responsibilities of banks and the interactions with ETFs. On 7 March
2013, the EBA published an opinion which provides guidance on the
evaluation of risks that might emerge at bank level through their
operational relationships with ETFs.
The opinion discusses good practices relating to:
- risk governance and permanent ETF risk management function
- general funding requirements and liquidity
- credit risk and collateral management
- market risk
- the stress testing framework
- conflict of interest policy.
The good practices are not legally binding, and their implementation
will depend on the specific characteristics of the credit institutions
concerned as well as on their involvement in ETF operation.
The EBA’s opinion was issued just after the release of the IOSCO
Technical Committee’s final report on principles of liquidity risk
management for CIS. IOSCO called on CIS operators to ensure that the
liquidity of their open-ended CIS allows them to meet redemption
obligations and other liabilities. Before and during any investment,
they should consider the liquidity of the types of instruments and
assets in which the CIS invests and their consistency with the overall
liquidity profile of the open-ended CIS. While liquidity risk is a
particular concern for open-ended CIS, certain aspects of the principles
are also relevant for closed-ended funds (for example, they may need to
meet margin calls or other cash commitments to counterparties on a
So what’s next? The European Commission (EC) is expected to issue
legislative proposals this month focusing on money market funds which
may echo issues covered in the recent European Systemic Risk Board
Recommendation (of 18 February 2013) advocating, amongst other things,
the conversion to variable Net Asset Value (NAV) funds to address
systemic concerns of ‘runs’ on constant NAV funds, as experienced by
some funds particularly in the US during the financial crisis. As with
the developments discussed earlier, this will focus on ensuring
financial stability. However, the EC is also planning to launch
legislative proposals on long-term investment funds by the summer, in
parallel with a wider review of issues relating to long-term finance of
the economy. This plays to the sustainable growth agenda which, if a
semblance of financial stability remains in Europe, is likely to come to
the fore given the economic challenges facing the Union more broadly.
We will have to wait and see whether the EC’s proposals strike the right
balance between these two important objectives, and whether what comes
out of the political machine at the end of the day does likewise.