The Great Financial Plumbing

From Northern Rock to Banking Union

Karel Lannoo

• Publisher: Centre for European Policy Studies
• Year: 2015
• ISBN:
  9781783484294
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Auditoría

The financial crisis has led to a far-reaching redesign of the European regulatory and supervisory framework. Following the commitments made in the context of the G-20, but also reacting to internal shortcomings, the EU engaged in a massive program to re-regulate financial markets. The EU furthermore redesigned the structure for supervisory cooperation, initially through the European Supervisory Authorities, and later in its ambition to form the Banking Union. In The Great Financial Plumbing, Karel Lannoo systematically assesses the new regulatory and supervisory framework. The book’s structure follows the big questions on the agenda: 1) What is Banking Union?
2) How have the concerns of the G-20 been addressed by the EU (oversight of credit-rating agencies, better capital for banks, the re-regulation of securities and derivatives markets, asset management, depositor protection and bank resolution)?
3) How were uniquely EU rules on state aid applied to the banking sector? This book is designed to give professionals, policy-makers and students a better understanding of the new regulatory framework and insights into the policy context that has led to the new rules governing financial markets in Europe.

1. THE POLICY REACTION TO THE CRISIS: A MOVING TARGET

This is not just another volume about the causes or the history of the financial crisis. Rather, it is a book about the actions taken by the European Union to prevent a crisis of this magnitude from ever erupting again. A far-reaching redesign of the European regulatory and supervisory framework was undertaken, following the commitments the EU made in the context of discussions in the G-20 summit meetings¹ and in reaction to serious internal shortcomings. The creation of a Banking Union (BU) with the shift of banking supervision from national authorities to the European Central Bank (ECB), at least for the eurozone, and the creation of a Single Resolution Board (SRB) have been the most tangible outcomes.

This book aims to systematically discuss and assess the new regulatory and supervisory framework in a readable and accessible way. The structure follows the big themes on the agenda: What is changing with Banking Union? Have the G-20 concerns been adequately addressed by the EU: oversight of credit rating agencies, better and more capital for banks, the re-regulation of securities and derivatives markets, asset management, depositor protection and bank resolution? And how were uniquely EU rules on the prohibition of state aid applied to the banking sector during the crisis?

Although much has been done at the global, regional and national level, this book concentrates on the response taken directly by the EU to the financial crisis. Some EU member states in particular, spurred on by their electorates, have taken action, but not necessarily in coordination with entities at the EU level. Attention is paid, however, when the response by EU member states has contravened EU rules, most importantly regarding those governing state aid to the banks. This book does not discuss the EU’s reaction to the economic crisis, although both crises ran in parallel, at least from 2010 onwards, as the worsening of the fiscal situation of the sovereigns affected the domestic banking sectors in the distressed countries and led to the formation of Banking Union.

This book presents seven different themes of re-regulation and new supervisory structures, in line with issues dominating the global and European agenda. Action on these items has not necessarily been coordinated. A political consensus grew at different stages during the crisis that action was necessary. Some policy actions even pre-date the financial crisis, such as the efforts to regulate rating agents. Other elements came very late, such as recognition of the need to transfer supervision to the ECB, as it became clear that the level of supervisory cooperation created with the European Supervisory Authorities (ESAs)² was insufficient to deal with the problems in the European banking sector. But the different themes are sequenced chronologically, in the same order as they emerged during the crisis.

Seen in hindsight, much was achieved at EU level over a period of about seven years. From the early days, in the second half of 2007 to June 2012, when agreement was reached on transferring banking supervision to the ECB, and to early 2014, when agreements were reached on the EU’s bank recovery and resolution Directive (BRRD) and the Single Resolution Mechanism (SRM). No less than 38 different actions in the area of financial reform were proposed by the European Commission during that period, most of which were completed by the end of 2014. These proposals entailed even more legislative actions, as often the particular financial reform was split over different legal instruments, a directive and a regulation, for example, or was further subdivided.

In the early days of the crisis, which was caused by growing risks and losses in the US subprime housing market, it rapidly became clear that the EU regulatory framework was inadequate and that supervisory cooperation was not as strong as it should have been, given the level of market integration. In certain domains, the reaction took time to materialise in concrete proposals, whereas in others, it crystallised rapidly. The bank run on Northern Rock in September 2007 – the first since Victorian times in Britain – emphasised that essential elements of the framework for managing a financial crisis simply did not work, and that the operational model and the level of harmonisation of the 1994 Directive on deposit guarantee schemes (DGS) were seriously flawed. But it was not until 2014 that agreement was finally reached on the need to implement real reform at EU level.

The failure of two local German banks in September 2007 revealed three major shortcomings: the absence of supervisory cooperation (or the presence of destructive regulatory competition in the EU), the deficiencies in the prudential rules covering securitisation and consolidation, and the lack of proper risk management in the banks. It brought about a consensus among EU member states on the need to insist on maximum harmonisation of rules and a fully identical set of financial rules, namely the ‘single rulebook’, and to improve supervisory cooperation and the functioning of the supervisory colleges of banks. The building blocks for an upgrade of the three Committees of Supervisors, the so-called ‘Level-3 Committees’ – the Committee of European Banking Supervisors (CEBS), the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) and the Committee of European Securities Regulators (CESR) – were being put in place that would eventually equip them to become fully-fledged agencies. On the legislative side, agreement was reached in the early days of the crisis that rating agencies should be regulated at EU level and the treatment of securitisation in the first capital requirements Directive (CRD I) should be changed.

On the more systemic side, however, there was scant awareness among policy-makers in the first year of the crisis, leading up to the failure of Lehman Brothers, of the deep weaknesses in the EU financial system and in its oversight.³ Against the background of mounting losses in the EU financial system, estimated at the time to amount to about €272 billion, no fundamental decisions were taken towards more centralised oversight. The finance ministers, meeting in the Ecofin Council, reacted by issuing a roadmap and increasing the level of tasks for the Level-3 Committees, but without upgrading their means or legal status. In its May 2008 meeting, the Council stressed in its conclusions: “The EU Committees of Supervisors should be able to gather aggregate information in order to assess these features within and across financial sectors and to alert the Economic and Financial Committee (EFC)⁴ to potential and imminent threats in the financial system.”

One may wonder, however, whether the Council fully appreciated the magnitude of the task it was assigning to the Level-3 Committees, each of which employed only about 15 persons. The Council also reacted with a new memorandum of understanding amongst the supervisory authorities, central banks and finance ministries to improve supervisory cooperation and the functioning of the Colleges. No less than 113(!) different EU authorities were signatories to the agreement. A more serious reaction, considering the staggering losses that were then mounting in the financial system, would have prepared the EU much better for confronting what was still to come.

The phase that started in September 2008 is well known, but many policy-makers continued to believe that the problem was caused by the US financial system. There was not only the failure of Lehman Brothers, but also the bail-out by the US Treasury of the insurance giant AIG and the growing problems in US monoline insurers. AIG alone received an emergency loan of $85 billion from the Federal Reserve of New York, $22.4 billion of which went to banks, and more than half of the latter sum went to European banks in collateral relating to credit default swap (CDS) transactions from AIG. Its default would thus have meant even-deeper trouble for European banks.

The biggest shock for the banks in Europe came from the short-term lending market, which froze almost overnight. Banks with a large amount of short-term loans on their balance sheets, often related to takeovers or risky business models, were the first victims, such as Dexia or Fortis in Belgium. Lending costs jumped overnight. The crisis had become systemic, which forced EU governments to react. Ireland was the first country to guarantee liabilities in its banking system, forcing the UK and other EU countries to follow suit. The Dutch, British and French governments suggested the creation of a European banking resolution fund, but Germany was strongly opposed to such an idea. The country-by-country reactions and the existence of a variety of national bank guarantee and bail-out schemes led to deep distortions in the single market, which fundamentally changed the landscape of European banking. The overall level of the support, representing about 14% of GDP, helped EU countries to recover rapidly, but it also lay the ground for the ensuing sovereign crisis, by rapidly increasing government-debt levels and highlighting the differences in the quality of public finances.

The EU reacted by instituting the High-Level Expert Group on EU Financial Supervision, chaired by Jacques de Larosière, former Governor of the Bank of France. The de Larosière report proposed, inter alia, the creation of the European System of Financial Supervisors (ESFS), composed of the European Supervisory Authorities (ESAs) and the European Systemic Risk Board (ESRB), and called for a meeting of the G-20 at the level of heads of state and government. The latter convened first in Washington, D.C. in November 2008, and set the stage for a globally coordinated process of financial re-regulation in the successive London and Pittsburgh G-20 summits. The London G-20 agreed “to extend regulation and oversight to all systemically important financial institutions, instruments and markets…to take action, once recovery is assured, to improve the quality, quantity, and international consistency of capital in the banking system”, to regulate rating agencies and hedge funds, and to ensure that “all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties”, and “to develop an international framework for cross-border bank resolution arrangements”. The Financial Stability Board (FSB) within the G-20 was given the central role of leading this process.

The G-20 agenda was followed-up closely by EU policy-makers, and formed the background on which the majority of the proposals for regulatory reform were based. But it became rapidly clear that the institutional reform that was intended by the creation of the ESAs was not sufficient, above all for banking. The stress tests carried out by the European Banking Authority (EBA) did not succeed in calming fears about the state of the EU banking sector, as their results were in each case rapidly overtaken by events. The stress test of July 2010 – which had been carried out by EBA’s predecessor (the CEBS) – concluded that an additional €3.5 billion capital was needed for about seven banks, five of which were Spanish. But by mid-August 2010, the moribund Anglo-Irish Bank, although it had not been included in the test, was in need of another transfusion of €10 billion and by September, it appeared that the capital needs of Spanish savings banks were much greater than originally foreseen. The 2011 stress test was followed by growing uncertainties about the capital needs of these Spanish banks, which were estimated to be around €60 billion, whereas the test had concluded that the minimum shortfall for eight banks in meeting a 5% core tier 1 ratio was about €2.5 billion. The deep uncertainties in European financial markets at that time led to a formal decision at the level of the heads of state and government in the October 2011 European Council to require EU banks to meet a 9% Tier 1 ratio by June 2012.

The sovereign crisis and the dreaded ‘doom loop’ created by the dependence of banks on the quality of the finances of their sovereign was the second element leading to the decision for deeper institutional reform, and the creation of a Banking Union. The wide differences in funding costs of banks risked derailing the single financial market, as the cost of credit to banks in the peripheral countries was much higher than in the North. This also risked undermining the single monetary policy.

The second report prepared under the leadership of Herman Van Rompuy (2012) and published ahead of the June 2012 European Council, proposed the creation of a Banking Union, to be composed of a single European banking supervision system, a European resolution and a European deposit insurance scheme. The European Council decided, barely two years after the start of the European Banking Authority, to move supervision to the ECB, based upon Art. 127(6) of the EU Treaty. Agreements on the deposit guarantee schemes Directive (DGSD) and the Single Resolution Mechanism (SRM) followed in early 2014, even if reaching agreement on the centralisation of the latter function at the eurozone level was problematic in view of the reach of the EU Treaty.

1.1 The book at a glance

Credit Rating Agencies: The early targets (chapter 2). From having virtually no rules, the EU moved with great alacrity to agree on regulation and centralised supervision of credit rating agencies (CRAs) in a matter of a few months. But the rules did not change the ‘issuer-pays’ model of rating agents and its inherent conflicts of interest. Five years after the Regulation on credit rating agencies came in force, the sector remains highly concentrated, with the Big 3 – Standard & Poor’s (S&P), Moody’s Investors Services and Fitch Ratings – controlling about 90% of the EU market. Also the regulatory reliance on ratings remains elevated, despite the ambition to reduce it, as both supervisors and monetary policy authorities continue to refer to ratings for policy purposes. A more fundamental change in the business model of rating agents could have avoided the detailed conflict-of-interest, transparency and competition provisions of the regulation.

Game Change in Asset Management (chapter 3). The asset management industry was more affected by the crisis than its representatives acknowledged. Not only did it solidify the view that the hedge fund industry should be regulated, but it also spilled over to other parts of the asset management industry, and more prudential and conduct-of-business regulation was adopted. The Ponzi scheme perpetrated by Bernard Madoff fell apart by the end of 2008, highlighting the lack of separation between depositories and managers. More conflict-of-interest and remuneration regulation followed in the wake of the overall debate over the distorted incentive structures found throughout the financial industry.

Solidifying Derivatives Markets and Financial Infrastructure (chapter 4). One of the hallmarks of the London and Pittsburgh G-20 summit meetings was the determination to require central clearing of OTC (over-the-counter) derivatives contracts, at least for the contracts that can be standardised. The result was a huge structural change, which a few years later brought the largest part of the OTC market into central clearing and trading. These changes, however, required detailed discussions on which products should be centrally cleared and even more on the prudential standards for central counterparties, which are still in the course of implementation.

New Capital Requirements: Basel III implementation in EU law (chapter 5). The element that attracted the most attention as a result of the crisis, namely the banks’ lack of capital, required extensive discussions before agreement was reached on the new rules at international level, with the Basel III agreement in December 2010, and even more time to formulate the EU rules in the capital requirements Directive (CRD IV) in September 2013. In the meantime, some steps were taken with the addition of ‘skin in the game’ or retention requirements for securitisation in 2009, and the governance and remuneration amendment...

Table of contents

• List of Figures, Tables and Boxes
• List of Abbreviations
• Foreword
• Preface
• 1. The Policy Reaction to the Crisis: A moving target
• 2. Credit Rating Agencies: The early targets
• 3. Game Change in Asset Management
• 4. Solidifying Derivatives Markets and Financial Infrastructure
• 5. New Capital Requirements: Basel III implementation in EU law
• 6. The ECB as Bank Supervisor under the Single Supervisory Mechanism
• 7. Recovery and Resolution, the Single Resolution Mechanism and Deposit Guarantee Schemes
• 8. The EU’s Bank State Aid Policy during the Crisis
• 9. Conclusions: Safe to bank?
• Annex: Overview of banking and finance legislation