It was a rather unusual statement that European Commission president, Jose Manuel Barroso, made in October 2008 in the wake of the Lehman Brothers’ bankruptcy. Turning his back on the usual “laissez-faire” mantra, he indeed publicly acknowledged the need to “rethink regulatory and supervision rules for financial markets“. Echoing alter-globalist rhetoric, he also emphasised firmly his wish to ensure that in the future such markets “function properly for the benefit of citizens and businesses, rather than themselves“.
Five years later, Mr. Barroso assesses with great satisfaction the work that has been achieved in this field. Speaking in September 2013 at the G20 Summit in Saint Petersburg, he ensured that, on financial regulation, “Europe has come very far in regulating financial markets“. It is true that, with more than 30 European Union laws enacted since 2008, the European Commission has been kept very busy with the regulation of the financial sector. Furthermore, there is absolutely no disputing the fact that these new pieces of legislation will contribute to reducing excessive risk-taking activities within the financial system. In that sense, they represent a significant reversal of previous internal market policies, which were systematically geared towards promoting the interests of the industry.
Two main factors have contributed to this change of direction. The most important one is undoubtedly the cost of the financial crisis. Between October 2008 and 31 December 2012, Member States provided €591.9 billion (4.6% of EU 2012 GDP) of capital support (recapitalisation and asset relief measures) to the financial sector. The guarantee measures and other forms of liquidity support reached their peak in 2009 at €906 billion (7.78% of EU 2012 GDP), dropping by almost half to €534.5 billion (4.14% of EU 2012 GDP) in 2012. Given that these unprecedented rescue programs were entirely funded by the taxpayer, policy makers have been left with no other choice but to adopt measures to deleverage the financial sector. Not acting would have simply amounted to political suicide. The second factor – although of lesser importance – lies in the personality of the current Internal Market Commissioner, Michel Barnier. While his predecessor, Charlie McCreevy, was a notorious supporter of market self-regulation, the French Commissioner’s political mind-set has proven to be relatively more open to tougher regulation.
Given that these unprecedented rescue programs were entirely funded by the taxpayer, policy makers have been left with no other choice but to adopt measures to deleverage the financial sector.
Although such regulatory moves have to be welcomed, it would be misleading to view them as the result of a paradigm shift in the way the EU approaches financial reforms. There are two main reasons for this. First of all, as outlined above, this trend is cyclical (not structural): the newly adopted legislative measures are essentially an institutional response to the current public anger at irresponsible bankers. But, as the trauma of the 2008 crisis recedes, the momentum for further financial reforms should progressively slip away. Secondly, although the progress made since 2008 in the field of financial integration is unprecedented, it still falls far short of what is needed to build a resilient financial sector and curb speculation. An explosive combination of intense lobbying from the industry, defensive positions from Member States (always eager to protect their own national ‘banking champions’), and ideological conservatism from a large majority of the Members of the European Parliament (MEPs) has led to the enactment of financial laws that lack ambition and are full of loopholes.
This is indeed the conclusion that can be drawn from the analysis of some of the key aspects of EU financial reforms that is provided below.
The banking reform jigsaw
The EU banking reform is far from being a uniform process. It comprises many different legislative components, which are progressing at different paces and intertwine in a complex way.
Three major steps have been taken in this respect during the 2009-2014 parliamentary term: first, the adoption of the so-called CRDIV package; secondly, the establishment of a single supervisory mechanism (SSM) and, thirdly, the agreement on the EU framework for bank recovery and resolution (BRRD).
In some respects, the adoption of the CRDIV package (April 2013) – which transposes, via a Regulation and a Directive, the new global standards on bank capital – constitutes the most significant breakthrough in terms of regulating Europe’s banking sector. Under this new prudential regime, bankers’ bonuses will be capped at twice their salary, banks will be subject to a strict transparency regime (under which they will be forced to disclose their activities in tax havens) and, for those which are deemed ‘too big to fail’ (i.e. banks whose bankruptcy would have serious consequences for the financial system and real economy), additional capital requirements will be introduced. However, these positive aspects must not be allowed to conceal the fact that the CRDIV package contains serious shortcomings. In particular, it does not include a binding leverage ratio for banks, which represents a failure to take firm action to limit leverage in the banking system. Furthermore, the CRDIV package introduces new liquidity rules that are much too weak to successfully limit EU banks’ excessive reliance on short term and unstable sources of funding. Yet, the 2008 crisis has highlighted how such dependence creates additional vulnerabilities within the financial system.
The agreement on a single supervisory mechanism (SSM) (concluded in March 2013) – the first stage in the establishment of a European Banking Union – was another major political achievement of the parliamentary term. As of November 2014, the European Central Bank (ECB) will be indeed fully entrusted with responsibility for the supervision of all banks in the Eurozone (and of those countries which decide to join the banking union), including the direct supervision of around 130 of Europe’s most ‘significant’ banks. While this new supervisory authority is essential to overhaul the current disjointed light-touch national supervision, it lacks nevertheless transparency and accountability. It is indeed unhealthy in a democracy to concentrate so much power in one institution, all the more so as the ECB will find it difficult to depart from its corporate culture of non-accountability. Furthermore, the European Parliament’s scrutiny role under the new framework is much too weak. According to the terms of the interinstitutional agreement concluded in September 2009, the ECB will only be required to submit to the European Parliament the information from the minutes of the Board of Supervisors that it regards as most important. Yet, the European Parliament should at least have had full access to the minutes of both the Board of Supervisors and the Governing Council.
The adoption of the EU framework for bank recovery and resolution (BRRD) in December 2013 is the third major step of the ongoing EU banking reforms. Needless to say that this new legislation – which aims at minimising taxpayers’ exposure to banks’ losses – is of crucial importance. Specifically, it states that shareholders and creditors shall be responsible for any bank losses up to 8% of the total assets before a resolution fund – based on contributions from the banking sector – or the State can intervene.
These so-called “bail-in” provisions are however tempered by two major negative aspects of the new legislation. Firstly, EU finance ministers have managed to insert in the text a provision allowing Member States to recapitalise their banks in a ‘preventive’ manner. In other words, if future banking stress tests reveal problems with the credit-worthiness or capitalisation of banks, the BBRD rules will allow for the use of public funds to prop them up. While any request will be subject to a priori approval by the European Commission, this is still a major setback.
Secondly, the provisions on the crisis management of cross-border banks are completely inadequate. Originally, the European Parliament wanted to ensure that the European Banking Authority (EBA) could arbitrate on cases where a bank crisis resolution was subject to dispute among national authorities. However, as a result of pressure from the Council, this was not included in the final deal. Instead, national authorities will be able to deviate from the burden sharing plans established in advance of resolutions.
Although three key banking legislations have already been adopted since 2009, the reform process is far from over. While some legislative pieces are entering into the final stage of negotiation between the Parliament and the Council (such as the single resolution mechanism (SRM), second pillar of the banking union), others are still in the pipeline (such as the upcoming rules on shadow banking or on structural reforms). It can already be safely predicted that the debate on structural reforms – which relates to the mandatory separation of high-risk trading activities of banks – will be one of the hottest issues of the next Parliamentary term.
The EU has clearly failed to deliver a regulatory response in line with the magnitude of the stakes. The adoption of legal provisions capable of effectively curbing unbridled speculation has been insufficient.
The OTC derivatives conundrum
Besides new rules on banking regulation, dozens of legislative texts aimed at bringing financial markets under control have also been endorsed since 2009. Their scope encompasses both the players of such markets (such as alternative investment funds (i.e. hedge funds and private equity funds), credit rating agencies, money market funds, etc.) and the financial instruments that are being traded on.
We will focus in this section on two major legislative files tackling the issue of derivatives, which were blamed for exacerbating the financial crisis. Although these financial instruments were originally used as hedges, they are indeed increasingly being used for purely speculative purposes (to bet on future changes in interest and exchange rates, share prices, the price of raw materials, or the risk of a loan not being repaid). Furthermore, 90% of the derivatives market is made up of so-called ‘over the counter’ (OTC – bilateral) transactions, which fall outside direct regulatory supervision.
The political agreement reached in February 2012 on over-the-counter derivative products (the so-called EMIR) was a key step towards tighter financial market rules. A crucial new provision is that the majority of privately traded over-the-counter derivatives will have to be cleared through central counterparties (CCPs). CCPs’ prime responsibility is to provide stability by reducing the risk of market participants defaulting on obligations. More specifically, they impose margin requirements and other risk controls in order to mutualise losses among trade participants.
While this new legislation will definitely contribute to bringing over-the-counter derivatives transactions out of the shadows, it is still much too inadequate to reduce risk in the financial system, and may even be counterproductive. As noted by Satyajit Das, expert in finance, CCPs may actually be the ultimate case of “too big to fail”: “the CCP effectively changes the structure of markets from a network that can survive one or more failures to a hub-and-spoke system that is vulnerable to a single failure. This increases risk concentrations within financial markets”.
Another key file dealing with the issue of derivatives is the newly revised legislation on markets in financial instruments (the so-called MiFID II) that was adopted last January. A key provision is the introduction of a new type of trading venue, called an organised trading facility (OTF), which is designed to trade over-the-counter derivatives. By doing so, the EU intends to comply with its G20 commitments according to which over-the-counter derivatives transactions should not only be processed through central counterparties (see above), but also take place on a regulated trading venue, with the aim of making them more transparent.
It can already be safely predicted that the debate on structural reforms – which relates to the mandatory separation of high-risk trading activities of banks – will be one of the hottest issues of the next Parliamentary term.
One may, however, question the new OTF category’s added value as it largely overlaps with existing regulated markets and multilateral trading venues and has weaker regulatory requirements (in particular on pre-trade transparency). There is thus a clear risk that the new OTF category will simply attract volumes away from regulated venues, while not reducing over-the-counter derivatives volumes.
Two other key provisions of MiFID II aim at reducing excessive price volatility in commodity derivatives markets. First of all, a position reporting obligation by category of trader will be introduced in order to help regulators and market participants to better assess the role of speculation in these markets. Secondly, competent authorities will be empowered to limit the size of a net position which a person may hold in commodity derivatives (traded on trading venues and over the counter) if there are concerns about disorderly markets. Provided that the European Securities and Market Authority (ESMA) properly calibrates the methodology for calculating these limits to be applied by national authorities, the measure could help to reduce the scope for gambling on food prices. This being said, given that such limits will be set nationally, rather than at the European level, there is a real risk of a ‘race to the bottom’ as member States could compete to set weaker limits.
Complex regulation: toothless reaction?
Despite some progress towards a more robust and safer financial sector, the EU has clearly failed to deliver a regulatory response in line with the magnitude of the stakes. The adoption of legal provisions capable of effectively curbing unbridled speculation has been insufficient. Instead, up to now, emphasis has been largely put on increasing the transparency of financial operations. This provides evidence that neoclassical economics, and in particular the rational expectations theory, still form the theoretical basis of EU policy-making. From this point of view, the more markets become transparent, the less regulation becomes relevant.
Although transparency undoubtedly facilitates the oversight capacity of competent authorities, it is however insufficient to bring the finance industry back under control. A radical shift – in the way the EU approaches financial regulation – is certainly needed to reach such a goal. This requires in the first place switching from complex to simple rules (i.e. rules that do not rely on assumptions and estimations, are not risk-sensitive, etc.) that are by their very nature less likely to be manipulated. In this respect, the introduction of stringent rules for the separation of banking activities (between those which are essential to society and those which are not), or a tax on the derivative liabilities of large banks would provide a good starting point. Simplifying financial provisions will be the most important challenge of the next legislative term.
 ‘Over-the-counter’ (OTC) markets are informal financial markets (primarily derivatives) in which there is no clearing house rules or binding rules governing trade. In other words, the conditions are left to be freely negotiated among investors.
 In the event of a default by one of the counter-parties, the CCP will use the margin posted by the defaulting counterparty to cover the losses incurred.
 In terms of commodities markets, experts consider that there is a level of speculation that is good, or even necessary – typically around 20-30%. But, today, speculation makes up around 70-80% of the activity.