Introduction: ICMA: Open questions

Author: | Published: 1 Oct 2009
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From its beginning as a modest offshore market, the international capital market – with Europe at its heart – has grown into a broad and deep market of around €10 trillion serving the needs of governments, supranationals and corporates from all over the world. From year to year and decade to decade, the market has expanded dynamically across all geographical and product areas. This has helped the free movement of capital across borders and the integration of economies, removing obstacles and building bridges linking the different national markets together, and enhancing structural reform and monetary integration.

Onset of financial crisis and the initial response

The dynamic development of the international capital market and accelerated globalisation has led to ever-more complex markets with many new asset classes. These pose market-related, legal and practical challenges to market participants as well as to supervisory and political authorities. Added to this has been the experience of the international financial crisis of the last two years. This has highlighted many respects in which more work is needed for a robust regulatory environment, designed to meet the challenges of today's financial market place. The period of the crisis has been marked by massive intervention by the financial authorities, particularly in the US and in Europe, in an attempt to restore orderly markets – through the recapitalisation of banks; the provision of government guarantees on interbank lending; and in some cases government purchases of toxic assets, all accompanied by a dramatic easing of monetary policy and selective fiscal stimulus, country by country, but in a coordinated pattern. The critical question continues to be whether this proves to be sufficient to adequately revive bank lending to the private sector, or whether further steps will be needed.

Conjunctively, in response to the crisis, the authorities are already moving towards changes in the regulation of the financial system. Globally, their starting point was the Group of 20 (G20) Summit in Washington last November. This was accompanied at European level by the February report on the supervision of the financial system, prepared by a panel of wise men chaired by Jacques de Larosière.

Following the subsequent G20 Summit in London on April 2, the immediate priority remains to recover from the international financial crisis by restoring confidence:

  • There is a consensus that monetary easing and fiscal stimulus are needed to end the global recession, though views differ about whether enough has been done already or more needs to be done.
  • The second objective is to stabilise the financial system through government involvement, where necessary, in restructuring banks (by insuring or purchasing so-called legacy assets to clean up bank balance sheets) and recapitalising them (by providing sufficient equity to withstand future losses if the market is not willing to provide it), as well as by providing guarantees on future lending until confidence is restored.
  • The third objective is to devise an exit strategy through the eventual sale of government-owned shares and tightening monetary and fiscal policy again when economic conditions permit.

But the longer-term issue is how to prevent another crisis on a similar scale, in which regard the G20 work plan lays out a lengthy list of tangible regulatory reforms. Progress reports affirm that these are being swiftly advanced through the ongoing efforts of various international fora, such as the IMF, and standard setting bodies, such as the Basel Committee on Banking Supervision. The September Pittsburgh G20 Summit meeting continues to build on all of this. It is equally clear, from both the de Larosière report, prepared for the European Commission, the subsequent EU communications and recommendations built thereon and the Turner review, prepared for the UK Chancellor, that there will be a new approach by the authorities in Europe – working within the global context. This will address each of financial regulation, the supervision of financial institutions and the stability of the financial system as a whole.

What can the market expect and what further issues need to be resolved?

What can the market expect?

Details of the main elements of the new system of financial markets regulation have not yet all been agreed, but – as things stand going into September 2009 – the proposals include the following:

  • Prudential supervision will be more intrusive, in the sense that supervisors will want to know in more detail what is going on – so that they can assess the systemic implications, rather than, as in some countries in the past, relying on a light-touch regime.
  • There will be much more emphasis on the effective regulation of liquidity.
  • The regulation of capital adequacy will change. Banks will in due course need more capital and of higher quality, particularly against risk taking on the trading book (less leverage will be permitted than in the past); and a maximum gross leverage ratio may be imposed as a back-stop.
  • A counter-cyclical capital regime is likely to be introduced, with capital buffers being built up in good times so they can be drawn down in difficult times.
  • The authorities are seeking powers to collect information on all significant unregulated financial institutions to allow assessment of overall system-wide risks.
  • Prudential regulation of capital and liquidity should extend to "bank-like institutions" – if they threaten financial stability.
  • Host supervisors are likely to rely less on home supervisors, following the Lehman insolvency; and host supervisors are likely to insist on having more control over foreign branches, or to convert foreign branches into subsidiaries, following the Landsbanki case.
  • Banks are being encouraged to tie pay to long term performance rather than short term profit – where that is not already the case.
  • There is continuing pressure for more transparency – though there are many ways in which much of the financial system is reasonably transparent already.
  • Financial markets will become more resilient, for example by increasing the role of central counterparty clearing houses; and reducing reliance on credit rating agencies.

Delivery of European micro-prudential supervision will remain the responsibility of national supervisors, but their efforts will be supported both by colleges, to face the challenges of cross-border groups, and a newly formed cohesive body, the European System of Financial Supervision (ESFS). The ESFS will draw upon the endeavours of three new European Supervisory Authorities, formed through the evolution and expansion of the three existing Level 3 committees: the Committee of European Securities Regulators (Cesr); the Committee of European Banking Supervisors (CEBS); and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). Flanking and supporting these revised institutional arrangements will also be a series of harmonisation measures, to deliver a single European rulebook; consistency of supervisory powers; and equivalent sanctions.

In addition a new European Systemic Risk Board (ESRB) will be established. The ESRB will be established as a new independent body, responsible for safeguarding financial stability by conducting macro-prudential supervision at the European level. The creation of the ESRB – to work in conjunction with the International Monetary Fund (IMF), the Financial Stability Board (FSB) and third-country counterparts – seeks to address one of the fundamental weaknesses highlighted by this crisis, which is the exposure of the financial system to interconnected, complex, sectoral and cross-sectoral systemic risks.

What further issues need to be resolved?

These proposals leave a number of important issues still to be resolved. First, what is systemically significant? Traditionally, there has always been an element of constructive ambiguity about this. But since the insolvency of Lehman Brothers, almost all significant financial institutions – and not just banks – in trouble have potentially had systemic implications: in a crisis, they are too large or too interconnected to fail. Some part of the solution lies in improved resolution frameworks, allowing for the orderly and rapid administration of failing institutions, but this is particularly challenging when faced with the complexities of cross-border entities and the associated divergence of the legal frameworks under which they operate.

Second, how should the authorities deal with financial institutions that are too large to be rescued by the small countries in which they are based? In the current crisis, as the Governor of the Bank of England has pointed out, financial institutions which have been global in life have become national in death. This is a particularly difficult issue in the case of banks operating cross-border in the euro area, where there is a single central bank, but national ministries of finance are the effective lenders of last resort, and it is not agreed how the burden is to be shared between them. Inter-related questions, such as the valuation of legacy assets and the continued divergence in accounting standards between the EU and the US, present further complicating issues.

Third, how can effective counter-cyclical policies be devised to allow regulation of the growth of the financial system? If it does become possible to rely on counter-cyclical policy as a "third leg of the stool", alongside monetary policy and fiscal policy, then financial crises may be less likely in future and economic recessions less severe. But are the authorities in practice prepared to lean against the wind in an economic upturn? After all, some regulators and central banks warned in advance about the risk of the current crisis (though none foresaw its scale), but they were not able to agree on what action to take and might have faced political resistance had they sought to do so.

Fourth, how to marry the top-down assessment of systemic risks with the bottom-up supervision of financial institutions? This proves difficult enough between ministries of finance, central banks and regulators at national level. But national authorities cannot easily act alone, given that regulation of the EU single market derives from European rather than national level; and that the financial markets are global in nature.

Fifth, how quickly should proposed new regulations be implemented? Banks may need more capital in future, but imposing new capital requirements now is likely to limit their ability to lend and delay the recovery.

Sixth, can the market play a role by regulating itself? The de Larosière report draws attention to the opportunity for the market to play such a role, so long as it implements its own proposals and supervisors are able to verify this. The crisis has clearly highlighted questions related to the value of self-regulation, but it undoubtedly still has an important role to play – as an integral component within a broader regulatory framework.

Finally, is it sufficient to assume that all financial crises are essentially the same, or could the next one be different? That risk is not a reason for failing to do what we can to learn the lessons from this crisis in an attempt to make the next one less severe than it otherwise might be.

In closing

In its activities ICMA has very often been the frontrunner in creating the framework of cross-border issuing, trading and investing, and has constantly helped to build the relationship amongst all market participants. In its dual capacity as a self-regulatory organisation and a trade association, ICMA has initiated numerous sets of standard practices to help develop efficient and well-functioning markets. ICMA is and always was a strong voice, in the promotion of free capital flows across borders and all other efforts on the long road to integrated capital and financial markets.

In this crisis, ICMA continues to play a major role, particularly due to its unmatched geographical and institutional diversity. As a cross-border association, ICMA sponsors and brings together sell and buy-side, works on the improvement of the legal framework and continues to see its mission to service the market as a whole. ICMA will continue to represent general market matters and views to those monetary and regulatory authorities vested with the responsibility to create the appropriate framework for a national and international financial system. In stressing that self-regulation can help to solve problems more efficiently, ICMA sees itself operating as a partner to these bodies.

About the author

David Hiscock joined the International Capital Market Association (ICMA) as Senior Advisor, Regulatory Policy in November 2008. He coordinates ICMA’s policy work on various initiatives undertaken on behalf of its members and the international capital market, particularly in response to current global market turbulence.

Having initially qualified as a UK Chartered Accountant, prior to this appointment Hiscock spent over 20 years at JP Morgan, where he had a variety of roles most recently that of Managing Director and European Head of Hybrid Capital Structuring.
Contact information

David Hiscock
International Capital Market Association (ICMA)

7 Limeharbour
E14 9NG
United Kingdom
Tel: +44 20 7517 3220