European Union: The EU response

Author: | Published: 1 Oct 2009
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The global financial crisis has led to calls for reform from legislators across the globe. The European Commission (Commission), influenced largely by the February 25 2009 report by Jacques de Larosière (de Larosière Report), has been among the most active in proposing reforms. The Commission's proposals include new regulatory bodies at the European level, changes to the way financial institutions are regulated in the EU, and changes to the regulation of certain financial products.

Although the crisis is global, and the G20 has taken a leading role in the regulatory response, the proposals of legislators, including the Commission, do not uniformly take a global approach.

Readers of this guide will invariably be active in both the EU and US. If new regulations in the EU and US conflict or do not provide for workable mutual recognition mechanisms, the efficacy of those regulations may be diminished and financial institutions operating on a global scale will face significant challenges in continuing those operations.

From the reports assessing the causes of the crisis and proposing regulatory reform, a general consensus has emerged on two elements. First, all systemically important institutions, instruments and markets should be regulated, preferably under the umbrella of a consolidated supervisor in each jurisdiction. Second, reform will be implemented at a national, not a supranational or international, level. These two elements contain an inherent conflict, as most systemically important institutions, instruments and markets are global rather than national. In this light, if the reforms are implemented on a jurisdiction-by-jurisdiction basis, there is the risk of inconsistency (both as to approach and as to timing) between different jurisdictions and different markets. In the case of EU initiatives, there is a tension between, on the one hand, the Commission's efforts to create a more centralised and harmonised financial regulatory system in Europe with, on the other hand, the independence to which EU member states are accustomed in this sector. This is an addition to potential tensions between the reforms proposed in the EU and the US.

The Commission and the European Council have called for an enhanced European financial supervisory framework, which will be composed of two new bodies: the European Systemic Risk Board (ESRB) and the European System of Financial Supervisors (ESFS).

The ESRB will be responsible for macro-prudential oversight; specifically monitoring and assessing potential threats to financial stability that arise from macro-economic developments and from developments within the financial system as a whole. It will not have any regulatory authority over financial institutions or markets. The ESFS will consist of a network of national financial supervisors working in tandem with three new European supervisory authorities: the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority. These three new bodies will replace the existing Committees of Supervisors, known as Level 3 committees, that advise the Commission under the Lamfalussy process. These proposals are designed to create a framework within which financial risk at the EU level will be supervised, and through which the actions of national supervisors may be coordinated. The new institutions will develop, in effect, a single European rulebook that will harmonise the differences in the national approaches to the transposition of existing and future community law, creating a core set of standards common to all member states. However, that rule book will be implemented at a national, not European, level.

The position in the US is complicated because of the division of responsibilities amongst various agencies. Recent US proposals would coordinate these agencies through the creation of the Financial Services Oversight Council, which would be composed of representatives from multiple agencies and chaired by the US Treasury Department. This body will also have a more formal role in the regulatory process. This approach is broadly similar to the position in the EU, in that a supervisor, comprising representatives from various bodies in the sector, will monitor risk on a macro-basis and act accordingly through those bodies. The interaction between the ESRB and its US equivalent will be key to the success of both initiatives. How this will occur remains to be seen.

As regulatory oversight will remain the principal responsibility of financial institutions' home regulator, issues arise as to how those home regulators will coordinate their efforts. One problem resulting from a lack of coordination between nations may be described as regulatory territorialism. For example, as demonstrated by the collapse of the Icelandic banking system, it is important to consider the relationship between the home regulator and the regulators in jurisdictions where branches are established (host regulators). The risk is that host regulators, in an effort to protect their local markets, will (if they do not already) ring fence the assets of a foreign branch or require foreign banks to operate through subsidiaries rather than branches as a way of doing cross-border business.

Another problem arising out of insufficient international cooperation is inconsistent or incompatible regulation. Cross-border regulated entities face potentially inconsistent regulations in jurisdictions in which they do business, thereby increasing the difficulty and cost of compliance. The traditional answer to this problem has come in one of two forms. First, different jurisdictions may aim to minimise differences in their regimes. Second, a host jurisdiction may, in deference to a foreign regulated entity's home regulator, take a light-touch approach to that entity. Importantly, both approaches require coordination at a supranational level.

To this end, one approach is to appoint colleges of supervisors, such as bodies comprised of national supervisory authorities of major cross-border financial institutions to address risk and regulatory issues on a global level. For example, the Financial Stability Board (FSB), a G20 council constituted by a representative from all G20 members, Spain and the Commission, has been mandated to facilitate supervisory colleges. Thus far, the FSB has established over thirty supervisory colleges.

The FSB has also published principles of cooperation for supervisors, central banks and finance ministries in preparing for financial crises and in managing them when they happen. At this stage, however, certain matters remain unclear, such as: the role and effect of such guidelines at a national level; and the consequences, if any, of a nation's failure to implement those guidelines.

Two crucial areas for international coordination are capital adequacy and accounting standards.

In the case of capital adequacy, reforms will certainly be directed at improving the quality, quantity and international consistency of capital in the banking system, preventing excessive leverage, and creating capital buffers. In the EU, the de Larosière report noted that a key goal is consistency of approach as to what constitutes Tier 1 capital, a project in which the Committee of European Banking Supervisors has been granted a central role. On the other hand, the G20 was clear that reform to capital requirements should only be implemented once global economic recovery is assured, since it is difficult in today's markets for financial institutions to raise additional capital other than from governments. The assumption is that Basel II will be revised and then, hopefully, implemented in a more coordinated and timely fashion than the initial version. The G20, in its September 5 and 6 meeting, issued a statement on banking which identifies certain necessary action: "Rapid progress in developing stronger prudential regulation by: requiring banks to hold more and better quality capital once recovery is assured; introducing countercyclical buffers; developing a leverage ratio as an element of the Basel framework; an international set of minimum quantitative standards for high quality liquidity; continuing to improve risk capture in the Basel II framework; accelerating work to develop macro-prudential tools; and exploring the possible role of contingent capital. We call on banks to retain a greater proportion of current profits to build capital, where needed, to support lending."

In the case of the accounting standard, cross-border inconsistency and a freedom of choice in the past resulted in similar institutions following different accounting standards. This affected their apparent health as the financial crisis hit. The G20 has called for improved accounting standards which deal with cyclicality, especially when used to determine capital adequacy. In the EU, the Commission has called for reflection on the mark-to-market principle and, in particular, recommended that expeditious solutions be found to accounting issues such as: the treatment of complex structured products; the valuation of assets in illiquid markets where mark-to-market cannot be applied; and the pro-cyclical and short-term approach promoted by current accounting standards. Similarly, in the US, in response to Congressional pressure, the Financial Accounting Standards Board (FASB) has issued guidance on mark-to-market accounting, particularly in the areas of impairment of debt securities and estimating values in illiquid markets. The American Bankers Association has criticised FASB, amongst other things, for not going far enough toward the use of economic value, as opposed to market value, for bank balance sheet accounting. The International Accounting Standards Board (IASB) has announced that it is reviewing its standard in that respect.

The IASB, whose standards have been adopted in the EU with respect to publicly traded companies, will have to cooperate effectively with FASB in the US to achieve the goals set by the G20. In October 2008, the IASB and the FASB set up the Financial Crisis Advisory Group which recently released a report highlighting the necessity of convergence of standards between the two entities. The implementation and enforcement of any agreed standards continues to be a significant concern.

The efforts in the EU and the US to plug holes in the regulatory structure have so far focused on alternative investment funds (in particular hedge funds and private equity funds) and credit rating agencies.

An important category of financial company that has so far not been regulated on a comprehensive basis is alternative investment funds, in particular hedge funds and private equity funds. There seems to be a growing consensus among legislators that hedge funds, at least, should be regulated in some capacity, though the precise content of such proposals remains unclear. There is less consensus as to whether private equity funds should also be regulated and, if so, how the approach should differ from that for hedge funds.

The G30 proposed that, rather than directly regulating hedge funds, the advisors of hedge funds (and possibly private equity funds) be registered and licensed in the jurisdiction in which the advisors reside as opposed to where the fund is incorporated (since many of the funds are incorporated in tax havens such as the Cayman Islands). Under the proposal, information about funds and advisors would be available not only to the regulator of the advisor but also to a systemic regulator (if there is one) overseeing macro-economic developments in the market. Such information would be confidential and would pertain to, amongst other things, the fund's liquidity needs, leverage, risk concentrations and possibly counterparties.

The Commission has proposed a Directive on Alternative Investment Fund Managers (AIFM Directive) which would, with certain exceptions, create a comprehensive supervisory framework for the registration and regulation of all non-retail alternative investment funds.

The proposed AIFM Directive has been intensely criticised for imposing onerous and unworkable requirements, failing to distinguish between the types of risks posed by different types of funds, and discriminating against non-EU funds. Although the Commission's proposal provides for a mutual recognition mechanism, this mechanism would be available (at the earliest) three years after the deadline for implementation of the directive and would be subject to conditions that may be difficult, if not impossible, to satisfy. In particular, mutual recognition would be available only if the Commission finds that a non-EU fund's home regulatory system is equivalent to the directive. It would be difficult for the Commission to declare US funds eligible for mutual recognition under its own proposal, since US reforms, as discussed below, take a different approach to regulating alternative investment funds. In this light, it seems likely that the Commission's proposal will be extensively revised. The Swedish Presidency has recently acknowledged this and other problems with the Commission's approach.

The proposal in the US is less restrictive. Primarily, the approach is to widen the net of those advisors caught by registration, disclosure, compliance or conduct-of-business requirements and fiduciary responsibilities. However, in contrast to the EU proposal, US regulation would not impose capital, leverage or similar financial requirements on hedge funds or private equity funds, other than financial holding companies whose size or other factors make them systemically significant, as determined by an interagency committee.

There is also a broad consensus that credit rating agencies (CRAs) must be tightly regulated. On July 27 2009, the Council adopted a regulation establishing the legal and regulatory framework for CRAs (CRA regulation).

The CRA regulation aims to: ensure CRAs avoid and appropriately manage any conflict of interest and remain vigilant on the quality of ratings and rating methodologies; increase CRAs' transparency; and implement an efficient registration and surveillance framework to prevent forum shopping and regulatory arbitrage. The CRA regulation applies only to credit ratings issued by agencies registered within the EU and which are intended either to be disclosed publicly or distributed by subscription. Foreign CRAs and their EU affiliates will be supervised through a college of supervisors coordinated and moderated through the Committee of European Securities Regulators.

As in the EU, major policy concerns caused by CRAs in the US are the management of conflicts of interest and the transparency of ratings methodologies. Other countries are also considering reforming CRAs. As more countries go down this path, issues will arise as to the potential effects of one jurisdiction's regulation of CRAs in other jurisdictions.

It is generally agreed that derivatives (and the markets in which they are traded) must be regulated. There is a growing view that market participants should be required to use central counterparties to clear transactions as a way to reduce the systemic risk of the insolvency of an important market participant.

On July 3 2009, the European Commission released a communication entitled Ensuring efficient, safe and sound derivatives markets, accompanied by a Staff Working Paper (together, the Derivatives Communication). It is expected that the European Commission will present legislative proposals in line with the Derivatives Communication recommendations by the end of 2009.

Based largely on the de Larosière report, the Derivatives Communication surveys the derivatives market and assesses current measures to reduce risk. The Derivatives Communication calls for an increased use of central counterparties, particularly in relation to standardised over-the-counter (OTC) products. Major derivatives dealers committed to the European Commission to move to the central clearing of credit default swaps referencing European companies by July 31 2009. The Commission is considering other ways to encourage the use of central counterparties, thereby managing risk on the derivatives markets. The Derivatives Communication also encourages execution of trades of derivatives on an organised trading venue in order to provide increased price transparency and strengthened risk management. It proposes the promotion of standardisation of OTC derivatives to promote product fungibility, as well as to increase legal certainty and operational efficiency. Transparency in derivatives markets will be further increased in the EU by the extension of the Transaction Reporting Exchange Mechanism, the system through which European regulators exchange transaction reports under the Markets in Financial Instruments Directive, to OTC derivatives linked to instruments already caught by that reporting system.

In the US, the reforms proposed in this area are more specific. The reforms proposed would, among other modifications, require broad categories of standardised OTC derivatives to be cleared by regulated clearing houses and traded on exchanges or exchange-like trading facilities.

Certain problems require consideration in light of such proposals. For example, central clearing requires standardisation of contracts. Many OTC derivative contracts are bespoke and cannot be cleared or regulated in the same way as standardised contracts.

The collection of relevant information also plays an important role. The Derivatives Communication advocates that for trades outside the central counterparty mechanism, increased transparency should be pursued through the creation and maintenance of a central data repository, which would contain information on the number of outstanding contracts and the size of outstanding positions in a particular contract. Similarly, in the US, it has been proposed that the US Commodities Futures Trading Commission and the Securities Exchange Commission impose recordkeeping and reporting requirements on all OTC derivatives. Certain of these requirements could be satisfied by clearing or, in cases of bespoke OTC derivatives, by reporting such trades to a regulated trade repository. Central counterparties and trade repositories would then publish aggregate data regarding open positions and trading volumes and provide regulators (on a confidential basis) information regarding individual counterparties' trades and positions. In the US, the Trade Information Warehouse operated by the US Depository Trust and Clearing Corporation already acts as such a data repository for credit default swaps.

Opinions differ on reforming the regulation of the origination and sale of asset-backed securities, in particular mortgage-backed securities, to align the interests of originators and investors. Problems arose out of the originate-to-distribute model, whereby intermediaries purchased securities from the originators of those securities solely for the purpose of resale. As the intermediaries did not intend to hold the securities in their own portfolio, they lacked the incentive to ensure the integrity of the securities' underlying assets.

One response is for skin-in-the-game regulations, whereby originators must retain an interest in tranches sold to investors (between 5% and 10%), thereby motivating them to maintain the integrity of the underlying assets. The European Council has adopted a directive amending credit institutions' capital requirements, requiring the originators of asset-backed securities in the EU to retain 5% of the risk transferred or sold to investors on their own balance sheets. Similar proposals have been made in the US and by International Organization of Securities Commissions.

Both the EU and US are moving on a variety of fronts to improve their financial regulatory systems in response to the financial crisis. The Commission and the European Council have been particularly active, proposing major reforms and accelerating the implementation of measures that were already under way. There is still considerable uncertainty regarding the final shape of some of these initiatives. Some initiatives seem likely to create tension with member state governments, while others may result in difficulties for institutions active both inside and outside the EU. On both sides of the Atlantic Ocean, the key challenge will be to ensure that steps towards reform reflect a global consensus reached in the G20 and to ensure that the move to tighten regulation of the financial system does not create unintended barriers for global financial institutions.

The authors wish to thank various members of the Cleary team for their assistance with this article. For more detailed and regular updates of regulatory measures in the UK, US and around the world, please see the Financial Crisis Resource Center on the Cleary Gottlieb homepage, created to provide public and timely information relating to the distress in global financial markets.

About the author

Edward F Greene is a partner based in the New York office of Cleary Gottlieb Steen & Hamilton LLP.

His practice focuses on securities, corporate governance, regulatory and financial services reform and other corporate law matters.

Greene served as General Counsel of the Securities and Exchange Commission from 1981 to 1982 and director of the Division of Corporation Finance from 1979 to 1981. From 2004 to 2008, Greene served as General Counsel of Citigroup’s Institutional Clients Group. He oversaw all legal aspects related to the group’s activities with issuers and investors worldwide, including investment banking, corporate lending, derivatives, sales and trading and transaction services. He served as Chairman of the Institutional Clients Group Business Practices Committee in connection with his responsibility for regulatory and transactional matters.
Contact information

Edward Greene
Cleary Gottlieb Steen & Hamilton LLP

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New York 10006
T: +1 212 225 2030
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About the author

James Modrall is a partner based in the Brussels office of Cleary Gottlieb Steen & Hamilton LLP.

He practises extensively in the area of EC and international competition law, in particular the review and clearance of international mergers and acquisitions. He also practises in a wide range of corporate and financial areas, in particular mergers, acquisitions, joint ventures and restructurings.

Modrall is a member of the bars in New York, Washington DC and Brussels. He is also a member of the American Bar Association and is active in its Antitrust Section, including as vice chairman of its Unilateral Conduct Committee (2005 to 2009) and vice chairman of its International Antitrust and Foreign Competition Law Committee (2003 to 2005).
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James Modrall
Cleary Gottlieb Steen & Hamilton LLP

Rue de la Loi 57
1040 Brussels
T: +32 2 287 2000
F: +32 2 231 1661

About the author

Andrew C Shutter is a partner based in the London office of Cleary Gottlieb Steen & Hamilton LLP.

Shutter’s practice focuses on the origination and restructuring of international debt and equity financing transactions. He represents issuers, borrowers and financial institutions in international capital markets, syndicated bank lending, project finance, derivatives and securitisation transactions. He also has experience in mergers and acquisitions, joint ventures and strategic investments.

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Andrew Shutter
Cleary Gottlieb Steen & Hamilton LLP

City Place House
55 Basinghall Street
London EC2V 5EH
T: +44 20 7614 2200
F: +44 20 7600 1698