2017 is set to be a year of acceleration in the pace of regulation of the financial services sector at global and European levels. The Basel Committee on Banking Supervision (BCBS) is making steady progress on plans including a leverage ratio surcharge for global systemically important institutions (G-SIIs). The Financial Stability Board (FSB) is also consulting on guiding principles and new global standards on how banks can be resolved in an orderly way should the worst happen.
The Single Supervisory Mechanism, within the European Central Bank, has identified monetary policy, including the ultra low or negative interest rate climate, potentially bad loans, geopolitical concerns and a potential reversal of risk premia in financial markets as among the biggest threats to financial stability in the banking sector in the year ahead.
Review of European Market Infrastructure Regulation
As the clock ticks down ahead of the January 2018 deadline for implementation of the Revised Payment Services Directive (PSD2) and the Revised Markets in Financial Instruments Directive (MiFID2), the European Commission is beginning work on its review from next April of the European Market Infrastructure Regulation (EMIR). Ostensibly, this latter REFIT review of the existing EMIR will focus on action to improve regulation of derivatives markets and central counter-parties, but it is being seen by others as an opportunity to repatriate to the Eurozone areas of financial markets architecture, such as the Euro-denominated trading in securities clearing based in London. Three quarters of such securities are cleared in London, and such a strategy could fracture the pooling of swaps and weaken European access to capital markets in London. Whatever the politics, it is difficult to see any economic benefit for the Eurozone in such an approach.
Progress on Capital Markets Union
If, as many believed, the aftermath of the UK’s vote to leave the European Union, and the departure of Jonathan Hill as Commissioner for Financial Services, would stall the desire of the EU institutions to deepen their plans for Capital Markets Union, they have been mistaken. The prospective departure of the United Kingdom from the EU, probable in spring 2019, has renewed momentum among the EU-27 to make speedy progress on EU personal pensions, securitisation markets, lending to small and medium sized enterprises, and on further aspects of banking reform, including making European banks less dependent on wholesale funding as a source of long-term financing for their operations.
New legislation on capital requirements, bank recovery and resolution
Hill’s successor, Commission Vice-President Valdis Dombrovskis, recently proposed making revisions to the Capital Requirements Regulation (CRR), the Capital Requirements Directive (CRD), the Bank Recovery and Resolution Directive (BRDD) and the Single Resolution Mechanism Regulation (SRMR), and with draft legislation on counter-party reform, as well as current legislation on reform of securitisations, this adds up to a significant package, designed to increase access to growth-enabling finance across the EU. Overall, the changes seek to introduce a binding leverage ratio of 3%; a net stable funding ratio (NSFR) governing stable, long-term sources of funding for institutions; and most controversially for some member states, such as the UK and Germany, new standards on the total loss-absorbing capacity (TLAC) of global systemically important institutions (G-SIIs), requiring those banks or financial institutions to carry more loss-absorbing and recapitalisation capital – at least 16% of risk-weighted assets by 2019, rising to at least 18% by 2022.
Given the stricken nature of several of Italy’s banks, and the difficulty of options for their recapitalisation, the need for structural reforms to deepen the Banking Union is essential. Progress on a single deposit guarantee scheme remains slow given political objections by some leading member states, so reforms will focus around strengthening the capacity of systemically important banks on sufficient capital buffers to deal with financial turbulence and to be resolved if the worst happens, without recourse to public funds.
The revisions to the CRR and CRD will introduce the requirements from the Basel Committee on Banking Supervision and the Financial Stability Board into the EU legal framework. They build upon the bail-in machinery introduced by the BRRD which ensured that regulators ascertain a minimum requirement for own funds and liabilities eligible for bail-in for each institution (known as MREL). From this, banks must have sufficient instruments that can be bailed-in by resolution authorities in the event of resolution being necessary, either by writing down shares and debt instruments or converting bail-inable debt instruments into new shares to recapitalise distressed institutions (contingency-convertible or coco bonds have a critical role here). The European Banking Authority has just issued a technical report echoing the FSB approach on MREL, namely that equity should not count equally towards MREL and capital buffers at the same time. In such circumstances, it recommends stacking capital buffers above MREL or by treating them as parallel frameworks.
The proposed legislative changes go further in one key respect however, the prospective requirement for the establishment of intermediate EU parent undertakings from third country banking groups headquartered outside the EU, which have two or more entity imprints within the EU with assets of more than €30bn (although this restriction on assets would not apply to non-EU G-SIIs). This would mean major US, or Swiss banking groups would be required to establish an intermediate EU parent undertaking (either an EU-regulated holding company, or via a separate banking institution within the EU) if they had two or more separate banking entities operating within the EU area. This could also have major implications post-2019 for a UK outside the EU, depending on the terms of any agreements around its departure.
The big question about 2017 is whether the incoming US administration will lead to a rethink among EU policymakers. The synergies between the Obama administration, the EU and the wider G20, over the proper regulatory balance between protecting taxpayers and the wider economy, promoting lending to the real economy, and ensuring that banks could be resolved in an orderly way if they failed, may be upended by a Trump administration signalling a willingness to reduce regulations upon the financial services sector to boost growth. How the UK and the EU respond in 2017 will be a test of economic, as well as regulatory, intent.
Written by William Bain, Head of Fintech, Financial Services and the Brexit Advisory Unit