«Summer 2014 Review of the Balance of Competences between the United Kingdom and the European Union The Single Market: Financial Services and the Free ...»
2.16 Bank failures tend to occur when banks are no longer able to fund themselves. In the past, such failures have been rare. This is because banks are so interconnected to each other and to the economy as a whole that an outright failure of a large bank would risk causing major disruption to the wider economy. Governments have typically stepped in to prevent the knock-on effects of failure using public money. Since markets are aware that large banks are unlikely to be allowed to fail, market discipline against excessive risk-taking tends not to operate. One major global policy objective since the financial crisis has been to make it possible for banks and other systemically important financial institutions to fail in an orderly way without causing collateral damage to the rest of the economy.
2.17 This objective has led to two policy initiatives: to upgrade depositor protection so as to discourage a retail run on the bank where depositors, fearful that a bank may fail, rush to withdraw all their money and thereby trigger the event they fear; and to make it easier to resolve a failing bank without placing it into insolvency and thereby causing large scale disruptions to the wider economy.
2.18 Regarding this first initiative, the financial crisis highlighted that the level of compensation paid to retail depositors in the event that a bank failed was inadequate. Because the rules of the Single Market permitted a bank authorised and supervised in one country to borrow money from depositors in another Member State, without that Member State being able to supervise it prudentially or demand from it prudential information,7 a harmonised deposit guarantee scheme was established with minimum compensation of €18,000. The collapse of the Icelandic banks and the run on Northern Rock highlighted the inadequacies of this limit, which was increased in a revision to the Deposit Guarantee Schemes Directive to €100,000 (£85,000) and which requires the money to be paid within 20 working days.8 CRD IV harmonised liquidity requirements and changed the branching regime so that host states ceased to have responsibility for branch liquidity but in respect of significant branches do now have rights to information and to participate in defined areas of supervisory decision-making.
In the UK, depositors are paid within 7 days.
26 Review of the Balance of Competences between the United Kingdom and the European Union:
The Single Market: Financial Services and the Free Movement of Capital
2.19 The second policy initiative was designed to make it easier to resolve a failing bank without placing it into insolvency and thereby causing large scale disruptions to the wider economy or a threat to public funds. In line with the international standards as set out by the FSB, the EU’s Bank Recovery and Resolution Directive (BRRD) sets out a range of measures to
help achieve this policy goal:
• First, by improving arrangements to help facilitate the recovery of institutions in difficulties, including through recovery planning and early intervention powers for supervisors, and to enhance resolvability, including through powers to require institutions and banking groups to take steps to facilitate the ease with which resolution tools may be applied in the event of failure;
• Second, by setting out a common set of resolution tools which may be applied in the event of failure as an alternative to insolvency; and
• Third, by placing those who lend to banks, especially bond-holders, at risk of being turned into shareholders and then having the value of that shareholding written down against the bank’s losses.
2.20 Overall, these measures will help ensure that the authorities can restructure failing institutions to restore viability at little or no direct cost to the tax-payer. The BRRD also provides for resolution financing arrangements in Member States, and the EU’s revised State aid rules require bond-holders to be bailed in as a condition for State aid.
Investment Firms and Markets
2.21 Banks are functionally characterised by the combination of borrowing large sums of money in relation to their own (shareholders’) funds, and of their borrowings being for short periods of time while their lending is for much longer periods (‘maturity transformation’).
Securities markets, by contrast, avoid the risks associated with banking. They permit those with money to buy an equity exposure to a company in the form of shares or to provide debt financing in the form of bonds.
2.22 Over the last thirty years, banks found that their larger corporate customers were viewed as a better credit risk by the bond markets and so were able to raise money more cheaply than banks could do.9 This phenomenon of ‘disintermediation’ pushed banks into protecting their franchise by seeking to become major players in the securities markets too. The institutional obstacles inhibiting fully fledged investment banking by commercial banks were removed in the UK in 1986 as a result of ‘Big Bang’ and in the US as a result of the repeal of the Glass-Steagall Act in 1999.10
2.23 Securities markets depend for their health on the quality of rules that promote price discovery, the ability to trade cheaply, fairly and quickly particularly at times of market The relative decline in the perceived credit-worthiness of banks was highlighted by their large losses on sovereign debt to Third World countries in the 1980s.
‘Big Bang’ is a phrase used to described the deregulation of UK securities markets on 27 October 1986.
This involved the abolition of fixed commission, ending the sectoral demarcation between jobbers and stock-brokers, permitting them to be owned by outside corporations, moving the London Stock Exchange from open-outcry to screen-based trading, and turning it into a private limited company. The long term result of Big Bang was the purchase of jobbers, brokers and the small UK merchant banks by large international banks, paving the way for modern investment banking. The Glass-Steagall Act is the US banking legislation that was passed in 1933, which prevented securities firms and investment banks from taking deposits and prevented commercial banks from undertaking most kinds of securities business, including: dealing in non-governmental securities for clients, investing in non-investment grade securities for themselves, underwriting or distributing non-governmental securities, or permitting commercial banks to affiliate with securities firms or investment banks.
Chapter 2: Current State of Competence 27volatility, the robustness of arrangements for settling trades, for authorising and supervising intermediaries and for deterring market abuse. Securities markets are therefore characterised by extensive rules in these areas. Within the EU, there are harmonised requirements that are designed to create a single market through the adoption
of common rules:
• The Prospectus Directive covers information which companies seeking to raise money (whether as equity or debt) need to provide to potential investors and the way in which it is to be provided;
• The Transparency Directive sets out detailed rules as to how companies that have issued securities must report to the markets in a timely way about their performance, in particular if an event arises that is likely to affect the value of their securities;
• The Markets in Financial Instruments Directive (MiFID) covers: the platforms for the trading of financial instruments, both exchanges and alternative venues; the trading of these financial instruments, in particular rules covering pre- and post-trade transparency; and the authorisation and conduct of intermediaries in financial markets;
• The European Market Infrastructure Regulation (EMIR) covers: the clearing of over-thecounter (OTC) derivative trades; the authorisation and prudential and conduct oversight of clearing houses and trade repositories; reporting requirements for derivative trades;
and risk management requirements for OTC derivatives which are not suitable for clearing;11
• The Central Securities Depositories Regulation (CSDR), most of which is expected to come into effect in 2014, covers the settlement of trades and the authorisation and supervision of central securities depositories (the infrastructures on which trades are settled);
• The Market Abuse Regulation (MAR) covers the deterrence and punishment of market abuse, including insider dealing, market manipulation and unlawful disclosure of information, and updates the Market Abuse Directive 2003 by addressing regulatory gaps and broadening the scope of the market abuse framework to reflect market developments and other legislation. MAR is also accompanied by a Directive on criminal sanctions for market abuse which requires Member States to establish criminal sanctions for, at least, serious cases of market abuse committed intentionally;12
• The proposed Benchmarks Regulation relates to all benchmarks, including key ones such as LIBOR and EURIBOR.13 Following the agreement by the International Organization for Securities Commissions (IOSCO) of principles for financial ‘Over-the-counter’ derivatives refer to derivative contracts that are traded bilaterally, rather than electronically over platforms such as the derivatives exchange, Liffe. OTC derivatives have an important role to play in allowing the broader economy to hedge risk, particularly where these hedges need to be bespoke. However, as part of the G20 commitment to improve the transparency of OTC derivatives markets, it was agreed that these instruments should be traded on exchanges or electronic trading platforms, wherever possible.
The EU Criminal Sanctions against Market Abuse Directive (CSMAD) attracts an ‘opt-in’ for the UK under Protocol 21 to the Treaties. The Government decided not to opt-in at the start of negotiations due to sequencing. CSMAD is dependent on MAR and MiFID for its scope. Both those instruments were still at an early stage of negotiation which meant it was not possible for the Government to consider the potential implications of CSMAD.
The London Interbank Offered Rate (LIBOR) and Euro Interbank Offered Rate (EURIBOR) are daily reference rates based on the average interest rate estimated by banks that they will offer to lend to other banks, within London and the euro area respectively.
28 Review of the Balance of Competences between the United Kingdom and the European Union:
The Single Market: Financial Services and the Free Movement of Capital benchmarks, the Commission published draft legislation in September 2013. The proposed Regulation aims to establish rules of good governance to ensure greater transparency, manage conflicts of interest and to ensure the representativeness of the benchmarks. It also seeks to establish a framework for the supervision of benchmarks, with penalties for non-compliance with established principles; and
• The Credit Rating Agencies (CRA) Regulation covers the authorisation and conduct of CRAs, organisations that assess the likelihood that an issuer of debt securities will be able to maintain its payments to bond-holders. Within the EU, CRAs are authorised and supervised not at the Member State level but by the European Securities and Markets Authority (ESMA).
2.24 Asset managers may provide advice to their clients about their portfolios or may manage such portfolios directly on a discretionary basis. They may also establish and manage collective funds which are then marketed to potential investors. Such asset management provides a way for clients to diversify their portfolio by buying a share in a company whose assets are shares or bonds of other companies (investment trusts), or by buying units in a fund comprised of the shares or bonds of other companies (open ended investment companies or unit trusts), considerable derivatives holdings (hedge funds) or shares that are not listed on an exchange (private equity funds).
2.25 The risks to investors who use asset managers are that: the advice is poor or the fund does not make clear what classes of assets it contains and their level of risk; investments are marketed to people for whom they are not suitable; the fund manager fails to abide by its proclaimed investment strategy; investments are bought and sold too fast, thereby generating fees for the intermediary but reducing value for the client; the fund fails to safeguard the assets it purchases or to keep proper records; or the actions of the fund managers are not supervised effectively by the fund management firm.
2.26 The EU has sought to remove obstacles to the sale and marketing of investment funds within the Single Market through two Directives, these are the Undertakings for Collective Investment in Transferable Securities Directive (UCITS), which is designed in particular for retail investors, and the Alternative Funds Management Directive (AIFMD), which covers all funds that are not UCITS.
2.27 The UCITS Directive (now on its fifth update) provides a harmonised framework of investor protection and product regulation for UCITS funds and UCITS fund managers.
Funds complying with the Directive’s requirements can market their units freely across the European Economic Area (EEA) on the basis of a single authorisation in their home Member State, subject to complying with the UCITS regime. Managers authorised to manage UCITS in one Member State can similarly offer their services across the EEA.
2.28 AIFMD establishes a new harmonised regulatory framework for managers of investment funds not already authorised under the UCITS Directive. AIFMD was primarily targeted at the hedge fund and private equity sectors, but covers many other categories of fund, including real estate and several types of retail schemes.
Insurance and Pensions
2.29 There are broadly two different kinds of insurance: general insurance, and long-term life insurance products. General insurance covers risk of loss resulting from fire, theft, accidents and so on. Long-term life insurance products are life insurance, pensions and annuities. The key risks for policy-holders are that an insurer fails and that legitimate claims