1. Regulation of Financial and Capital Markets
Petr Gapko

2. What are Financial and Capital Markets?
Financial markets in economics are markets, where participants can trade securities, insurance, money, commodities and other fungible items at low transaction costs.
We divide financial market as follows:
Money Market
Capital Market (Primary and Secondary)
Insurance Market
Derivatives Market
Forex Market
Other Markets

3. What do we need to regulate?
Financial intermediates – BANKS, brokers, …
Flow of money
Financial risks
Information
Behavior
Participants
Debts
The toughest regulation - LICENCES

4. Who regulates? Supervisor of Financial markets – Central Bank
Regulates banks on the basis of Basel II
In CR – Czech National Bank (CNB)
Supervisor of Capital & Securities markets – Securities Exchange Commission (SEC)
Uses the MiFID framework
In CR SEC is a part of CNB
Supervises whole markets and intermediates
Supranational supervision: EU Commission, ESMA, European Banking Authority (EBA)
EU Commission develops the framework
CNB has a real domestic regulatory function
EBA performs the EU-wide regulation institution

5. Who regulates? Banking Regulation Capital & Securities Markets
1st level of regulation: National regulator (CNB)
Regulates intra-market entities (banks in the Czech Republic)
2nd level of regulation: Supranational regulator (EBA)
Regulator of regulators (supervises national forms of regulations)
3rd level of regulation: Legislative regulator (European Commission, European Parliament)
Regulator of the law (sets up the rules)
Capital & Securities Markets
2nd level of regulation: Supranational regulator (ESMA)
3rd level of regulation: Legislative regulator (EC, EP)

6. Who regulates?
But…what about a bank with HQ in Austria and operating activities in the CR???
Home vs. host regulator principle
Home regulator of the Austrian bank is always an Austrian regulator
Host regulator is then the Czech regulator
Co-operation between the home and the host regulator
Regulation on the individual and consolidated basis
What if the bank operating in the CR has been established in a non-EU country?
Only that part of the bank operating in the EU can be regulated
Czech regulator acts as a home regulator for the part of the bank operating in the Czech Republic

7. “MiFID” Directive
The Markets in Financial Instruments Directive (MiFID) goal:
to complete the process of creating a single EU market for investment services
to respond to changes and innovations which have occurred in securities markets
to protect investors by making markets deeper, more competitive and more robust against fraud and abuse
Replaces the Investment Services Directive (Directive 93/22/EEC)
MiFID is the cornerstone of the European Commission's Financial Services Action Plan

8. “MiFID” Directive – Key aspects
Authorisation, regulation and passporting
Client categorisation
Client order handling
Pre-trade transparency
Post-trade transparency
Best execution
Systematic Internaliser

9. MiFID - Authorisation, regulation and passporting
Firms covered by MiFID will be authorised and regulated in their "home state" (broadly, the country in which they have their registered office). Once a firm has been authorised, it will be able to use the MiFID passport to provide services to customers in other EU member states. These services will be regulated by the member state in their "home state" (whereas currently under ISD, a service is regulated by the member state in which the service takes place).

10. MiFID - Client categorisation
MiFID requires firms to categorise clients as "eligible counterparties", professional clients or retail clients (these have increasing levels of protection). Clear procedures must be in place to categorise clients and assess their suitability for each type of investment product. That said, the appropriateness of any investment advice or suggested financial transaction must still be verified before being given.

11. MiFID - Client order handling
MiFID has requirements relating to the information that needs to be captured when accepting client orders, ensuring that a firm is acting in a client's best interests and as to how orders from different clients may be aggregated.

12. MiFID - Pre-trade transparency
MiFID will require that operators of continuous order-matching systems must make aggregated order information on "liquid shares" available at the five best price levels on the buy and sell side; for quote-driven markets, the best bids and offers of market makers must be made available.

13. MiFID - Post-trade transparency
MiFID will require firms to publish the price, volume and time of all trades in listed shares, even if executed outside of a regulated market, unless certain requirements are met to allow for deferred publication.

14. MiFID - Best execution
MiFID will require that firms take all reasonable steps to obtain the best possible result in the execution of an order for a client. The best possible result is not limited to execution price but also includes cost, speed, likelihood of execution and likelihood of settlement and any other factors deemed relevant.

15. MiFID - Systematic Internaliser
a Systematic Internaliser is a firm that executes orders from its clients against its own book or against orders from other clients. MiFID will treat Systematic Internalisers as mini-exchanges, hence, for example, they will be subject to pre-trade and post-trade transparency requirements

16. Basel II – need for capital soundness
Issued by the Basel Committee on Banking Supervision
Transposed to the EU law by a CRD (Capital Requirements Directive)
The purpose is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face
Claims that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold
Main aims:
Ensure that capital allocation is more risk sensitive;
Separating operational risk from credit risk, and quantifying both;
Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

17. Basel II – need for capital soundness
Based on three pillars:
(1) minimum capital requirements (addressing risk)
(2) banks’ own internal capital requirements assesment and supervisory review
(3) market discipline – to promote greater stability in the financial system
Biggest difference between Basel I and Basel II:
In the first pillar, only credit risk was dealt with in Basel I. Market risk was an afterthought and operational risk was not dealt with at all
Second and Third pillars were not dealt with in Basel I at all

18. Basel II – The First Pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. Other risks are not considered fully quantifiable at this stage.
The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach".
For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or STA, and advanced measurement approach or AMA.
For market risk the preferred approach is Vaule-at-Risk

19. Basel II – The Second Pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as
systemic risk
pension risk
concentration risk
strategic risk
reputation risk
liquidity risk
legal risk

20. Basel II – The Second Pillar
Bank should identify all potentially material risks it faces and develop appropriate methods to measure them
Bank should construct a forward looking (at least) three year capital plan and stress it
Bank should maintain appropriate risk governance structure, create an independent risk function and allocate sufficient sources for sound risk management
The bank’s process of risk management together with main numeric outputs is reported to the regulator once a year in an ICAAP report
Regulators should audit on a regular basis the bank’s risk management process: SREP (supervisory review and evaluation process)

21. Basel II – The Third Pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
Each bank should regularly (quarterly) publish quantitative as well as qualitative information such as exposures, capital requirements, positions in derivatives, ownership structure, governance structure, financial results…
All the information have to be reported not only to the regulator, but also should be publicly available (i.e. bank’s web site)

22. Basel II – The Future
Work is apparently already finished on Basel III. The goals of this project are to refine the definition of bank capital, quantify further classes of risk and to further improve the sensitivity of the risk measures.
Basel III will impose further rules on especially liquidity management and capital adequacy
Bsel III document ready, split into CRR and CRD.
Readings:

23. Basel III main enhancements
New definition of capital
Capital buffers
Liquidity requirements
Leverage ratio
Counterparty credit risk
Bank resolution framework

24. Basel III regulation vs. directive
CRD IV
Capital buffers, Corporate governance, Sanctions, Regulation Practice
CRR IV
Capital requirements, Liquidity requirements (LCR 2015?, NSFR 2018?), Leverage ratio (Pillar II 2015?, Pillar I 2018?), Counterparty credit risk
Enforcement CRD/CRR IV planned from 2013, full implementation in 2019

25. CRR: Capital Definition
Capital Requirements Regulation capital definition:
- Tier 1 + Tier 2 (no Tier 3)
Tier 1 further decomposed into:
- Core Tier 1 (shareholders’ equity )
- Additional Tier 1
Core Tier 1 requirements:
3,5 % by
4,0 % by
4,5 % by
Tier 1 requirements:
4,5 % by
5,5 % by
6,0 % by

26. CRD: Capital buffers Conservation buffer
- Created from the Core Tier 1; can be breached, but in case of breach limitations on dividend repatriation
- Applied from
- From by max 0,625 %
- From by max 1,25 %
- From by max 1,875 %
- From max 2,5 %
Countercyclical buffer
- Specific for individual countries, EU regulatory body creates methodology, applied by regulators in individual countries
- Can be applied for specific institutions
- Calculated quarterly, based on the deviation of a ratio of loans to GDP from a trend and other macroeconomic indicators
- Enforcement the same with conservation buffer but can be extraordinarily higher

27. Capital requirements in summary

28. Globally Systemically important financial institutions(G-SIFI)
Too big to fail
2009 Second meeting of G20:We want more regulation to prevent the systemic risks
2010 Financial Stability Board (FSB) developed a policy framework (final implementation 2019)
Incorporated according to size, complexity and systemic interconnectedness

29. Policy measures Recovery and resolution planning Powers for regulators
Higher capital requirement (1% - 3.5%)
More intensive supervision

30. G-SIFI
2011 Basel Committee on Banking Supervision – methodology for banks (will be extended to non-banks)
International Association of Insurance Supervisors – methodology for insurance companies ( )
2011: 29 banks (17 Europe, 8 America, 4 Asia) (revision in November)
Starting November 2014 (FSB)/ Report by EU Commission December 2014

31. G-SIFI in 2011 (based on 2009 data)
Belgium: Dexia
China: Bank of China
France: Banque Populaire, BNP Paribas, Crédit Agricole, Société Générale
Germany: Commerzbank, Deutsche Bank
Italy: Unicredit
Japan: Mitsubishi, Mizuho, Sumitomo Mitsui
Netherlands: ING
Spain: Santander
Sweden: Nordea
Switzerland: Credit Suisse, UBS
UK: Barclays, HSBC, Lloyds, Royal Bank of Scotland
US: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, State Street, Wells Fargo

32. Recommended literature
BASEL II
The New Basel Capital Accord (Downloadable from:
Marc Saidenberg, Til Schuermann: The New Basel Capital Accord and Questions for Research (Downloadable from:
MiFID
COMMISSION DIRECTIVE 2004/39/EC (MiFID Level 1)
COMMISSION DIRECTIVE 2006/73/EC (MiFID Level 2)
COMMISSION REGULATION (EC) No 1287/2006

33. Thank you for your attention… …Any questions?
My contact details for consultations:
Petr Gapko