THE STATE OF PLAY OF BANKING REGULATORY REFORMS … ON THE ROAD TO BASLE III THE STATE OF PLAY OF BANKING REGULATORY REFORMS … ON THE ROAD TO BASLE III Chamber of Advocates Malta Friday 12 November 2010 Marcel Cassar

Overview  Regulatory reform in the US and the EU – state of play  From Basle II to Basle III …  Any questions ?

US/EU Regulatory Reform Comparison A comparison between US measures under the Dodd-Frank Act & measures taken/ envisaged in the EU  Macro & micro economic oversight  Crisis management & bank resolution  Taxes/levies on financial institutions  Deposit compensation schemes  Limits on scope and size of financial firms  Remuneration policies  Alternative investment funds  Investor protection  Prudential regulation  Other: CRAs, securitisation, market abuse, derivatives

Macro- economic oversight  Creation of a Financial Stability Oversight Council (FSOC), tasked to identify potential threats to the stability of the financial system and to make according recommendations to the supervisory authorities  The FSOC will be chaired by the Treasury Secretary and composed by members of the federal supervisory authorities. It will also include its own office of financial research  Recommendations to the Fed may for example include banks’ capital requirements, leverage ratios, liquidity, and risk management. The FSOC can decide to extend the Fed’s supervisory authority to non-financial companies that pose risks to the financial system. In extreme cases, the FSOC would have the power to break up large, complex companies  The Council will also release period reports on its findings Agreement of September 2010:  Creation of the European Systemic Risk Board (ESRB) to supervise the soundness of the whole financial system; including e.g. the potential existence of asset bubbles and the functioning of market infrastructures. The ESRB shall issue warnings when it has identified risks, and shall issue recommendations to the country/ies concerned. Countries are to react to these recommendations on a ‘comply or explain’ basis  The Secretariat of the ESRB will be held by the European Central Bank, building on the ECB’s existing staff and resources. The President of the European Central Bank will be the first Chair of the ESRB.

Micro- economic oversight  For the most part, maintenance of the existing supervisory bodies, but with some adaptations to their respective responsibilities and authority; notably in view of the coordinating role of the FSOC  Only the OTS will be abolished  Powers of the Federal Reserve are strengthened in some areas, but are subjected to control/ support by the FSOC or Treasury for significant decisions. In principle, the Fed keeps its authority to supervise banks of all sizes and is even granted additional powers to supervise systemically important financial firms (other than banks). Changes will also be made to the Fed’s internal governance system. Banks will no longer have a say in the election of the Fed’s regional presidents.  Increased integration of the European supervisory system:  Upgrading of the Lamfalussy Level 3 supervisory committees into Authorities with a European mandate and powers (European Supervisory Authorities, ESAs). In particular: CEBS to be upgraded to the European Banking Authority (EBA) ; CESR to be upgraded to the European Securities and Markets Authority (ESMA)  The authorities will among other things be charged with the creation of a single rulebook and with ensuring the consistent application of these rules by national supervisors. In some cases, the ESAs can take binding decisions.

Crisis management & bank resolution  Creation of a resolution authority: federal regulators will have the power to seize and break up financial firms whose collapse might cause widespread damage. The FDIC will be in charge of the liquidation procedure (as already the case today for smaller institutions). Treasury can be authorised to supply funds to cover up-front costs, but subject to a ‘repayment plan’  The costs of winding up failing institutions must first be borne by shareholders and non-protected creditors. Under certain conditions, the FDIC can guarantee deposits to avoid bank runs. Legislative proposal in The Commission intends to propose a ‘toolbox’ of measures including:  Preparatory and preventive measures such as resolution plans.  Early action powers and resolution powers for supervisory authorities.  Coordination and coordination between national authorities in the case of cross-border bank failures. In the longer term, this should be developed into a more integrated crisis management framework.  National bank resolution funds with common rules and contributions paid by banks. The funds would be used to ensure that a bank’s failure is managed in an orderly way, but not to bail out or rescue banks.  The Commission’s proposal also aims at achieving some harmonisation of national approaches to bank levies

Taxes/ Levies on financial institutions  The previously foreseen bank fee of up to $ 19 billion has been dropped.  The Obama Administration apparently continues to envisage a ‘financial crisis responsibility fee’ to reduce the public deficit. This fee could be imposed on banks with assets above $50 billion, but a new legislative proposal has yet to be defined.  Due to the Republican victory in the November elections, the introduction of a bank fee appears less likely.  Different national initiatives have been taken, including:  Bonus taxes in the UK, France and Portugal  A general fee of 0.036% on big banks’ liabilities in Sweden, introduced in 2009 and a proposal for a levy of 0.07% on banks’ assets in Austria, to raise €500 million;  A bank levy in Germany, the UK and France. In May 2010, the European Commission proposed a framework of national bank resolution funds, to be funded through bank levies. This was also intended to achieve some harmonisation of the national approaches to bank levies (cf. section on ‘bank resolution’ above). However, to date the proposal has not received considerable support from Member States.  The Commission is currently exploring the possibility of an additional tax for financial institutions, with a view to making proposals by mid  Suggestions for a Tobin tax or a financial transaction tax do not so far seem to find the necessary amount of support to be taken forward.

Deposit compensation schemes  Insurance granted through the Federal Deposit Insurance Corporation to be raised to $250,000, up from $100,000. This will apply retro-actively from January COM legislative proposal of July 2010:  Minimum threshold of ensured deposits raised from 20,000€ to initially 50,000€, then 100,000€  Pay-out periods reduced to seven days  Full re-imbursement, i.e. abolishment of the possibility of co-insurance.  Under certain conditions, deposit guarantee funds may be used for bank resolution purposes

Limits on scope and size of financial firms’ activities  ‘Volcker rule light’, limited to the largest banks: these are prohibited from trading with their own funds. A general exemption applies for investments in public debt. The largest banks’ investment in hedge funds and private equity funds is limited to ≤3% of a bank’s capital. The rule remains vague, however, in a number of important aspects and leaves details to regulators. E.g. in the application of exemptions for risk- mitigating hedging activities and the phasing-in period (rule will come into effect some time between 2014 and 2020)  Limit on banks’ size: mergers and acquisitions are not allowed where the new institution would hold more than 10% of all liabilities in the US banking sector  Stringent limitations on banks’ derivatives business: banks may only conduct business in certain types of derivatives considered to be important for banks to hedge their own risk (including e.g. interest-rate swaps, foreign- exchange swaps and credit derivatives but not derivatives in agricultural commodities, most metals and energy swaps, which would instead have to be conducted through affiliates).  These proposals find relatively little support in the EU  In the UK, the new Conservative- Liberal government is conducting a study on the separation of traditional banking and investment banking (results to be published by mid-2011).

Remuneration policies  ‘Say on pay’: non-binding shareholder vote on executive remuneration  Enhanced independence of the remuneration committees  Regulatory oversight over FI’s remuneration packages, in order to ensure that remuneration structures are designed in a manner that refrains from putting financial stability at risk  Enhanced transparency requirements on executive remuneration  Bonus payments made to management can be reclaimed in the case of accounting irregularities  CRD 3 includes prescriptive remuneration standards which become effective 1 January Implementation guidelines to be adopted by the Committee of European Banking Supervisors could be relatively restrictive and conservative.  National initiatives. For example, in France the FSB recommendations will become binding by law  In addition, the Commission has adopted a Communication and two complementary recommendations on remuneration policies. One of the recommendations refers to financial services sector pay. Remuneration policies for risk-taking staff should be (i) consistent with and promote sound and effective risk management; (ii) transparent internally; (iii) clear and properly documented and contain measures to avoid conflicts of interest; (iii) adequately disclosed to stakeholders; and (iv) adequately supervised by competent authorities.

Alternative investment funds  Managers of private funds will be required to register with the SEC and to provide information about their trades and portfolios, so as to enable the SEC to assess systemic risks.  Smaller funds (up to $100 million in assets) will be subject to state supervision, rather than federal supervision  Non-US funds are exempted if they do not have a commercial presence in the US and if US clients, collectively, hold assets of less than $25 million in these funds  In addition to existing regulation of harmonised ‘UCITS’ funds:  Alternative Investment Fund Managers Directive (expected to be passed in November 2011): Regulation of all managers of non-UCITS funds with strict requirements on, amongst other things: conduct of business; disclosure and reporting to regulators; a depositary requirement, including the requirement to separate funds’ assets from the custodian’s assets; the requirement for independent valuation.

Investor protection  Creation of a Consumer Financial Protection Bureau within the Federal Reserve, but with far-reaching independence. The Bureau would have authority to determine and enforce rules in the area of consumer protection for banks and credit unions with assets of more than $10 billion and for certain other non-bank financial firms, but not insurance companies and auto dealers.  The Bureau would include special offices for Financial Education and for Fair Lending and Equal Opportunity.  Minimum underwriting standards for home mortgages. Lenders are required to ensure a borrower can repay a home loan by verifying income, credit history and job status. Brokers’ remuneration may only vary in line with the amount of the mortgage, commissions that vary in line with the interest rate are banned.  Diverse initiatives aimed at retail investor protection at both national level and EU level.  At EU level, this includes e.g. the planned standardisation of disclosure requirements for ‘typical’ retail investment products such as investment funds, unit-linked life insurance products and certificates designed for retail investors.  Commission comprehensive work on ‘responsible lending and borrowing’ standards. The Commission is currently considering appropriate ways to improve investor protection in the area of credit intermediation. Specifically, the Commission is looking at brokers’ incentives, pre-contractual information and advice, and lenders’ post-lending responsibilities.

Investor protection (cont.)  Municipal advisers have to register with the SEC and will be subject to a fiduciary duty.  Authority for the SEC to raise standards for all broker-dealers who give investment advice, including the possibility to impose a fiduciary duty on broker-dealers (as is already the case for investment advisers).  Creation of Committees composed of investors, mandated to safeguard investors interests’ in respect of securities markets.

Prudential regulation  Reinforced regulation and supervision of all banks.  The stricter standards include minimum capital requirements for all US banks and generally enhanced capital requirements (risk-based and leverage limits); liquidity and concentration requirements; the development of bank- resolution plans (‘living wills’); and short-term debt limits.  Particularly strict requirements apply to ‘systemically significant institutions’ (SSIs). Designation of which institutions are considered systemically significant to lie with the FSOC. The Fed is authorised to define rules for and to supervise these largest/ most interconnected firms. The FSOC can however recommend rules to the Fed.  Bank holding companies with total consolidated assets of at least $ 50 billion and systemically significant nonbank financial institutions can also be required to maintain a debt-equity ratio of not more than 15:1. However, this requirement will be triggered only upon a finding of the FSOC that such company poses a ‘grave threat’ to the financial stability of the US. Extensive changes to the Capital Requirements Directive under preparation, including:  Additional capital requirements for the trading book, based on stress conditions  More disclosure by banks about their holdings in complex products  Stricter limits on large exposures, including restrictions on inter-bank lending  Harmonisation of the definition of own funds, in particular with respect to the recognition of hybrid capital  Clarification of national supervisory authorities’ responsibilities, both during ‘normal’ and ‘crisis’ periods, as well as requirements for more coordination and information exchange between national authorities. ‘Home’ authorities will have some decisive authorities in the framework of supervisory colleges.

Prudential regulation (cont.)  Large bank holding companies will be prohibited from using trust-preferred securities as a form of capital after a phasing-out period of five years (grandfathering clause for smaller banks). In addition, the FSOC may under certain conditions require SSIs’ to take mitigating actions such as the termination of certain activities, the divesting of businesses and the application of stricter prudential requirements.  Basel II: in principle, it is still foreseen that the largest US institutions would move towards Basel II. However, the timetable is uncertain. Officially announced deadlines vary between 2010 and Basel II would also be considered a ‘minimum standard’ (according to the Federal Reserve), rather than a benchmark for far-reaching international harmonisation.

The Basle Accord evolution  Basle I: Minimum capital Basic risk weighting  Basle II: Changes to risk weights but Pillars 2 & 3 not implemented in full (practically)  Basle III: Changes to risk weights Changes to definition of capital New (experimental) measures Accounting changes

Basle II to Basle III … definition of capital & minimum ratios Basle II Basle III Tier 1 = 4%Tier 1 = 6% a [of which Core = 2%][of which ‘Core’ = 4.5%] a [of which ‘Core’, a Countercyclical Capital Buffer ≤ 2.5%] b Tier 2 = difference Total = 8% Capital Conservation Buffer ≤ 2.5% b Total = 8%Total (inc. Buffer) = 10.5% a by 2015 b by 2019

But on the road to Basle III …  Still unresolved issues … SIFIs, Countercyclical capital buffer, NSF ratio  How much capital would European banks need to meet the new requirements?  What is this going to cost: (a) the new Basle III measures, and (b) overall regulatory reforms by way of economic impact?  What about the level playing field -- US/EU?  Need for clarity, consistency & co-operation in implementation otherwise recovery of market confidence in the financial system will be difficult.

THE STATE OF PLAY OF BANKING REGULATORY REFORMS … ON THE ROAD TO BASLE III Thank you ….. Questions?