The Larosière Report: tolling the bell for financial markets de-regulation?
By Axelle Ferey*, Ernst & Young, Luxembourg
LFR
September 2009
For many years the word “deregulation” was associated with feverish financial innovation. However it seems currently banned forever from the European and global financial arena. Would this mean that regulation as proposed by the Larosière Report is the miracle cure to Europe economic troubles? We will see that things are more complex and that not only regulation is at stake in the current debate but also supervision, both at macro-economic and micro-economic levels. With respect to the potential power of the Report on shaping business, and that of funds in particular, we believe that the Report shall be considered as a milestone and as such will durably impact the financial sector worldwide in the years to come.
« An ambitious framework without being unrealistic (Jacques de Larosière ) »
In November 2008 the European Commission set up a High Level Expert Group around Jacques de Larosière to make recommendations aiming at strengthening the European supervisory and financial stability framework. The so-called Larosière Report (the Report) was released in February 2009.
Based on the fact that the crisis revealed the weakness of existing mechanisms for regulation and supervision the Report makes 30 recommendations for a new European financial supervisory framework organized into four chapters covering: 1. Causes of the financial crisis 2. Policy and regulatory repair 3. EU supervisory repair 4. Global repair which acknowledges the fact that if conclusions are drawn for Europe financial regulation and supervision issues are de facto global issues.
Building upon the core concept of financial stability that shall be promoted through harmonized and tailored regulatory solutions across Europe, the Report starts with a summary of the challenges faced by Europe in which it is stated that “Financial regulation and supervision have been too weak and have provided the wrong incentives. Global markets have fanned the contagion.” It then goes on with a thorough analysis of the main causes of the financial crisis where it offers some extremely valuable insights. Without really pointing any fingers it stresses the complexity and interconnectedness of major factors that amplified the crisis. Several causes and points needing to be addressed are cited such as macro-economic causes, risk management, credit rating agencies, corporate governance, regulatory / supervisory issues and global institutional weakness.
The whole Report is articulated around two core concepts, regulation and supervision and two core levels, the macro-economic level and the micro-economic one that are clearly distinguished. Whereas supervision is defined as the power to ensure that rules are adequately implemented regulation is defined as the set of rules applicable to a given profession or sector. Going beyond its initial mandate that was limited to supervision, the Group analyses whether existing regulation is relevant, whether it contains incentives towards short-termism and risk-taking, as well as whether complete areas of financial services do not unduly escape control and regulation, such as funds. Where shortages or inappropriate regulation have been identified the idea is to address them or change them respectively. As far as regulation is concerned the major problem identified is the pro-cyclicality of certain rules, whereas for supervision the Group intends to put a captain in the boat, which first task will be to supervise financial activity, as a sailor would scrutinize the horizon.
Following this Report the European Commission issued a communication on May 27 endorsing the Group’s recommendations and encouraging Member States to do the same, therefore initiating a complete reform of the European financial system.
The model proposed: central regulation – local supervision
The two most striking – and commented - recommendations of the Report relate to:
First, the setting-up of a European Council on Systemic Risk (ECSR) composed of the heads of the national Central Banks and placed under the aegis of the European Central Bank (ECB). This proposal therefore recognizes the major role for financial stability played by the ECB at the peak of the crisis through its massive injections of liquidities; it also promotes its role as a supra-national body, being chaired by an independent personality. The ECSR aims at monitoring and assessing the risks to the stability of the financial system as a whole. This role will be fulfilled by pooling information from national central banks, comparing observations on macro-economic and prudential developments, giving direction on these issues, providing sufficiently early warning of macro-economic risks to EU supervisors as well as recommendation on how to prevent crisis and address the risks identified. The creation of this new innovative body is intended to address one of the fundamental weaknesses highlighted by the crisis, namely the exposure of the financial system to interconnected, complex, sectoral and cross-sectoral systemic risks. According to the experts, two conditions are mandatory to the effective functioning of the ECSR: communication of information between national supervisors and all central banks must be made compulsory and the early warning system to be implemented should be combined with a mechanism guaranteeing swift corrective action. Let’s listen to Mr. de Larosière on that topic: “The first thing is to have a captain in the boat in charge of scrutinizing the horizon; depending upon his observations early warnings can be issued, that can translate into recommendations. And from there onwards either the recipients act or they chose not to act. But in such a case the lack of action will be reported to the Council, and becomes public”.
Second, the creation of a European System of Financial Supervisors (ESFS) consisting of a decentralized network of national supervisors working in tandem with the new European Supervisory Authorities in the area of micro-prudential supervision. This will be achieved by turning the three advisory European Committees of national financial regulators (the CESR: European Committees of European Securities Regulators, the CEBS: Committee of European Banking Supervisors and the CEIOPS: Committee of European Insurance and Occupational Pensions Supervisors) into three real, independent European Authorities, with extended and legal powers which makes this proposal particularly important. Therefore if existing national supervisors closest to the markets and institutions they supervise would continue to carry-out day-to-day supervision and preserve the majority of their present competences, the Authorities will represent the EU-level and coordinate the application of common high level supervisory standards and guarantee strong cooperation between national supervisors. For cross-border institutions, the ESFS should continue to rely mainly on the colleges of supervisors to be introduced by the revised CRD and Solvency II directive. However these colleges should be increasingly linked to the level 3 committees as well as the ECB through staff exchanges. A two-stage process is proposed to strengthen the supervision of the European financial sector. In a first stage (2009-2010) the Group calls for strengthening national supervisory authorities. The EC is invited to start preparing legal proposals to set up the new Authorities. During this first stage the EU institutions and the level 3 committees should also develop a more harmonized set of rules for the EU financial sector, as well as supervisory powers and sanctioning regimes to be ready by the beginning of 2013. As far as supervisory colleges are concerned the Group calls for their immediate expansion and for establishing colleges for all major cross-border firms by the end of 2009. At the beginning of stage 2 (2011-2012) the three new Authorities will be set up with the following major roles (i) a legally binding mediation role with regards to cross-border institutions (ii) development and interpretation role of technical standards in the area of regulation (iii) definition of common supervisory practices and arrangements for the colleges of supervisors as well as recommendation with regards to national supervisory authorities and (iv) key coordination role in crisis management through facilitating cooperation and exchange of information between competent authorities in crisis situations. The drivers behind the network are clear: foster harmonized rules and coherent supervisory practice and enforcement, or as Mr. de Larosière puts it “a single harmonized rulebook, a single standardized enforcement”. The proposal also aims at enhancing trust between national supervisors and ensuring that: (1) host supervisors have an appropriate say in the setting of financial stability policies and (2) cross-border risks are addressed more effectively. It has to be noted that the idea to set up such a supervision is not new: in 2004 already the CESR requested that its powers be broadened; however people were not ready at that time. Since then the financial crisis happened…
Through the two above-mentioned pillars the European Union intends to strengthen coordination of macro- and micro-prudential supervision of all financial players. As pointed out recently by Commissioner McCreevy Europe is also thereby endosring the G20 call to take action to build a stronger, more globally consistent regulatory and supervisory system for the future of financial services.
Europe as a financial services regulator champion? Challenges and Opportunities
If generally welcomed – people in particular generally agree that the ESFS coupled with the proposed new Authority in charge of macro-prudential supervision, the ESRC, will benefit financial stability and positively perceive the details concerning the regulatory reform - the Report however gave rise to several comments and criticisms that we will now briefly present before analyzing the opportunities at stake for Europe.
The most critical ones have commented upon the lack of ambition with respect to the discussion of the supervisory architecture that would derive from the EU having overlooked the highly political character of the preliminary choices that need to be confronted in order to implement the new framework. In particular the implications in terms of sovereignty between inter-national and supra-national character of the new architecture have been stressed, as well as the issue of integration of economic policy within Europe the implementation of which seems to remain a pious hope whereas it would directly impact the efficiency and coherence of the regulatory and supervisory proposals contained in the Report. All in all the Report would essentially amount to an in-depth updating of the Lamfalussy framework without re-considering the fundamental intergovernmental character of its architecture despite the fact that it has been identified as its main weakness.
Some also wonder how to practically ensure coherence in the application and interpretation of the rules within the Eurozone, whereas others stress that the size of entities and specialization of activities is only lightly touched upon in the Report and question the real advantage of having three separate legal entities in charge of the Banking, Insurance and Securities sector in terms of reducing systemic risk.
For the ABBL, the proposal as it stands raises three major issues: (i) that of scope of the ESFS where the ABBL suggests that a distinction between “systemic banks” vs “non-systemic banks” would be more relevant; (ii) that of crisis management in case of bankruptcy where the ABBL suggests that EU systemic banks supervised by the ESFS should be subject to complete EU-wide financial arrangements while for EU non-systemic banks the financial responsibility could remain national and (iii) that of structure of the ESFS’ new Authorities. Indeed dispute resolution and the sharing of power between home and host regulators (in the case of cross-border groups), as well as transfer of power to EU institutions are proving the most problematic. Currently the Level 3 committees use peer review to solve disputes but most of the decisions are down to the home authorities. The Group proposes a system of binding mediation to replace it but the experience of the Solvency II Directive at the end of last year did not prove that effective with “mutual suspicion” between home and host regulators. Will the only working solution to give powers away to host regulators go through a pan-EU body? The question remains open at this stage.
Some of these criticisms and comments are indeed relevant. However one may wonder if there is not a mix between the policy-design level on the one hand and that of its practical implementation on the other hand, which ultimately raises the issue of usefulness of such High-Level reports. We believe that such reports shall mainly be seen as starting points of a process aiming at re establishing confidence among market participants and setting up policy priorities for action. This process requires not to get lost into details and this may explain why several practical questions remain open. More importantly assessing the Report along this “set of thoughts” criteria may well enable it to deploy the full range of opportunities it triggers…as well as real challenges it poses.
Indeed we believe that this Report should be seen as an opportunity for the European Union: (i) an opportunity to state that the financial sector has and will continue to have a vital economic impact in Europe and globally in terms of growth and employment prospects. Many countries have investment needs and this hunger for capital will require the support of the international markets and the development of new ideas and structures. As such Europe needs a long term approach to financial services that is sufficiently robust to withstand challenging and volatile conditions, such as those faced today, and fully play its role in aiding the recovery. To this end corrective actions need to be taken based on the lessons learnt (ii) an opportunity to acknowledge through the effective implementation of a new innovative framework that adequate regulation will be the main key success factor for financial markets, as well as an important condition to create a favorable business environment for firms (iii) an opportunity to restore public trust in the aftermath of the financial crisis by addressing the deficiencies that have been identified and improve corporate governance and last but not least (iv) an opportunity for Europe to play an active role in regulatory leadership worldwide advocating that future success depends on the creation and adherence to high standards. In that respect the G-20 summit has answered favorably to the European leadership and it shall be noted that much of the thinking on the future of financial regulation came out of the Larosière Report.
Does this mean that there are no challenges left? Obviously not. We see as the main challenge facing Europe and its regulators today their ability to avoid overzealous interventionist reactions that would undermine the competitiveness of the EU industry at international level. As a matter of fact the history of responses to past crisis suggests that there has often been a “political” response, with unintended consequences. One can wonder for instance if current legislative proposals to apply additional regulation to private funds, and HF and PE funds in particular, on both sides of the Atlantic and through the AIFM directive in Europe is not to a certain extent an answer to the internationally growing political clamor towards additional regulation to be applied to private funds as a result of their rapid development. The practical issues raised by the AIFM directive when applied to Private Equity, for instance, reminds us that translating a framework into beneficial outcomes is just as important as getting the framework right.
The Larosière Report initiated as a political answer to the crisis rapidly emerged as a clear signal that a new era for financial regulation and supervision has come. As Commissioner McCreevy put it recently, “this is really the first time that there is a window of opportunity to get our house in order”. In such a context, the challenge will lie in finding the right balance between “putting the house in order” and “making it a place where no one can live”.
*Axelle Ferey is Senior Manager, Private Equity, Product and Account Development Ernst and Young, Luxembourg
Posted on 10 September 2009
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