The De Larosière Group Report (25Th February 2009)

D R A F T

The De Larosière Group Report (25th February 2009)

European Commission Communication “Driving European Recovery” (4th March 2009)

A response by the Futures and Options Association

APRIL 2009

The High Level Group Report on Financial Supervision in the EU (25/2/09)

(“the Report”)

and

European Commission Communication: “Driving European Recovery” (4/3/2009)

(“the Communication”)

1. Introduction

1.1 The Futures and Options Association (FOA) is the principal European industry association for over 170 firms and organisations engaged in the carrying on of business in futures, options and other derivatives. Its international membership includes banks, financial institutions, brokers, commodity trade houses, energy and power market participants, exchanges, spread betting companies, clearing houses, IT providers, lawyers, accountants and consultants (see Appendix 1).

1.2 The FOA supports the conclusions of the De Larosière Report that the failure of global financial services regulation to prevent or at least contain the crisis calls for “a profound review of regulatory policy” (page 15, Report) and that repair is therefore “necessary and urgent” (page 3, Report). For its part, the European Commission emphasised that the “unprecedented interdependence” established through the single European market “put the spotlight on the importance of coordination” and “reinforced the need for solidarity among the twenty-seven member states” (pages 2 and 3, Communication).

1.3 The FOA agrees that, while it is important that the process of EU regulatory repair conforms to common global high-level standards and objectives, urgent preventative and curative action by the Commission is necessary and in the EU public interest.

This means that the European Commission and the Parliament cannot wait on “the pace of the slowest” to secure global consensus. As it is put in the Communication, “The inefficiencies in the present structure need to be resolved as quickly as possible” (page 6). It follows, however, from this observation that the justification for early action should be less about aspirations to assume global leadership (but see para 5.1) and more about the duty of EU institutions to deliver on their public interest responsibilities.

Notwithstanding the foregoing, there are a number of comprehensive reports that have been issued by the international standard setters which, although set at a high level, should enable the Commission, as it develops its agenda for EU reform, to sustain, where possible, a consensual approach towards regulatory repair. There are, however, real risks in acting on a unilateral basis as evidenced by the extensive debate over the differences in approach between the EU and the US in terms of the central counterparty clearing of credit derivative swaps (CDSs) and the approach to securitisation in the CRD and credit rating agencies (CRAs). These point to the need for a more detailed level of consensus-building that will become increasingly necessary, particularly in the context of global markets and business.

1.4 The FOA notes and agrees with the findings of the De Larosière Group Report that the crisis was caused by a variety of factors, namely:

(a) excessive stakeholder pressures for the delivery of increasingly higher returns in a highly competitive global environment, which compelled many institutions to trade in high return, but also higher risk, markets/products;

(b) a lethal product and risk combination of product complexity and lack of transparency, which led to mispricing, “an overestimation of the ability of financial firms as a whole to manage their risks”, an underestimation of the capital necessary to support those risks (particularly liquidity risk) and over-reliance on the flawed rating methodologies of credit rating agencies;

(d) weaknesses in corporate governance, including over-emphasis on short-term performance with inadequate recognition being given to the need for a more “long-term, through the cycle perspective”;

(e) severe gaps in regulatory coverage (e.g. hedge funds, various off-balance sheet items, mortgage brokers, credit rating agencies, etc.);

(f) lack of rules’ consistency;

(g) the lack of an adequate crisis management structure, largely because of the fragmented nature of the EU’s supervisory arrangements;

(h) failures on the part of EU supervisors:

(i) to “spot the degree to which a number of EU financial institutions had accumulated – often off-balance sheet – exceptionally high exposures to highly complex, later to become, illiquid, financial assets” and, where there had been identification of the building up of risk, a failure to “recognise or act upon the collective seriousness of the problem” (page 10, Report);

(ii) to challenge the business model of thinly capitalised investment banks or to recognise their capability to become highly leveraged and so generate severe systemic problems;

(iii) to focus adequately on macro-systemic risks (as opposed to micro-prudential risks), compounded by the general view that distribution of risk through securitisation would mitigate risk to the system when, in fact, it had the opposite effect;

(iv) including poor information-sharing, insufficient supervisory and regulatory resources and an inadequate mix of skills, all of which was exacerbated by the tendency of national supervisors to protect local interests and apply local laws first and “a lack of trust amongst EU supervisors” (Annex 4).

1.5 The FOA supports the Commission’s programme as identified in its Communication (page 2, Annex 1) for:

(a) delivering a new supervisory framework for detecting and acting on potential risks “early” and “before they have an impact”;

(b) “closing the gaps where European or international regulation is insufficient”;

(d) improving risk management systems and controls; and

(e) developing a more effective sanctioning process against market wrongdoing.

1.6 The FOA believes, however, that the investment banking model has been a highly effective business model from which not only the banks, but their shareholders and other stakeholders, the wider public and governments have benefitted over many years, i.e. it is not banking diversity or the model itself that has generated the crisis, but rather the excess to which elements of it were taken. For this reason, the FOA welcomes the observations in Footnote 9 on page 42 in the Report, which give some support for the universal banking model and the comment in Annex 3 of the Report which states that the Group refrained from “implying any judgement on the evolution of large cross-banking groups”. The FOA believes this balanced approach is critical to sustaining the market and service competitiveness of EU banks and other financial institutions.

2. Principles of Better Regulation

2.1 The FOA is disappointed that neither the De Larosière Group nor the EU Commission emphasised the importance of observing the Principles of Better Regulation at the outset of either of their reports or of adopting a risk-based and forensic approach to “regulatory repair”. More positively, there are a number of scattered and helpful references to the need for regulatory proportionality, e.g.:

(a) Over-regulation “slows down financial innovation and therefore undermines economic growth in the wider economy” (page 13, Report)

(b) Due priority should be given to “private sector solutions” (para 128, Report)

(d) The Lamfalussy Report delivered greater accountability through regulatory consultation and transparency (Annex 3, Report)

(e) While there must be clear lines of accountability, the new “authorities” (and this applies also to the national supervisors) should be independent from any form of interference, particularly political interference

(f) The commitment of the Commission that it will “prepare its proposals on the basis of an impact assessment in line with its better regulation principles” (which means, presumably, assessing impact across a broad spectrum of very differentiated regulated firms which pose very different risks to the system) (page 6, Communication).

2.2 The FOA believes strongly therefore that the criteria set out in para 2.1 above, which have not been challenged by the emergence of the current crisis, should continue to govern the process of regulatory repair, the actions of national supervisors and the policy-making and oversight responsibilities of the proposed new EU “authorities”.

2.3 More particularly, avoidance of a “one size fits all” approach (an approach which was frequently repudiated by the Commission as part of its regulatory policy) is essential for the purpose of:

(a) sustaining the economic viability of small, medium-sized and niche enterprises, which are, in large part, the “green shoots” of global recovery, but which are particularly vulnerable to the impact of high-cost and burdensome regulation; and

(b) giving full effect to the fact that large numbers of differentiated financial service suppliers played no part in causing the crisis and are simply struggling to survive in a climate of declining business volumes, consumer confidence and lending levels.

As it is put in the Communication, “the EU needs to continue its own work to improving the business environment, to support the small and medium-size enterprises likely to lead the way when recovery comes” (page 10) and that means the Commission taking full account of “the crucial importance of SMEs” and the “think small first” principle (page 12). It is important that this policy is delivered in practice, bearing in mind the potential for disproportionate high-cost regulation to impair seriously the economic contribution of small businesses to the well-being of the EU.

2.4 As stated in para 1.5, the FOA believes that it was the excess to which certain elements of the banking model were taken that caused the crisis, rather than the banking model itself. Accordingly, if dealing excess was a major contributor to the crisis, regulatory excess will just as surely delay its recovery.

3. EU Structural Repair for Macro-Prudential Supervision

3.1 Since supervisors have been more closely focussed on micro-prudential supervision rather than macro-prudential supervision (which looks at the financial system as a whole in terms of protecting the economy from significant loss in real output), the Report recommends the establishment of a new European Systemic Risk Council (ESRC), which would combine the ECB and the ESCB and which would become responsible for macro-prudential supervision.

The FOA welcomes this decision by the De Larosière Group and supports its rejection of the notion that the ECB should have a role in micro-prudential supervision.

3.2 The FOA recognises that the ECB is the most influential central bank in Europe and that it will and should have significant influence over the direction of the new Council, but believes that the De Larosière Group Report gives undue precedence to its role within the Council – both formally and informally – insofar as it:

(a) “supports an extended role for the ECB in macro-prudential oversight”;

(b) states that “the ECB should be tasked with the role of ensuring adequate macro-prudential supervision within the EU”;

(d) while recognising that all national central banks should be associated with this process and not merely those of the Euro area, states that the new European Systemic Risk Council (ESRC) should be set up “under the auspices and with the logical support of the ECB”; that its Chairman would be the President of the ECB; and that its Secretariat would be provided by the ECB.

The FOA notes and supports the Commission’s public position that, in its legislative role, it draws no distinction between the Eurozone and non-Eurozone member states, but would emphasise that, in considering the implementation of the De Larosière Group recommendations, that impartiality should be reflected in the establishment of the ESRC.

3.3 The terms of reference and the constitution of the new Council need to establish an appropriate balance between:

(a) the capability of central banks to act independently, particularly in non-Eurozone states, and the understandable need to develop pan-EU common approaches to the management of macro-prudential and financial stability and crisis prevention and/or mitigation; and between

(b) the ECB and the non-ECB members of the ESCB in the exercise of the decision-making powers of the ESRC.

3.4 The FOA recognises the political importance of full member state representation on the ESRC, but it should also provide for an adequate level of supervisory representation (including those engaged in non-bank supervisory activities, e.g. capital and derivative markets and insurance). Of course, unduly broad participation (further complicated by the fact that, in some member states, banking supervision is not the responsibility of the central bank) could mean that the ESRC becomes sclerotic and unable to perform its tasks expeditiously. Consideration may have to be given to the use of emergency powers and/or the use of an Executive Committee and/or facilitating a fast-track decision-making process via, for example, limiting some participants to non-voting observer status and/or utilising economically-weighted voting.

3.5 The FOA supports the first of the five key objectives identified in the Communication, namely, to provide the EU “with a supervisory framework that detects potential risks early, deals with them effectively before they have an impact, and meets the challenge of complex international financial markets” (page 2, Annex 1), i.e. to address the need for early action.

3.6 The FOA notes that many of the contributory factors that led to the current crisis were identified by a number of regulatory authorities, yet the underlying question is what was done about them. Were they factored into supervisory visits? Did they result in any regulatory action? Did they lead to any coordinated policies for action on a cross-border basis of their impact?

There is no practical regulatory advantage in establishing a mechanism for early identification of areas for concern if they are not capable of being acted upon or are not acted upon on an expedited basis sufficient to either prevent or at least mitigate the consequences of a financial crisis.

4. EU Structural Repair for Micro-Supervision

4.1 The Proposal to Establish a new European System of Financial Supervision (ESFS)

4.1.1 The Report notes the inability of existing Level 3 Committees to converge their activities “sufficiently” and the complex and fragmented nature of current arrangements. This is endorsed in Annex 1 of the Communication, which states that the EU’s cross-border supervisory cooperation was “ineffective and unresponsive” and that the system “failed to adjust to the complexity, internationalisation and inter-linkages of the financial markets” (page 2). As a result, the Report has recommended: