AB Direct

A financial services sector newsletter of the Association of Chartered Certified Accountants

London under threat

Filed in: , solvency ii, london, banking, barclays, new york, basel iii, markets, singapore, regulation

How seriously might the latest series of financial scandals affect London’s standing as the leading financial marketplace?

London under threat

How seriously might the latest series of financial scandals affect London’s standing as the leading financial marketplace, asks Richard Willsher.

Many outside of the City and beyond British shores will be saying, ‘I told you so.’ Effectively self-regulating markets ruled by corporate fat cats and dealt in by big-bonus-earning wide boys is the picture they see of London as a global financial centre. So how seriously might the latest series of financial scandals affect London’s standing as a leading, trustworthy financial marketplace?

The LIBOR rigging scandal is widening. The New York attorney general has a subpoenaed seven banks. While these include four non-UK banks, Deutsche, Citi, JP Morgan Chase and UBS, the heat remains on the City, as it is the London interbank offered rate that is the issue. Meanwhile HSBC and Standard Chartered still appear to be in deep water with US regulators despite their attempts to settle.

London looks under siege. The New York hounds are in full cry. Bloomberg, the news service founded and majority owned by the current New York City mayor, ran a story on 6 July entitled, 'Made-in-London Scandals Risk City Reputation as Money Center.' The story catalogues a series of London events and misdemeanours including the losses made by the London operations of AIG, J.P. Morgan Chase, Bear Stearns and Lehman Brothers. The bad apples were and are over here, not over there.

European Union regulators are gunning for the City too it appears. While broad, industry wide bodies of regulation such as Basel III and Solvency II will affect banks and insurance companies across the EU, they will impact the City more because there are simply more of them there than anywhere else. The Alternative Investment Fund Managers Directive, the European Markets Infrastructure Regulation, the Markets in Financial Instruments Directive and the proposed Financial Transactions or ‘Tobin’ Tax would have a greater effect on London’s financial markets, because they are far bigger than others in the Single Market and the world’s significant market players tend to use London as a principal trading hub.

Those who speak for the City sound a little contrite but see regulatory attacks coming from the City’s biggest competitors. ‘The Barclays LIBOR affair has certainly made the task of explaining, supporting and promoting the City more difficult,’ admits Mark Boleat, chairman of Policy and Resources Committee, City of London Corporation. ‘It has given ammunition to those inside the country who want to see the UK’s financial services industry reduced in size, and to those overseas who want to challenge London’s status as a global financial centre.’

London’s challengers are not only based in developed western economies either. Financial markets such as Dubai, Singapore and Hong Kong are well located to profit from financial services business gushing from India’s and China’s rapidly growing economies, whether on the macro scale of raising capital and recycling liquidity or handling the wealth of the growing number of high net worth individuals in these regions. Their institutions and individuals may read reports about what appears to be rotten in the City of London and prefer to keep their business closer to home.

Part of the UK government’s response has been to rejig the tri-partite regulatory system. HM Treasury is abolishing the Financial Services Authority. The Bank of England will oversee the ‘wider economic and financial risks to the stability of the system.’ The Prudential Regulation Authority (PRA) will be responsible for the day-to-day supervision of financial institutions. The Financial Conduct Authority (FCA), will, ‘take a tough approach to regulating how firms conduct their business.’

On top of this the European Banking Authority (EBA) functions as the top European Union regulator for banks. Interestingly however from the midst of the cacophony of name-calling and competitors baying for London’s blood, the role of the EBA may offer some scope for optimism in the City.

The EBA lists among its roles ‘preventing regulatory arbitrage, guaranteeing a level playing field, strengthening international supervisory coordination and promoting supervisory convergence…’ If it achieves these things then London ought not to fear for its future, especially if the level playing field extends to coordinating regulation and supervision with regimes in the US and other financial centres.

London’s location may still count for something, slung as it is between Asia and North America time zones, though with electronic trading and communications this may not be as important as it was. The thing about London is the sheer scale of its infrastructure. While the LIBOR scandal rumbles on, London’s other markets such as foreign exchange, commodities exchanges, Lloyds of London, its stock market, and debt and derivatives markets function well and scoop a large global market share. Its support services such as commercial property, fund management, legal, accounting, actuarial and consulting services remain those of choice for many of the world’s major businesses.

No one is likely to deny at this point that where there’s money there’s muck. When the stakes are so high and there is so much money in play, there is a good chance mistakes will be made and crime may fester. All the regulation in the world is unlikely to stop this once and for all but on a level playing field, London has an edge.

There used to be an old joke that if you dropped two bankers from an aeroplane, a clearing banker and an investment banker, the clearing banker would cover his private parts in an attempt to protect his most valuable assets while the investment banker would grab his briefcase and run to do the next deal. London’s financial services’ greatest asset will be their ability to follow the money and move smartly on. And yes, they are now going to have to do so quicker, better, cleaner and more transparently to win the business.

Collision avoided but what of Basel III?

Filed in: , bank, banking, fsa, france, basel, germany, euro, eu, eurozone

The issues that gave rise to the early May spat in Brussels between UK Chancellor Osborne and EU Commissioner responsible for the internal market and services Michel Barnier look to have been resolved. But will the EU’s banking regulation match up to the standards set by Basel III?

Collision avoided but what of Basel III?

The issues that gave rise to the early May spat in Brussels between UK Chancellor Osborne and EU Commissioner responsible for the internal market and services Michel Barnier look to have been resolved. But will the EU’s banking regulation match up to the standards set by Basel III?

As we go to press, Brussels has announced that a deal has been struck that will open the way forward to the next stage of EU banking reforms.

Monsieur Barnier’s task is to regulate as he put it '…every financial actor, financial market, financial activity and product…' in the European Union, carrying through pledges made by the G20 club of nations following the 2008 financial crisis. As far as regulating the banking system is concerned this means writing into EU law the so called Basel III guidance developed by the Bank of International Settlement’s Committee on Banking Supervision.

Basel III sets out a three-pillar structure, which the UK Financial Services Authority describes as follows:

  • Pillar I sets out the minimum capital requirements firms will be required to meet for credit, market and operational risk.
  • Under Pillar 2, firms and supervisors have to take a view on whether a firm should hold additional capital against risks not covered in Pillar I and must take action accordingly.
  • Pillar 3 aims to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management.

These measures will be implemented in the EU by means of the Capital Requirements Directive (CRD) and it was the fourth iteration of this that was in discussion when Messrs. Osborne and Barnier found themselves at odds. Once agreed, it will form part of the Single European Rulebook governing all 8,300 EU banks. There was to be relatively little margin to vary the capital that banks must hold in relation to their 'risk-weighted assets' (RWA), that is the loans that they make to borrowers of differing credit standings.

CRD VI allows for some flexibility in the amount of capital required but sets a maximum ceiling for this. The British position is that the proposed levels are not flexible enough. In September 2011 the Vickers Report of the UK’s Independent Commission on Banking made this recommendation among others, 'The international reform agenda – notably the Basel process and EU initiatives – is making important headway, but needs to be supported and enhanced by national measures. This is especially so given the position of the UK as an open economy with very large banks extensively engaged in global wholesale and investment banking alongside UK retail banking. Indeed part of the challenge for reform is to reconcile the UK’s position as an international financial centre with stable banking in the UK.'

This however set London and Brussels on a collision course. A requirement for UK banks to hold higher levels of regulatory capital suggests on the face of it that UK banks would be disadvantaged because the cost of doing so would render them less competitive. However the concern in Brussels was that more strongly capitalised UK based banks would attract more business from banks in the rest of Europe, which would be perceived as weaker banking partners. And so the cherished single market goal of a level banking playing field would be compromised.

French and German banks have been lobbying hard to be allowed to hold lower levels of capital. This however plays to a downward spiral where potentially under capitalised banks pose a greater risk to their respective governments that would need to rescue them in case of distress, so impairing their sovereign credit ratings.

The UK argues that it is a special case because it is home to the largest financial services sector in the European time zones. The financial sector plays a bigger role in the UK’s economy than it does in that of any other EU country.

'London is a very important centre but... there are other centres alongside London which also merit consideration,' says Mr. Barnier, a former French government minister, reports Reuters. The level EU playing field must take precedence.

Now it is reported that the UK and, by implication, any other European country can gold-plate its banks through exceeding the EU’s capital requirements. The UK will be allowed to implement the Vickers recommendations without reference to Brussels. Others will be allowed to hold less capital than Basel III has suggested. This now hits not only at the fundamental ideal of unity across the single market, which members supposedly bought into when they joined, for better or worse, but also at the standards set by the Basel Committee on Banking Supervision.

The fine resolutions of the G20 representatives to avert and avoid any future financial crisis are at stake here. They risk becoming slowly and at times somewhat acrimoniously watered down in the process of compromise and counter-compromise EU politics. This is not what the great and good had in mind when they met in Washington in November 2008, in the aftermath of the Lehman’s collapse and the world wide financial meltdown that followed it, and from which EU and global economies have yet to recover.

Scotland – how independent can it be?

Filed in: trade, standard life, financial, pound, independence, scotland

The Scottish National Party’s vision statement sets the scene. ‘It will create a partnership of equals - a social union to replace the current political union. That means, on independence day, we'll no longer have a Tory government, but the Queen will be our head of state, the Pound will be our currency and you will still be watching your favourite programmes on the BBC. As members of the EU there will continue to be open borders, shared rights, free trade and extensive cooperation.

Scotland – how independent can it be?

The Scottish National Party’s vision statement sets the scene. ‘It will create a partnership of equals - a social union to replace the current political union. That means, on independence day, we'll no longer have a Tory government, but the Queen will be our head of state, the Pound will be our currency and you will still be watching your favourite programmes on the BBC. As members of the EU there will continue to be open borders, shared rights, free trade and extensive cooperation.

The big difference will be that Scotland's future will be in our own hands. Instead of only deciding some issues here in Scotland, independence will allow us to take decisions on all the major issues. That is the reality of independence in this interdependent world.’

The last sentence gives the game away. How much independence Scotland would have while using the Pound Sterling as its currency and with much of its legislation deriving from the EU is a moot point.

The financial services sector accounts for around 7% of Scottish gross domestic product, according to Scottish Development International, the country’s inward investment promotion agency. The industry directly employs 95,000 people and 70,000 indirectly and generates in the region of £7bn for the Scottish economy. Its traditional strengths are in insurance, investment management, asset servicing and banking.

Moreover, they are international in scope. A spokesperson for Standard Life, the savings and investments business, told the Daily Telegraph, ‘Scotland's constitutional future is a matter for politicians and voters. However, it is important to Standard Life that Scotland continues to create a competitive environment from which to do business.’ 

The italics are mine. The point is that Standard Life and other major Scottish financial sector players long ago outgrew their home country. They are bound to look at Scottish independence pragmatically in terms what is good or bad for their businesses.

Owen Kelly, chief executive of Scottish Financial Enterprise, which represents the industry north of the border says, ‘It is important that some uncertainties are removed. Issues like currency, membership of the EU, regulation and the possible impact on the UK as a single market… need to be clarified so that companies, employees, customers and shareholders can understand the changes that independence will bring.’

There has been very little clarity as yet. Regulation is one area where the SNP has nailed its colours to the mast. In September 2008, in the wake of the Lehmans collapse the party’s Ian Hudghton commented, ‘It is clear that the UK authorities have let Scotland down and we could support constructive suggestions on tighter regulation, particularly proposals for EU-wide action to co-ordinate standards and increase transparency…Our core belief is that we want to see an independent Scotland with the powers to regulate the Scottish institutions…’

Regulation matters greatly to all financial services firms but it looks improbable that Scotland could or would regulate its firms more than the EU requires. If they did it would disadvantage them and they might consider moving to a less regulated regime. If Scotland’s regulatory regime was less stringent than the EU’s then it would be in breach of EU law.

How much independence can they really have therefore?
SNP spokespeople have referred to Ireland’s International Financial Services Centre as a role model for Scotland’s financial sector. Its success lies principally in tax legislation. If Scotland can secure an EU carve out for similar tax incentives they may well be able to attract financial services businesses to move there. However, Luxembourg, Switzerland, Monaco, Jersey and Guernsey are already much further along the curve and Scotland would find it hard to catch up.

Which leads to the question of Scotland’s independent tax raising powers. As long as it continues to use the Pound as its currency it will not be able to regulate the strength of its currency, nor its interest rates. Taxation is a remaining economic lever. If it were to adopt the Euro however, and this has been mooted, the likelihood is that it might well have to submit to unitary Eurozone taxation, which would hobble its independence.

Scotland’s interdependency with other countries and economies means that it cannot simply play with its own financial and fiscal train set in any way it pleases, and financial services firms appreciate the implications of this better than most.

So in the final analysis, money is so fungible and the financial services industry so international and so competitive, it is difficult to see how Scottish independence will really make any difference to the way Scottish and British firms will operate.

If Scotland’s regime proves onerous, its firms will be forced to play the game of regulatory arbitrage. At the same time it cannot, within the scope of its international memberships and obligations, have much room to manoeuvre in establishing an operating environment that is significantly more competitive than other countries and financial centres.

Tobin or not Tobin?

Filed in: tax, bank, banking, financial transactions tax, markets, tobin, ftt

The banking industry is against it. The securities firms and asset managers are against it. But what's the Financial Transactions Tax (FTT) really about?

Tobin or not Tobin?

The banking industry is against it. The securities firms and asset managers are against it. But what's the Financial Transactions Tax (FTT) really about?

When American Nobel Prize winning economist James Tobin proposed such a tax, it was to be on cross border foreign exchange transactions. He devised it following the abandonment of the Bretton Woods monetary system.

In essence, it was to be a tool to help central banks control currency speculation and in particular to protect the US dollar which had become the global reference currency.

Now that the euro needs protection, how appropriate to dust off the idea and see if it can be used to help fix the problem. But the EU proposal goes further than Tobin. First rejected by the G20 in 2010 and again at their meeting in Cannes in November this year, the plan is to levy a tax of 0.1% on stock and bond transactions and 0.01% on derivatives.

Analyst Jon Peace at Nomura suggests that this could raise between €30bn and €50bn annually and would come into force in 2014. Research by consultants PwC says, 'European policy makers believe that it will cleanse the market of high-tech practices which fuel speculation, market noise and technical trading and market volatility. Various other market behaviours and business models are likely to be severely affected as well.'

A similar tax has been proposed in the US by Democrat senator Tom Harkin who is quoted by Bloomberg as saying, '…It’s a significant way to raise some needed revenue. Quite frankly, I bet nobody would even feel it...'

International battle lines have firmed up and an FTT is opposed by the US and UK, while France and Germany are its principal supporters. The bankers’ position explained by the British Bankers Association is this: 'This transaction tax is a job loser and the costs will be borne by the wider economy… Financial transaction taxes are not taxes on banks - they are taxes collected for governments by banks. Banks conduct transactions for their customers, therefore any tax on transactions would be an additional tax on customers…'

The BBA continues, '… Anything less than a globally-applied, uniform tax would distort the markets and reward dissenting low-tax regimes rather than raising significant revenue. The UK would be particularly affected by any such tax, as it is the world’s financial centre. Four of every five financial transactions in the EU take place in the UK.'

Understandably, Prime Minister Cameron and Chancellor Osborne broadly support this position. German parliamentarian and Chancellor Merkel ally, Volker Kauder, has accused the UK of selfishness in the face of a pan-EU crisis. 'To applause,' reported the Financial Times on 15 November, 'he said it was not acceptable that the UK was "only defending its own interests" rather than that of the wider EU.'

Economics and politics
If a FTT was introduced it would particularly affect certain types of high volume, low margin transactions such as high velocity trading of stocks and bonds and this is where the financial agenda aligns with a political one.

Significant market movements resulting from large, often automated, algorithmic strategies, are viewed by politicians who support the FTT as uncontrollable market manipulation. They say that this benefits only a small group of large financial institutions and hedge funds and their wealthy private and institutional investors. And their timing of the FTT proposal is propitious.

Popular support for banks in particular and the financial services industry in general is at an all time low. Few lay voices would be raised against this 'Robin Hood tax,' styled as a levy on the industry rather than on its customers.

Moreover, similar opportunism has been displayed by the likes of Bill Gates and the Archbishop of Canterbury to promote their charitable or moral agendas, seeking a slice of the FTT pie. But there is more to this.

If implemented across the EU it would be an initial step towards pan-European taxation, which supporters of a closer EU regard as essential if the EU project and its associated currency are to be a long-term success.

Those who oppose fiscal union, such as many in the UK and elsewhere in Northern Europe, do so because they see it as hard working Northern Europeans having to pay for the results of political corruption, wide scale tax evasion and the excesses of la dolce vita in the south.

So a Tobin tax may be portrayed as a timely strike against the banking industry to get it to pay the price for its outrageous fortune. And it may be a way of taking up arms against a sea of economic troubles, and by opposing, end them.

But there are much bigger, more profound, much longer-tailed political issues at play here, which may override all others in the decades to come.

Eurozone - disaster averted?

Filed in: banks, euro, eurozone, efsf, bailout, sovereign

Under the latest scheme involving the Institute of International Finance (IIF), a global association of major financial institutions and the participation of the European Financial Stability Facility (EFSF), the €250bn Eurozone bailout fund, financial institutions have agreed to shoulder losses.

Eurozone - disaster averted?

Under the latest scheme involving the Institute of International Finance (IIF), a global association of major financial institutions and the participation of the European Financial Stability Facility (EFSF), the €250bn Eurozone bailout fund, financial institutions have agreed to shoulder losses.

Lenders have agreed to exchange the Greek debt they currently hold for instruments with maturities out to 30 years. They have also agreed to accept a loss on their original investment of 21% calculated by means of present valuing the expected future cash flows at a discount rate of 9%.

Whereas a Greek default would have crystallised an immediate loss for the debt holders, the current plan, scheduled to begin this month, will spread the pain over many years.

The private sector bondholders will lose something but their losses may not be that great. 'That’s why I believe that any one, two or even three Eurozone countries failing will not actually damage British banks that much,' says Ralph Silva, analyst at research and broadcast firm SRN. 'I’d have to revise that view if the haircut turned out to be much larger but I suspect they are not going to be that significant.'

To put the British banks’ position in perspective, total debt exposure to Greece including public sector, banks and non-bank private sector totalled US$14.65bn according to statistics released by the Bank of England in its 24 June 2011 Financial Stability Report.

Comparable figures for other problem Eurozone countries are: Ireland US$136.6 billion, Italy US$68.8bn, Portugal US$26.6bn and Spain US$100.8bn. This excludes exposures to derivatives and guarantees.

Bank exposure to Eurozone debtors falls into several categories. They may be loans, investments in the form of bonds, they may be collateral held in the form of debt securities, or they could be securities in a trading portfolio as assets held for sale.

The nature of these holdings affects their impact on the holders, though in any event they need to be written down in accounting terms. The question for regulatory purposes is whether further capital is required to restore capital adequacy ratios. As yet the impact is not sufficiently severe for this to be necessary.

An example of how one bank has dealt with its exposure is described in analysis from Moody’s Investors Service. 'Royal Bank of Scotland… took a £733m charge for 50% of its entire Greek debt available-for-sale portfolio (including maturities before and after 2020), fully reflecting the low market value that existed at 30 June, 2011. RBS said there is evidence that all Greek debt securities are impaired at 30 June, and as such the bank has recognized an impairment charge for all of these securities that it holds, whether or not each is eligible to participate in the exchange offer.'

In practice, however, assuming the offer as described above is finalized, RBS would be in a position to write back £275m of this charge, according to Moody’s. Moreover, moving the exposure to a long-term investment or loan book from the trading book averts the need to mark the exposure to what are, at present, rather volatile markets.

The position of insurance companies is similar. They may also hold Greek debt as part of their capital and/or as investments. However, Ralph Silva’s view is that insurers will be even less affected, as their time frames tend to be longer. While they may also need to provide for their Greek or other Eurozone exposures they would be much more severely impacted by short-term catastrophic events that they insure, such as a 9/11 or hurricane Katrina event.

One catastrophe that has, for the moment as least, been avoided is that of the partial collapse of the Euro due to one or more sovereign default.

As Andrew Gray, UK banking leader at consultants PriceWaterhouseCoopers, points out, because economies of different sizes and performances are yoked together in the Euro, they have surrendered two important levers of control over their economies: exchange rates – the ability to devalue if necessary, and interest rates - to control inflation. Gray says that the Greek situation takes us into uncharted economic management territory.

For the UK’s financial institutions this is extremely important. Dealing with a default of a relatively minor Eurozone economy is one thing, but the collapse of the European single currency would be truly catastrophic because of the vast scale of the Euro denominated assets that British banks and insurance companies hold.

Unpicking the Euro into constituent currencies and the consequent devaluation of weaker local currencies as well as revaluation of stronger ones, is a nightmare scenario that no one wants to contemplate. Hopefully the Greek rescheduling model will mean that we will never have to.

European Banks Take Different Perspectives on Greek Debt Impairment Charges.

Extracted from 'Moody's Weekly Credit Outlook', dated 8 August 2011.

Will the insurance sector be ready for Solvency II?

Filed in: , solvency ii, it, insurance, fsa, regulation

While a large proportion of Europe’s insurance sector seems well advanced in its preparations for new Solvency II regulation, closer examination reveals glaring differences between how jurisdictions and types of insurance firms are progressing.

Will the insurance sector be ready for Solvency II?

While a large proportion of Europe’s insurance sector seems well advanced in its preparations for new Solvency II regulation, closer examination reveals glaring differences between how jurisdictions and types of insurance firms are progressing.

In March the European Insurance and Occupational Pensions Authority (EIOPA), responsible for regulating the EU insurance sector, released its report on the fifth Quantitative Impact Study (QIS5). This was the latest in a series of 'field tests' to determine the effects and practical concerns arising from Solvency II’s requirements. The results, drawn from 30 countries, and covering a large majority of substantial insurance groups, as well as a lesser proportion of small firms, showed there were notable differences in their preparedness as the clock ticks towards the end 2012 target date.

In the UK, QIS5 showed that large groups were well ahead in their preparations. Peter Gatenby, who leads the actuarial work of accountants and advisors Mazars in the life, pensions and healthcare sectors, says that the largest firms such as Aviva, Prudential, Zurich and Standard Life started their preparations early. They also resourced their Solvency II teams while good people were more readily available. However, smaller firms tended to get started later and some now face a lack of expert staff, which in turn means that they are forced to pay more for the expertise they need. Alex Lenihan, head of financial services, Russam GMS, a provider of interim management staff, says that there is definitely a lack of good staff, and those who are available can be expected to charge top rates.

On the technical level, the requirements of Solvency II entail significant IT cost, which can be difficult to quantify. As one chief information officer puts it, 'as a comparison we know from Basel II experience (the banking industry’s equivalent of Solvency II) that IT resources and budget should not be under estimated. The reality from Basel II is that the banks spent between three to six times more than they originally budgeted for and 70% of that was on IT.'

Another lesson from Basel II that insurers are now learning to live with is that some classes of business will now be so capital intensive that they may have to reprice them, restructure them or withdraw them. This was a key finding of the EIOPA report.

Consultants KPMG say that industry consolidation will inevitably follow. This will be 'driven by companies seeking to increase diversification, which is rewarded under Solvency II. In addition, we expect that companies struggling to meet the new capital requirements may look to merge with, or be acquired by, companies with higher levels of capital,' they add.

A troubling aspect of Solvency II is the mismatch between regulators in different jurisdictions. The UK’s FSA is regarded as being a leader among regulators, with a rigorous approach to its regulatory duties. Others, among which Gibraltar and Ireland were mentioned by one expert, are regarded as having a 'lighter touch'. This, says Mazars’ Peter Gatenby provides scope for 'regulatory arbitrage' where firms may seek to rebase their operations to jurisdictions where they believe the regulation enforcement may be less onerous. He notes that Aviva and Zurich have both announced relocations of the head offices of their non-life businesses to Ireland with their European operations becoming branches rather than local subsidiaries.

At the same time insurers are facing some difficult valuation issues on both sides of their balance sheets. Those with long tail liabilities fear more costly valuation requirements under Solvency II. 'There remain a number of outstanding issues in Solvency II, particularly the treatment of some long-term products which carry guarantees for consumers,' says Peter Vipond, Director of Financial Regulation and Taxation at the Association of British Insurers.

On the asset side they face similar issues to those that banks have had to tackle under Basel II in marking to market the securities held in their portfolios. Banks have lamented how volatility in market pricing of, for example, their bond portfolios, affects their capital requirements and does not take into account the smoothing of prices over time. Insurance firms will now have to live with this.

Some smaller firms at the bottom of the insurance market food chain may have their work cut out in meeting all of Solvency II’s requirements by deadline, but there is some give and take in the system. The concept of 'proportionality allows regulators to be more flexible to firms that do not greatly impact consumers or the stability of markets as a whole. But taking this into account and considering the different speeds and rigour adopted by regulators in different jurisdictions it is difficult to see that there will be anything like a level pan-European insurance playing field come 2013. Although a high degree of uniformity is the holy grail of joined up regulation post the financial crisis, commentators seem to be saying that this is unlikely to be achieved in the foreseeable future. Consequently there are bound to be winners and losers across the European insurance sector and some losers may feel that their businesses will have been disadvantaged unfairly by powers and circumstances beyond their control.

Solvency II
In the words of the UK Financial Services Authority (FSA), Solvency II 'will set out new, stronger EU-wide requirements on capital adequacy and risk management for insurers with the aim of increasing protection for policyholders. The strengthened regime should reduce the possibility of consumer loss or market disruption in insurance.'

Insurance firms will be required to have implemented its terms by 1 January 2013, assuming the European Parliament approval process follows its expected course. This will be the first major overhaul of insurance industry regulation since Solvency I in 2002. It is built around three key sets of requirements or 'pillars'. The following description is reproduced courtesy of Lloyds of London:

Pillar 1 - Capital requirements
There are two thresholds:
- Solvency Capital Requirement (SCR)
- Minimum Capital Requirement (MCR)

SCR is calculated using either a standard formula or, with regulatory approval, an internal model.

MCR is calculated as a linear function of specified variables: it cannot fall below 25%, or exceed 45% of an insurer's SCR.

There are also harmonised standards for the valuation of assets and liabilities.

Pillar 2 - Governance and supervision
Effective risk management system.

Own Risk and Solvency Assessment (ORSA)

Supervisory review and intervention.

Pillar 3 - Disclosure
Insurers required to publish details of the risks facing them, capital adequacy and risk management.

Transparency and open information are intended to assist market forces in imposing greater discipline on the industry.

FSA tightens its grip

Filed in: fsa, insider trading, regulator, regulation, fraud, sec

Slowly but surely the UK Financial Services Authority (FSA) is quashing market abuse and bringing insider traders to book, explains Richard Willsher.

FSA tightens its grip

Slowly but surely the UK Financial Services Authority (FSA) is quashing market abuse and bringing insider traders to book, explains Richard Willsher.

On 7 February 2011 the FSA announced: 'the Upper Tribunal (Tax and Chancery Chamber) has directed the Financial Services Authority (FSA) to fine David Massey £150,000 and ban him from performing any role in regulated financial services for engaging in market abuse'.

Massey’s crime was to short sell shares in Eicom just before it was about to issue new stock at a lower price, having received inside information of the impending issue from the company. It emerged that Massey had had a close relationship with the company that he failed to disclose. He also tried to hide his insider dealing from his employers Zimmerman Adams International, where he was a corporate finance executive.

This, the latest in a series of discoveries, arrests and prosecutions by the UK markets regulator, tells us several things. Firstly, that it is closing its net around wrongdoers. Secondly, that market abuse does not pay – Massey is reported to have earned £100,000 from his Eicom trades but was fined £150,000 and banned from the financial services industry. Thirdly, it supports the long-term aims of Margaret Cole, managing director of enforcement and financial crime at the FSA, to clean up the market. She commented, 'Massey used the trust invested in him by both parties to create the opportunity to trade on the basis of inside information and he distorted the truth to hide his actions, profiting at the expense of other market users. This type of conduct threatens the integrity of the market and will not be tolerated by the FSA'.

Credible deterrence
The key concept underlying the strategy that Cole has been pursuing since 2007 is 'credible deterrence'. This involves using several tactics:

  • obtaining criminal prosecutions where possible
  • bringing cases using its own Regulatory Decisions Committee as well as using the Tribunal process
  • developing its in-house transaction reporting system to pick up irregular or suspicious dealing activity
  • working with other agencies such as the Serious Organised Crime Agency, City of London Police and other police forces on searches, arrests and extradition
  • working with regulators in other jurisdictions to expose international conspiracies which threaten the integrity of the UK markets.

In 2010 the FSA levied fines of over £89m during the year for offences across the full range of its supervisory activities. In terms of market abuse, of which insider trading is a subset, the FSA can only levy civil fines. The total collected here amounted to £10 million, with five successful criminal insider-dealing prosecutions. Although hardly a vast sum, this represents a degree of success.

It also launched a much-publicised series of dawn raids in spring of 2010, which it was keen to make public. Announcing its actions and successes is part of the credible deterrence programme.

'In terms of insider dealing, the FSA seem to be following through on what they have been promising for a long time and have made sure that the action they have taken is well publicised,' says Carmen Reynolds, a partner in the banking and capital markets group at international law firm White & Case. We can expect that there will be further announcements in due course as suspects arrested over the last couple of years are brought to court.

International cooperation
No market is an island. Regulators across the globe have long recognised that as capital, trading and markets become more international, people aiming to exploit illegal, specialised knowledge to their own advantage can only be apprehended if they work together. Indeed, just as the global financial system itself is only as strong as its weakest link, so too regulation and law enforcement.

For example, on 30 December 2010 the SEC announced that it had charged a San Francisco based former Deloitte Tax LLP partner and his wife, Arnold and Annabel McClellan, with leaking inside information about merger and acquisition deals to relatives in the UK. The FSA brought charges against James and Miranda Sanders, the London-based relatives. The allegation is that they gained US$3 million through their efforts.

Clearly international insider trading can produce significant sums for those involved and so significant penalties need to be imposed if they are to prove dissuasive. Here the United States’ Securities and Exchange Commission has a distinct advantage over the FSA as it is empowered to levy massive fines, far in excess of those possible in the English courts. However, how many such international groups may operate in this way we cannot know and it seems unlikely that the McClellens and the Sanders are unique in devising such schemes.

What other recent cases have shown is that so-called 'expert rings' are now being targeted by regulators. The Galleon case is one example. Here the SEC alleges that Galleon Management LP, a New York based hedge fund, engaged in insider trading where others involved included 'senior executives at IBM, Intel and McKinsey & Company'. A number of those charged have pleaded guilty while the investigation continues to widen its list of suspects and other similar rings appear to be being uncovered in the US.

Elsewhere, in the European Union and in Hong Kong for example, there are moves afoot to tighten insider-trading regulation, though at differing pace. But it is difficult to know whether they are doing enough. For example, despite the FSA’s efforts, reports suggest that significant volumes of trading may be occurring around the time of almost one third of UK takeovers, some of which could be suspicious. And what of those whose success at insider trading is never identified or, if it is, then cannot be pursued by regulators for lack of evidence? Are we seeing the rump of insider trades now brought to light or merely the tips of much larger market abuse icebergs? As long as we do not know the answer to these questions, markets cannot be said to be clean or fair, even though the FSA and others seem from their public announcements to be making inroads among criminals and market abusers.

SIFIs - under control yet?

Filed in: , banks, insurance, fsa, basel, fsb, sifi, g20, bis, regulation

It’s more than two years since the collapse of Lehman Brothers and the financial crisis that ensued. Richard Willsher asks whether the regulators are any further ahead with reining in the ‘systemically important financial institutions (SIFIs)’ that could threaten the world’s financial system?

SIFIs – under control yet?

It’s more than two years since the collapse of Lehman Brothers and the financial crisis that ensued. Richard Willsher asks whether the regulators are any further ahead with reining in the ‘systemically important financial institutions (SIFIs)’ that could threaten the world’s financial system?

What are SIFIs?
This is a simple enough question on the face of it. The Financial Stability Board (FSB), the super regulator coordinating the work of national and international financial regulators and standard setting bodies, defines SIFIs as financial institutions whose ‘…disorderly failure, because of their size, complexity and systemic inter-connectedness, would cause significant disruption to the wider financial system and economic activity’. In other words organisations that are too big to be allowed to fail. But who the SIFIs actually are is a matter of great conjecture and the FSB is keeping its cards close to its chest.

When the Financial Times on 29 November last year reported a list of 30 SIFIs – see list at the end – that included the big banks in the major economies plus six European insurance industry giants, the FSB was not best pleased. A year later the UK Financial Services Authority (FSA) chairman and FSB member Adair Turner said in a speech to insurance regulators in Dubai that the FSB did not believe insurance firms should be on the list because they didn’t pose systemic risks like the big banks. The FSB says it will issue its list of SIFIs next year.

So where are we now?
The Seoul summit, according to a letter to G20 leaders from FSB chairman Mario Draghi, marked ‘...the delivery of two central elements of the reform programme… to create a sounder financial system and reduce systemic risk globally’. These were ‘a materially strengthened global framework for bank capital and liquidity, and a comprehensive policy framework to address the moral hazard risks associated with institutions that are too big (or complex) to fail.’

The first of these was the Basel III framework produced by the Basle Committee on Banking Supervision of the Bank for International Settlements (BIS). It sets out recommendations for increased capital and liquidity buffers for central banks to implement with the banks under their supervision.

These are due to start to be implemented on 1 January 2013 and the process completed by 1 January 2019. In the meantime there is almost daily a report from a bank or banking representative organisation or pressure group or commentator arguing that Basel III will have damaging effects on one bank or another or on the business that banks will able, or inclined, to undertake. In terms of ‘delivery’ at Seoul the acid test will be what happens if there is a threat to a SIFI between now and 2019? Moreover, what if the threat did not arise from the same banking problems that caused the 2008 crisis?

The idea of addressing the moral hazard element of the reform programme is that ‘too-big-to-fail’ institutions should not in future be bailed out by the taxpayer. The FSB has come up with a five-point action plan:

  * ‘improvement in resolution regimes’ which means having a bailout contingency plan to sort out the mess without damaging the financial system and without turning to the taxpayer
  * an even more stringent set of rules than Basel III for SIFIs, so that they can absorb losses and which reflect the risks that they pose to the global financial system
  * tighter national supervision of SIFIs
  * stronger standards for core national financial infrastructures that can prevent knock-on effects of the failure of individual institutions
  * a ‘peer review’ to be carried out by the FSB to ensure ‘effectiveness and consistency’ of national regulatory measures to start by the beginning of 2012.

National and international regulation and supervision
One of the key problems facing the FSB and the other supra-national bodies such as the BIS and the International Monetary Fund is ‘the weakest link’. Unless all governments and their regulators use the same standards and degree of stringency in their supervision there will be a risk that a particular institution in a particular jurisdiction may trigger a domino effect should it be stressed or fail. Moreover, a weak supervisory or regulatory environment may result is so-called ‘regulatory arbitrage’ where financial institutions may spot loopholes they can exploit for their greater profit. For this reason internationally coordinated super-regulation is the goal.

But it is not an easy one to achieve. There are some, for example in the USA, who criticise the FSB for being unelected and dominated by European banking representatives. They argue for greater autonomy for US financial institutions, which ought to set alarm bells ringing in light of the manner in which the sub-prime crisis came about and was led by US investment banks creating risk capacity by selling toxic debt packages to the world’s banks and other investors.

For this reason perhaps, another key plank in the FSB’s action plan is to reduce the dependency on credit rating agencies. According to the Draghi letter, ratings are ‘hard wired’ into the debt markets such that when a rating agency changes a rating it produces ‘mechanistic market responses’. This is regulator speak for herd behaviour, which may lead to over reactions and panics in the markets.

In the elliptical way that the dialogue between regulators and politicians about regulating the financial system seems to work, the FSB has made its set of recommendations to the G20 leaders and they have accepted them. The process of regulating the financial system in order to avoid a future Armageddon is grinding on but it is long way from being concluded.

Indeed it may never be; new risks and perils are certain to arise, which will need to be addressed as they occur. The SIFIs are core to the entire financial system and how to tackle and control them is still the subject of debate and, in large measure, experimentation. It has taken two years so far and the chances that the world financial system can ever be made shatterproof, let alone by 2019, still hangs in the balance.

Richard Willsher is a freelance journalist

30 possible SIFIs

Bank of America Merrill Lynch
Goldman Sachs
JPMorgan Chase
Morgan Stanley

Royal Bank of Canada

UK groups
Royal Bank of Scotland
Standard Chartered

Credit Suisse

BNP Paribas
Société Générale


Mitsubishi UFJ
Sumitomo Mitsui

Banca Intesa

Deutsche Bank


Insurance groups
Swiss Re

This list appeared in the Financial Times on 29 November 2009