Judgement day for the EU FTT: Will the ECJ rule in favour of taxation without representation?

There has been an important development brewing in the UK’s flagship case against the EU's proposed Financial Transaction Tax (FTT). We've known for some time that the European Court of Justice (ECJ) will take a shortened proceeding and rule on the case on the 30 April – this has now become public, as European Voice reported this morning. A ruling hadn't originally been expected until 2015. We expect the ECJ to either throw out the case or rule against the UK - which is problematic for numerous reasons.

We have covered the FTT extensively and the court case is an important marker for the UK’s place in the EU.

The UK claims that the use of enhanced cooperation here is fundamentally against the EU treaties as it imposes costs on those outside the FTT-zone. If the ECJ rules against the UK, it could become a wide-ranging precedent with three key effects:

• Allowing for the broader use of enhanced cooperation (even with extraterritorial impacts) including for eurozone integration
• Making it more difficult for the UK to employ a veto over further EU integration it's not part of 
• Undermining trust in the ECJ as a fair, impartial arbiter and guardian of the single market

However, it's important not to be too alarmist about this. While the ruling looks unlikely to go in the UK's favour (but it still could) it seems more likely to be dismissed on grounds of the UK's challenge being premature (given that the proposal is yet to be finalised) rather than being outright wrong. So the UK will have another shot at challenging the final decision.

Also, the FTT is likely to be substantially watered down so the actual effect might be far less damaging than the Commission proposal pursued under enhanced cooperation. As a key proponent of a watered down FTT, the UK is already to a large extent a winner. Finally, this is a different sub-set to the eurozone (with Ireland and the Netherlands outside).

Below is a Q&A on the issue - pardon the length of it.

What are the UK’s objections?
As a recap, the UK has called for the decision authorising the use of ‘enhanced cooperation’ for the FTT to be annulled. As such it is not directly challenging the measure itself. The key reasons for the UK’s challenge are (as published by the ECJ):

1. The FTT is not compatible with Article 327 of EU Treaties which states that any member states not participating under enhanced cooperation must not feel any impact. The FTT will hit UK firms if there are any transactions with those inside the FTT zone.
2. There is no basis in international tax law which justifies imposing taxes on a sovereign state which does not wish to be part of said tax regime. Adopting a law with extraterritorial effects does not fit with the code of international tax law.
3. The tax will be distortionary and impact competition across the EU. Rather than improving the single market it could fragment it.
4. The FTT is not compatible with Article 332 of the EU treaties which states that any expenditure from enhanced cooperation will come from those directly involved. Given that taxes will be raised from UK and other countries not involved, this has been breached. The UK would also likely be directly responsible for collecting and enforcing this tax due to rules on mutual assistance, producing a further burden.

What are the potential outcomes from the ruling?

1. The ECJ rules in favour of the UK – seems very unlikely, but not impossible. In this case the Council would be forced to reconsider the FTT. It would need to adjust the details of the FTT to fit with the ECJ’s ruling and then get renewed support for enhanced cooperation.
2. The ECJ rules against the UK and dismisses some or all of its claims – possible. This could amount to the ECJ ruling that the FTT does not have any extraterritorial effects nor that it cuts across the single market. This would not only set a worrying precedent for any future challenge against the specific nature of the FTT itself but also for the UK’s position in the EU more generally, weakening its ability to bloc future eurozone integration with a direct or indirect impact on the UK. Combine this with the growing use of intergovernmental agreements and using the single market legal base for eurozone integration and it's clear the net effect is reduced UK leverage in Europe. 
3. The ECJ deems the challenge premature or unwarranted – likely. Given that the FTT is still a work in progress and the final proposal remains uncertain, the ECJ could throw the complaint out on technical grounds. This would not be too detrimental to the UK, although it would still be a blow as the UK was hoping to stop the FTT as soon as possible. It would also mean that, out of four key legal challenges on financial services at the ECJ (short selling, FTT, bankers bonus cap and ECB location policy) the UK is now at 0/2 - not exactly an encouraging score.

Usually, ECJ cases take a minimum of 16 months to work their way through the process of deciding a case. This has taken around 12 months.Written proceedings and arguments were concluded in January this year, normally the case would then move onto a hearing and an Advocate General would present an opinion before the final ruling. The fact that the ECJ has effectively skipped two steps and moved straight to the ruling. This could suggest that the ECJ considers it a straightforward case, which is unlikely to have been the case if the ECJ ruled against the European Commission (always very controversial).

Does this mean the UK was wrong to launch its challenge?

• In the end, we still think it was the right thing for the UK to do. It seems clear to most that there are numerous negative side-effects from the FTT, many of which seem to break rules enshrined in the EU treaties. The broader point is that the UK is right to establish the boundaries of what the EU can do and what enhanced cooperation can be used for. 
• The one caveat in this instance is that, given the large and growing concerns about the FTT, it has floundered and stalled on its own to a large extent, suggesting the legal challenge may not have been necessary. This would especially be true if it ends up going against the UK and setting the precedent described above.

Is this the end of the story?

If the ECJ rules in favour of the UK, the European Commission will need to table a new proposal. If the challenge is either thrown out or goes against the UK, the Government can still challenge the final legislation (as opposed to the decision to authorise enhanced cooperation). 

If the ECJ does end up throwing out the challenge for being premature, then the process has taught us little and the final result remains to be seen. It does raise the question though: why was authorisation given for enhanced cooperation before the final make-up of the proposal was known?

ECJ rules against the UK in landmark short-selling case

The ECJ this morning rejected all the UK’s claims against the EU's short selling regulation. The result was surprising given that the Court's Advocate General Niilo Jääskinen issued an opinion supporting the UK’s position last September – court rulings often, but not always, follow these opinions.

The nub of the UK's complaint was that the new regulation transferred too much discretionary power to ESMA (the European Securities and Markets Authority) to ban short-selling over the heads of national regulators. And that the legal base for doing so in the EU treaties was unsatisfactory. The case could therefore set an important precedent.

The UK’s complaint as described by the court:

The United Kingdom contends, inter alia, that ESMA has been given a very large measure of discretion of a political nature which is at odds with EU principles relating to the delegation of powers. The United Kingdom also submits that Article 114 TFEU is not the correct legal basis for the adoption of the rules laid down in Article 28 of the regulation.

The full regulation and article 28 can be found here.

Here is what Jääskinen had to say about the complaint in September:

"The outcome is not harmonisation but the replacement of national decision-making with EU level decision-making. This goes beyond the limits of Article 114."

While he didn’t side with the UK on all issues, he did recommend changing the legal base of the regulation to Article 352, which would have given the UK a veto.

However, the ECJ took a very different line arguing that the regulation is in line with the treaties since ESMA already has a role to play in this area and because the powers are limited to times when financial market stability is in question - of course when this is, remains to be defined by ESMA itself. The court also suggests that, contrary to the Advocate General's view, the new rules do provide for harmonisation.

As we noted before, this ruling has the potential to be very important for the UK and could set the tone/precedent for future rulings. The court’s decision to reject the UK’s claim could have some important implications:

• Firstly, it potentially sets a precedent for the transfer of powers to an EU agency under the single market article (114). This is decided under qualified majority vote (QMV) meaning the UK does not have a veto. Not only that, but the scope of the powers remains vague and widespread, allowing ESMA quite a significant amount of leeway in deciding where to act in what the UK Government would argue are political decisions.

• More generally, there will be a concern that it could allow the use of Article 114 to be stretched – a question which is raised in some of the UK’s other on-going court challenges against EU financial regulation.

• This will raise concerns in the UK over two issues – financial services regulation and the split between euro and non-euro countries. The first is obvious given that the UK may feel its ability to legally protect itself against burdensome regulation is now diminished. The second stems from the potential abuse of the single market article to further the needs of the eurozone - the short-selling ban was largely conceived following the eurozone/financial crisis to combat 'speculators'.

• One saving grace may be that the ruling is quite specific in terms of financial market oversight, a role which the agency in question (ESMA) already has a part in. However, only time and future legal challenges will tell far-reching the implications of this ruling will be.

What happens now?

Given that the ECJ rejected all aspects of the UK's claim, it is dismissed entirely. There is little more the UK can do from a legal aspect, unless it decides to challenge other parts of the regulation but that seems unlikely.

The UK can continue to work behind the scenes to limit the practical power of ESMA and define strict criteria for when it can act on this issue. Of course, if any decision to limit short-selling by ESMA does happen, it could always challenge that specific move.

Nevertheless, this is clearly a political blow to the UK.  

ECJ legal opinion marks important preliminary victory for UK in short selling dispute

The UK has this morning been set on the path to an important victory at the European Court of Justice, after the Advocate General Niilo Jääskinen supported the UK’s claim that the EU's short selling Regulation transfers too much power to the European Securities Markets Authority (ESMA).

The opinion is not binding, but is followed in the majority of cases.

The UK objected to the EU's short selling regulation on a number of levels, but the main concern was that Article 28 of the Regulation - which allows ESMA to impose temporary short selling bans in emergency situations, overruling national financial supervisors - amounted to a significant transfer of power to an EU institution, and therefore Article 114 of the EU treaty (the single market article) was not a valid legal base for the Regulation.

The Advocate General did not side with the UK on all points, but on this key issue, he said:

"The outcome is not harmonisation but the replacement of national decision-making with EU level decision-making. This goes beyond the limits of Article 114."

Jääskinen went on to suggest that an alternative legal base for the regulation could be found and recommended Article 352 of the EU treaties. Although this may seem a technical point, it is extremely important. Article 352 (which sets out the so-called 'flexibility clause') requires unanimity, meaning the UK could veto the proposal.

If the ECJ were to follow the advice of its Advocate General, this could prove to be an important ruling for a number of reasons:

• First, it would halt the transfer of further powers (without national permission) to an EU agency and allow the UK to keep control over an important part of financial services regulation;
• Secondly, it would show that the UK government can have success using the right legal channels effectively. This could bode well for other cases, such as the on-going dispute on UK rules on EU migrants’ access to benefits, or ECB demands that transactions denominated in euros be cleared exclusively within the eurozone;
• It also highlights that the single market article, which, as we noted before, has been stretched significantly, cannot be a ubiquitous catch-all legal base for things the Commission believes fit with its view of the single market. This could become important in future negotiations, particularly over banking union.

The FTT is dying a death of a thousand cuts – this could be the final one

The EU’s Financial Transaction Tax has taken another big blow today – possibly a fatal one.

A leaked legal opinion by the European Council’s legal service has warned that the current set up of the FTT pursued by 11 member states “infringes” on and “is not compatible” with the current EU treaties (the FT’s Brussels blog has posted the full text and done a good round up of the issues at play).

The legal service was asked to look specifically into whether the FTT’s counterparty principle (taxation based on where the counterparty of the transaction is based) infringed on the right of member states which are not taking part in enhanced cooperation policy not to be affected by said policy (Article 327 TFEU).

The criticism is very much in line with complaints raised by the UK as well as by previous leaked documents (which we exclusively published) which showed growing concerns over the extraterritoriality of the FTT and that it may be discriminatory against non-participating members:

“Concerning the deemed establishment based on the counterparty principle, raises issues of extraterritorial exercise of jurisdiction, disrespect of non-participating Member States' rights under the Treaty, and compatibility with the principles of free movement of capital and non-discrimination.”

“[The counterparty principle] would constitute the exercise of jurisdiction over entities located outside the geographical area concerned by the legislation adopted under the enhanced cooperation.”

“The FTT proposed will be levied not only on risky activities but to a large extent also on activities with a genuine economic substance that are not liable to contribute to systemic risk and which are indispensable for the activities of non-financial business entities. Where activities are covered that can indeed be considered to be liable to contribute to financial markets' risk, it has not been demonstrated that the interests of Member States' are endangered to a point that the Union should divert from its attitude in principle of restraint as to extraterritorial exercise of jurisdiction.”

Those are just a few of the very clear and strongly worded arguments put forth by the legal service. Given the clarity and depth of the arguments presented it is hard not to see this as the final nail in the coffin for this (much maligned) proposal for the FTT.

Given the politics of this, there will have to be some form of 'financial transaction tax'. But, this is now likely to amount to a significantly watered down tax, possibly focused solely on equities and levied at a much lower rate only on those specifically trading the products (similar to the UK's stamp duty).

In any case, this is a big win for the UK – although how much credit it can take for it is unclear. In the end the combination of legal overstretch as well as the potential to inflict significant financial damage on fragile eurozone states has undermined the FTT. Equally this is a blow to the Commission and the European Parliament which have pushed hard and invested a lot of time resources into getting this version of the FTT through.

That said, the Commission has remained unsurprisingly steadfast, suggesting that it rejects the legal opinion and believes the current set up is compatible with the EU treaties. The German government has also suggested it will continue to pursue the FTT, but has said that it will seek to iron out all legal uncertainties first (though some in Germany have previously raised concerns about the substance of tax).

Ultimately, this may have to be decided in court. But the case for the FTT has certainly taken another hefty blow.

The EU wades into the murky world of shadow banking

The European Commission this morning unveiled its initial proposals to regulate ‘shadow banking’ and money market funds (MMFs) – the press release is here and the FAQs are here and here.

We covered this issue back in May when we exclusively released the initial drafts of the proposals – not too much has changed since then. We’ll refrain from recapping the details since the press releases lay them out but below we outline some of our thoughts.

• The key point in the regulation is that MMFs will be required to hold a ‘Net Asset Value’ Buffer, equal to 3% of all assets under management; the Commission predicts this will “result in an increase of the management fees of 0.09% to 0.30% annually”. There will also be harmonisation with UCITS and AIFMD to move towards a uniform set of rules for the shadow banking sector.

• As we noted before, the required buffer has real potential to harm the MMF industry. Given the record low interest rates, and very low returns on liquid short term debt, many funds are struggling to stay afloat (with some already shutting down). Although an outcry against increased costs may be expected from the industry, in this case many of the concerns seem valid given the very small margins involved in these funds.

• There are also some requirements on MMFs holding very liquid assets which can be sold off quickly, while also limiting the level of assets taken from a single issuer to encourage diversification. These rules seem sensible but add further constraints to the returns and flexibility of these funds. There is always a risk in dictating the investment decisions to the market, although its important that the risks in these funds is made clear. It also seems to be doubling up the effort of the buffer mentioned above  - given that losses of such funds rarely exceed 3% (as the Commission itself notes), pushing beyond this level seems slightly redundant.

• The question of ‘sponsors’ – the banks or institutions which own and/or backstop an MMF – is also vital for a couple of reasons. First, its clear that some sponsors have a competitive advantage, larger institutions will have the ability to provide greater financial aid to its MMF if it gets into trouble – this gives large banks a significant advantage over smaller asset managers. Secondly, it also provides another clear link between the shadow and traditional banking sector, this could potentially become an avenue for contagion (as was seen in the financial crisis) if MMFs get into trouble and need to be bailed out.

• Much of the rest of the regulation looks fairly sensible at first glance. It’s clear there needs to be greater transparency within the MMF sector – it can no longer be assumed to be equivalent to bank deposits. There also needs to be significantly less emphasis on external ratings by the credit rating agencies (equally true of the standard banking sector ). Furthermore, investors need to be clearer on the risk taken on when investing in these funds and their approach used to make profit (short term funding of long term assets).

• The broader shadow banking communication remains fairly vague but it is certainly an area which needs to be regulated. The main aim should be to incorporate international regulatory efforts with the existing multitude of EU regulations (many of which cover parts of the shadow banking sector) and avoid duplication. Tackling the issue of ‘collateral chains’ (using a single piece of collateral many times) is also vital, although the importance of the repo market should not be forgotten (see failure of the FTT).

All that said, there is a long way to go in these regulations yet. There is likely to be significant industry opposition (or at least discussion) and approval from both the European Parliament and member states will be tough to gain. It also seems unlikely that this will be completed before next May’s European elections, adding further delays but also raises the question of whether the next Commission will push in the same direction on this issue.

Open Europe publishes Commission regulation which seeks to move Libor oversight to Paris

As the FTT threat wanes (a sizeable victory for the UK we might add) another battle threatens to flare up in the wider debate about financial regulation within the EU – albeit a smaller but still concerning one.

As the FT reported yesterday, there is a regulation in the pipeline in which the Commission proposes significantly stepping up the regulation of benchmark indexes and rates used in financial markets and contracts. In particular though, it proposes moving the supervision of key benchmarks, such as Libor, to the European Securities and Markets Authority (ESMA).

As we did consistently throughout the FTT debate, we have got our hand on, and have exclusively published these latest plans – see here.

What are the key points of the plans?

• The main focus of the regulation is to move the oversight of thousands of benchmarks used in trillions of dollars’ worth of financial contracts and instruments away from self-regulation (or from being unregulated) to being under direct supervision.
• However, importantly, the proposal sees the most important benchmarks, such as Libor and Euribor, being supervised by ESMA since, in the Commission’s view, fractured oversight harms the single market.
• The plan also looks to step up the legal liability involved in the benchmarks (making any manipulation a criminal offence across the board) but also allowing supervisors more control to compel participation in certain benchmarks and allow for consistent oversight.

Open Europe's take on the plans

• First, let’s make it clear that Libor has patently failed and needs to be reworked. Everyone accepts that. However, the UK is currently in the midst of doing just this, following the recommendations of the Wheatley Review earlier this year (which happen to line up closely with those of IOSCO the international body looking into this issue).

• This makes the proposal particularly badly timed. It is ultimately based on an outdated view of Libor which is already under review and beign changed. In fact, if you look at the substance of the UK review and the international recommendations (upon which the Commission based its proposals) they line up fairly closely with the EU plans other than where the control rests.

• The Commission justification for needing an EU regulation on this issue also seems a bit of a stretch to us. Sure, some of these benchmarks are used in the rest of Europe but they are also used all over the world. However, all those involved in Libor will have a presence in London. As is well known, the large majority of European trades which involve many of these benchmarks will also take place in London. Why the oversight should not be focused there is still not clear.

• There is also rightly a significant concern over the rigidity of the Commission proposal. Firstly, the plan to base all submissions off actual transactions seems unrealistic. This issue came up in the initial debate about reworking Libor – ultimately, there are not nearly enough interbank transactions to actually produce the rates for the ten currencies and the 15 different maturities which Libor currently covers.

• Linked to the above point is the concern about the ability to force banks to comply and take on significant legal and regulatory responsibility for their submissions. Ultimately this is a large liability to take on off the back of what is still an estimate.

• This is a very technical subject. It is almost impossible to lay down all the rules and structures for how various benchmarks should be judged. Surely, the approach varies wildly depending on the benchmark and may even change depending on the wider economic and financial circumstance. This raises two concerns: the rigid framework presented may leave substantial grey areas but more importantly a lot of power for setting the technical details will be left up to the Commission, after the political negotiations have finished. As we saw with the bankers bonus’ regulation this can has a very large impact on the scope and practical implementation of the rules.

• It sets a worrying precedent, especially as the ECB is set to take over as the single eurozone supervisor and the potential for eurozone caucusing on this issue increases. As we saw with the regulation over Credit Rating Agencies (CRAs) over the last few years this can be dangerous. The initial drafts of the CRA regulations are quite similar to this one, however, worryingly it has extended and escalated over time. The UK government should look to tackle this issue head on to avoid a similar scenario.

Overall then, although Libor needs to be reworked and better supervised, it’s not clear why this needs to be done at the EU level, particularly when the UK is in the middle of its own reworking. The rigidity of the proposal also raises questions about its practical implementation. At the very most, there could be an EU directive on this issue setting out a broad approach with room for national flexibility. Ideally though, this should be left to individual states where the rules can be drawn by those who are most impacted by them and closer to the stakeholders. This should of course be combined with on-going global cooperation as is already underway.

Thankfully, it seems we are not the only ones with these concerns and some watering down of these rules already looks likely.

When ideology meets economic reality (part III): Germany squabbles over the Financial Transaction Tax

The Bundesbank, The Deutscher Aktieninstitute (DAI), and even EU civil servants from the 11 participating countries have all warned against the FTT in its current form.

Today saw yet another German voice raised again the tax – this time from the very party that is meant to be its greatest champion. Nils Schmid, Baden-Württemberg's Minister of Finance – from the German social democrats (SPD)— wrote a letter to German Finance Minister Wolfgang Schäuble condemning the FTT in its current form as “rubbish.” Ouch.

Schmid’s intervention, says that "If the financial transaction tax is implemented as is currently planned, initial estimates show that it is likely to have a serious impact on certain segments of the market (money and capital)." He then calls for a “proper configuration” of the FTT.

So why is this important? Twofold:  first, it shows that in light of the overwhelming evidence of the negative economic impact of the FTT in its current form, the support for the proposal is quickly evaporating.

This now extends to the German political parties that have strongly endorsed it. Remember, the FTT is one of the SPD’s main campaigning issues, and served as the party’s quid pro quo for accepting the EU fiscal treaty. Although Schmid caveated his position, saying that he is not opposed to the idea of a FTT in theory, the point has most definitely been made.

Secondly, the FTT controversy has legs to become battleground ahead of the German elections in September. It is an issue that may split politics, both, within the parties and on a national level.

Officially, Schmid’s letter was met with a standard diplomatic line from the German Finance Ministry – which says it is taking concerns raised by Schmid and German banks “seriously.” They won’t say so in public, but the German finance ministry was most likely nodding approvingly…

Meanwhile, deputy chairman of the FDP parliamentary group ,Volker Wissing, saw his opportunity to strike – and took it, saying that Schmid's letter shows with which "naivety" and "rose-tinted blindness", the SPD had driven the demand for a financial transaction tax.

So far the SPD have remained stumm on Schmid’s intervention. But watch this space. If influential figures within SPD are the latest to start make noises about this, then surely, the Commission’s proposal cannot stand?

"If you had kept quiet, you would have remained a philosopher" - The Commission utterly fails to address flaws in the financial transaction tax

There's an old Latin saying, "If you had kept quiet, you would have remained a philosopher." Reading the Commission's defence of its proposed EU financial transaction tax (FTT), that phrase immediately sprung to mind. It's not the strongest piece, to say the least.

In our continuing quest for transparency, we have published the Commission’s direct response to the concerns raised by the 11 participating FTT member states (docs which we exclusively published last month).

The Commission's response ranges from weak to capricious to outright ridiculous. For example, when it says that "we're not aware of any credit crunch" in Europe. Right...

Arguably the most worrying part of this response is the tone. The Commission is essentially saying ‘we know better’ than financial markets. For example, in dealing with concerns over the impact of the FTT on short term trading, it suggests much short term trading is often “myopic” and that asset managers which trade predominantly in the short term should be subject to less investor demand in transparent markets, despite the success of money market funds and their importance for liquidity.

Now, 'financial markets' are diverse, far from perfect and certainly not always right. However, the Commission would be remiss to just dismiss concerns raised by governments inside and outside the FTT zone - but also actors from across the business and manufacturing community (in addition to virtually every bank in Europe).

We have long suggested that there are three key areas of concern which will have to be addressed before the FTT can even hope of being implemented without huge market distortions – the extraterritoriality, the impact on repo markets and the impact on government (and corporate) bond markets.

Many of the concerns raised by the 11 FTT states - and the Commission's response - related to these issues. Sorry in advance for the length of this post but here are the key points:

Extraterritoriality

As reported this morning, the Commission argues that a “business case” can be created for enforcing the FTT outside the FTT zone. Essentially, exchanges and clearing houses will be responsible for collecting the tax and if they don’t,  the firms in the FTT zone will not want to trade with them.

This is concerning development for a number of reasons:

• First, it will increase tensions and splits within the single market. Financial firms are unlikely to just roll over and accept this. In fact, given the size of the market outside the FTT zone, they could validly refuse to trade with those inside the FTT zone. In any case, the prospects of a scenario similar to that of escalating protectionism in trade dispute cannot be ruled out.
• It also seems very punitive, using alterations in the legislation (the joint and several liability) to enforce it in areas where the tax has already been rejected.
• This also assumes firms do not move out of the FTT zone to escape the tax. This seems unlikely in the first instance, while not being able to trade with those outside the FTT zone if they do not pay the tax (or having to pay their share yourself) seems to make staying inside even less appealing.

The Commission also accepts that double taxation is a concern. However, the proposed solution of setting up agreements on where the tax will fall, seems unlikely especially in the UK’s case since it has launched a legal challenge against the tax.

Impact on government and corporate debt

The Commission also fails to provide much comfort on the impact of the FTT on national debt and borrowing costs. It admits it has been unable to estimate the impact due to lack of info, but further accepts that “Member States might be better placed to have access to such information.”

This raises two questions:

• First, surely legislating on such a sensitive issue without fully knowing the costs on a key area, with many of countries involved in the midst of an economic crisis, is nothing short of negligent.
• Second, if member states are better placed to judge these issues, why does the Commission and the EU need to take the lead and push such a tax in the first place?

Furthermore, we doubt the concerns over ‘redistribution’ will have been assuaged as the Commission accepts that some money from the trading of government bonds will not go to the country that issued them.

This could be of concern for countries such as Spain, Italy or even France which have huge debt markets but whose debt is widely traded around the world and the EU but international firms. It also seems to punish small countries with less developed financial sectors, since the tax will be paid where the bond is traded firstly with the residence principle only kicking in afterwards.

Possibly more worrying is the response to concerns over the corporate debt market. The Commission seems to brush this off, adding that it is “not aware of any credit crunch” with regards to borrowing for businesses. This is despite the clear survey results showing businesses struggle to access credit in many European countries and the many, many press stories on the issue. It surely cannot argue that given the state of the economy, now is the best time to implement the tax.

Repo markets

As we have highlighted this is an area of serious concern. Unfortunately, the Commission continues to persist with a weak counter-argument insisting that repo markets can be easily replaced by secured loans or lending by central banks (while accepting the short term repo market will be all but destroyed by the tax).

This argument is flawed for numerous reasons:

• The market has access to these other instruments but see repo as preferable, the Commission still insists, however, that it knows better.
• Moving more lending to central banks is not desirable! European policy makers are working hard to restore usual financial markets and move lending off central bank balance sheets.
• Without normal functioning markets, monetary policy cannot have an effective impact, while in the eurozone money will not flow cross border and imbalances will continue to build up (any hope of an integrated banking union would be dead).
• Furthermore, all the risks will be taken onto the central banks’ taxpayer-backed balance sheet – surely this is a terrible form of risk being socialised but profit privatised.
• Secured loans do not provide the same level of legal protection as repos. Since collateral is purchased under a repo, if there is a default the collateral has already changed hands. However, under secured loans the claim would go back into normal (lengthy and costly) insolvency proceedings.

The Commission does raise the point that Repos can hurt financial stability, but surely this is more a case for effective supervision and regulation than taxing the market out of existence.

With widespread talk of the FTT being shelved for at least another year, perhaps it's time for the Commission to just admit defeat?

Another blow in the bank bonus debate - but there's something far more fundamental at work here

Yesterday saw the opening salvo of what is sure to become a heated debate over the new ‘technical standards’ for the EU’s banker bonus rules.

Why is this so important? Well, these rules will essentially determine how far reaching the EU's already controversial bankers' bonus cap will be. But this decision also encapsulates a range of other issues that will have a defining impact in the way Europe is governed in future - and whether there's a future for the UK in there somewhere.

With that in mind, the first draft produced yesterday to launch a period of public consultation on the standards would have been particularly worrying. The key points are:

Standard quantitative criteria: related to the level of variable or total gross remuneration in absolute or in relative terms. In this respect, staff should be identified as material risk takers if:

 (i) their total remuneration exceeds, in absolute terms,  €500,000 per year, or
 (ii) they are included in the 0.3 % of staff with the highest remuneration in the institution, or
 (iii) their remuneration bracket is equal or greater than the lowest total remuneration of senior management and other risk takers, or
 (iv) their variable remuneration exceeds €75,000 and 75% of the fixed component of remuneration.

As the numerous press reports today have highlighted, these are far more wide ranging than many expected and are likely to further raise concerns that these rules will have a substantial negative impact on the City of London (and therefore the UK economy). (For background on these concerns see here and here). There are several different things going on here:

Are the EU agencies already exceeding their mandate? As we flagged up at the time of their creation, there's a substantial risk of mission creep under the EU's three supervisory agencies - EBA, ESMA, EIOPA - due to the fluid nature of these bodies. Remember, under the ECJ court case which allowed these agencies to be established under the EU single market (via QMV and co-decision), they should be blocked from having any type of decision-making powers. But EBA's standards on remuneration comes worryingly close to legislation.

Politicisation of ‘technical standards’: Related to this, and as we also flagged up at the time, technical standards have a worrying tendency to become politicised - which clearly is the case here. This type of stuff should be decided through political negotiations and defined within the regulation. Any necessary technical background and info should be provided for and incorporated, even is this means delaying the legislation slightly.

Need for non-eurozone safeguards ASAP: Though this isn't strictly a eurozone vs non-eurozone issue, it does illustrate just how vulnerable the UK and other outs could be to eurozone caucusing in banking / financial rule-making. This is also exactly why the UK and other non-eurozone countries need to ensure that the agreement in principle for double majority at the European Banking Authority - that Open Europe first floated - are held up and pushed through.

Trade-off between "single rulebook" and control: The UK says it likes the EBA since it contributes to a single rulebook for the single market, and can, for example, contribute to stamping out protectionist implementation of banking rules in Europe. This is all true. However, it does, of course, assume that the UK itself is writing the single rulebook, which may or may not be the case.

Democratic accountability: As the Times noted today, with central banks such as the Bank of England (BoE) and the ECB taking over financial supervision they must become more transparent and accountable. In this case it is unclear what role the BoE played in drafting the rules or whether they raised the concerns pushed by the government and firms in the UK.

What next?

Again, this is only a first draft. The public consultation is open until August, after which the EBA will review the evidence and provide a new draft - so a lot of the issues we highlight below should be considered with this in mind. There will then be a vote in the EBA with the final standards needing to be submitted to the Commission (which will approve or reject them) in March. One final interesting point here is that any vote in the EBA could come close to coinciding with the introduction of any double majority rules, although there are a lot of hurdles to overcome before then.

Expect a summer of furious lobbying and behind the scenes discussions as the UK and others make a final push to water down these proposals.

Where do EU member states stand on bank bail-in plans?

It’s been pretty tough to follow where countries stand on the latest proposals for the EU’s Recovery and Resolution Directive, not least because the debate has lasted three years with people mostly talking past each other.

But the Cypriot crisis has now focused minds and a deal is top of the agenda. The proposal will lay out rules for bank bail-ins and dealing with cross-border banks, while it also links closely with plans for a eurozone banking union. To clear up the differences, we have put together a table.

(The table is broadly ordered by how strongly the country is in favour of uninsured depositor preference and how strongly against flexibility it is. Hence Spain which is strongly for depositor preference and little flexibility is near the top, while Sweden which barely favours a bail-in plan and wants significant flexibility is near the bottom – click to enlarge):

As you can see, there are some big splits remaining. The ECB, Spain, Portugal and France (amongst others) want a clear depositor preference regime – where uninsured depositors are the last to be written down. On the other hand, Germany, the Netherlands and the UK want more equality between senior bondholders and uninsured depositors. Going even further, there are Sweden, Poland and Denmark - which have already clearly defined national schemes which do not fit well with the EU plans for a bail-in hierarchy.

Another area of disagreement is the amount of national flexibility. Sweden, the UK and the Netherlands are pushing hard for flexibility, particularly for non-euro members. This has some backing from Germany. Further disagreements over the timeline for implementation and the level of resolution funds needed remain a bit of a free for all.

The few points they do agree on include: complete protection for insured depositors, a broad bail-in scheme and (somewhat ironically) the fact that this legislation is urgent.

We will keep updating the table as the negotiations develop. There is a lot of talk of compromise but as of yet there is a long way to get there.

When ideology meets economic reality (Part III): Opposition to the FTT grows at the heart of Europe

As we noted recently with the exclusive release of  internal documents on the Financial Transaction Tax (FTT), even amongst those who are championing the proposal, there are a huge number of concerns. Well, those concerns are growing by the week, it seems. The last few days have seen several new interventions. 

First, there is a report from the Deutscher Aktieninstitute (DAI), an organisation representing German listed companies and investors, which warns that the FTT will cost German companies up to €1.5 billion per year. Blue-chip companies, including Siemens and Bayer, say they will face tens of millions of euros of additional cost from the tax due transactions they make to hedge currency and other risks.

What makes this intervention to significant is that we're talking wholesome, exporting German businesses - in the German public mind the very opposite to ‘speculative’ finance. As DAI chief-executive Christine Bortenlaenger put it, the tax is “a direct strike against the export-oriented German economy”.

This comes not long after the important intervention by Bundesbank President Jens Weidmann where he warned, as we did a few days before, that the FTT could impact monetary policy. With the German elections only a few months away, these concerns will be hard to dismiss.

Secondly, the Dutch Central Bank has issued a warning that the tax will cost the Netherlands a minimum of €500m, half of which will be paid by its large pension fund sector. This is all despite the country not taking part in the FTT directly. Dutch Finance Minister Jeroen Dijsselbloem hinted that the country is looking for a change in the way that the tax is structured so that it does not impact those not directly taking part.

Lastly, Financial News notes that MEPs – who have generally been the most stringent defenders of the tax – may be changing their minds somewhat. Over 100 amendments have been submitted to the current FTT proposal in the European Parliament. Changes include exemptions for pension funds and repo markets as well as calls for a more extensive cost benefit analysis of the impact of the tax  (though the EP doesn't have a binding vote on the FTT, it's still politically signifcant).

This cacophony of voices are strengthened by the fact that many of the concerns raised fall on the same points again and again – the impact on repo markets, the cost to pension funds, the knock on costs for retail borrowers and the reduction in lending to the real economy.

As we have long expected, there seems to be a growing feeling that the FTT will need to be watered down or altered in places if it is to come into force and not have a huge negative impact. The populist rhetoric of the tax seems to be finally butting up against the economic and financial realities which many long warned about.

Exclusive: Internal docs give first look at EU plans to regulate 'shadow banking'

The Times reports today on another round of exclusive documents leaked by Open Europe, this time regarding European Commission plans to regulate the ‘shadow banking sector’. See here and here for the docs.

A rather niche story you might think but it could have important implications for the way money is lent throughout the economy. Below we provide some background and our thoughts on the proposals.

What is the shadow banking sector?

“The FSB defined the shadow banking system as "the system of credit intermediation that involves entities and activities outside the regular banking system". This definition implies the shadow banking system is based on two intertwined pillars.

First, entities operating outside the regular banking system engaged in one of the following activities:

• accepting funding with deposit-like characteristics;
• performing maturity and/or liquidity transformation;
• undergoing credit risk transfer; and,
• using direct or indirect financial leverage.

Second, activities that could act as important sources of funding of non-bank entities. These activities include securitisation, securities lending and repurchase transactions ("repo").”

Essentially, it is made up of institutions outside the banking sector but which provide paths for borrowing and lending as well as significant financial investments. According to the Financial Stability Board (FSB) in 2011 it totalled €51 trillion worldwide.

Why are there concerns regarding it and are they valid?

• Shadow banking came to light in the aftermath of the financial crisis where it is thought to have played an important role in allowing the financial sector to hide the true level of risk in the system.
• There are some valid concerns over shadow banking. It operates outside but closely related to and interlinked with the regular banking system. This means it falls outside of scope of regular supervision and regulation.
• Often pursue highly leveraged activities, search for high yields and transform maturities from short to long (can cause a mismatch in funding if a crisis hits). There is significant use of opaque securitisation, hard to judge real value.
• Often have very low levels of capital, funded in the short term by lending and investments which needs to be regularly rolled over. This is used to fund long term assets. Helps boost profits but also magnifies losses. Due to this set up, the system very exposed to liquidity crises which can hit hard and fast.
• IMF recommended recently that key aims should be to reduce spill over from shadow banking to regular banking system (reduce prospects for rapid contagion in a crisis) and to reduce the procyclicatlity of the shadow system.
• All that said, it does provide a valuable service in many cases, particularly as an alternative method for distributing credit to the real economy when the banking sector is failing to do so sufficiently.

Thoughts on the EU proposals so far

• The proposals are still at an early stage and subject to change. A key issue is how any shadow banking regulation will fit with the raft of other financial regulation in the pipeline or already in force – AIFMD, CRD IV, EMIR, UCITS, and Solvency II to name but a few.
• Importantly, many of these other regulations already cover many of the institutions involved in the shadow banking sector. Avoiding double regulation and inefficiency is vital, therefore judging and implementing the current regulations is important before a shadow bank regulation is brought in.
• Shadow banking is not part of regular market and those involved do not have deposits so there is no question of a government backstop or bailout scenario. Can and should go bust. The main point is that any shadow banking crisis should not transform into a ‘systemic crisis’. The approach should therefore be ‘macroprudential’, taking an overview of the market and ensuring it is not overly risky and/or that it is not too heavily intertwined with regular banking sector.
• This may be more effectively done by setting out guidelines for supervision and cross border data collection that a strict regulation.
• The EU must also be wary of regulating against specific financial instruments, which could have perverse effects. For example, ‘securitisation’ has become a hot topic. This tool was misused during the financial crisis but is not an inherently bad thing. As ECB President Mario Draghi pointed out recently, effective securitisation of SME loans could help boost lending to SMEs and increase level of quality assets in Europe.
• Money Market Funds are different to many other parts of this sector. They are essentially pools of deposits or excess funds from finanical firms which are invested in the short term to gain small gains above what standard deposits would reap. They invest heavily in short term government, corporate and finanical debt and play a key role in providing liquidity to the market. The Commission looks to be regulating these separately, which is the right way to go. However, any small increase in costs could hamper the whole industry since their margins are so low - in fact some have already been closed due to the record low interest rates. 

As we said the proposals are just getting going so all this is still open. Regulation of the shadow banking sector is necessary but its also vital to note that it plays an important role in providing credit to the real economy (despite its rather ominous sounding name). At this point in time its not clear that a regulation is needed immediately and it may be more effective to improve and work with what is currently on the table. Furthermore, in an ideal world, any attempt to tackle it would be done on a global level in the form of a set of guidelines and plans for data sharing and increased transparency.

When ideology meets economic reality (Part II): Bundesbank says EU financial transaction tax could make banks more reliant on cheap ECB money

As was made evident by the internal memo about the EU financial transaction tax (FTT) - that we exclusively published yesterday - there are plenty of concerns amongst the supposed champions of the idea.

Today, another heavyweight institution raised the alarm: Die Bundesbank.

This could come across as a niche issue, as with most central banking issues. But as with most central banking issues it could also be of vital political importance in Germany.

As we noted in our flash analysis on the UK’s FTT challenge last Friday, the proposal could have a worrying impact on ECB monetary policy:

Increasing banks’ reliance on cheap ECB cash: With central bank lending exempt from the FTT but the market channels to obtain liquidity hit hard, the FTT actually provides a perverse incentive for banks to borrow cheap money from the ECB and central banks. This runs completely contrary to efforts in the Eurozone to get banks off ECB liquidity and could instead further entrench market fragmentation.

This is a point which has been rarely made in the FTT debate but whose implications for Germany - already deeply worried about weak banks over-reliance on cheap ECB funding - could be huge. Sure enough, Bundesbank President Jens Weidmann today raised concerns over this very issue. In a speech in Dresden, he said:

The introduction of the tax has basically been decided but the unintended side effects could be considerable: In its currently envisaged form, the tax will cover asset-backed money market funds, so-called repo firms, and significantly damage the repo market. However, the repo market has a central role in ensuring the equalisation of liquidity between commercial banks.

If it does not function correctly, the corresponding institutions are diverted onto the Eurosystem, and the Central Banks remain massively and permanently involved in the liquidity equalisation between the Banks.

From a monetary policy perspective, the financial transactions tax in its current form is therefore to be viewed very critically, and it shows how important it is to precisely test a regulatory scheme before its introduction. This however takes a bit of time.

Exactly as we warned. More banks - particularly in the southern eurozone - borrowing from the ECB would not only increase German exposure to the crisis (ultimately, the ECB is taxpayer-backed). But it also negatively impacts the independence of ECB monetary policy since it will hamper the central bank's ability to exit its abnormal liquidity operations and therefore impact its ability to control policy.

This also gets to the heart of what we (and others) have been saying about the FTT.  Although the headline goals and figures look nice, the multitude of side effects (for financial markets, for pensions and even for central banks) mean the real impact of the FTT is far beyond what is envisaged or what can be effectively managed by the regulation.

Watch this space. This could become a big issue in Germany.

EXCLUSIVE: Internal documents reveal countries' concerns with FTT proposal (or when ideology meets economic reality)

The European Commission, of course, doesn't get what the fuss is about, but some countries that are meant to participate in the much-criticised EU financial transaction tax now seem to be going very cold on the idea. Or at least on the way the tax is drafted at the moment.

We have got our hands on the memo from the eleven countries that under "enhanced cooperation" have signed up to the tax - reported in yesterday's press summary - which raises a series of concerns about the Commission's draft. Exclusively, we today publish the full six-page memo here.

The memo, which in painful EU-jargon is known as a "non-paper", was last week discussed amongst civil servants from EU member states, at a meeting behind behind closed doors. So this isn't reflecting any final position on behalf of the eleven (who disagree amongst themselves on a number of issues). 

However, this is revealing stuff - it's clear that though several countries are supportive of the FTT in public, they have a whole host of concerns in private.  The document is desperately looking for answers on how the Tobin tax would work in practice. This is, of course, in addition to the more fundamental objections to the FTT raised by the UK's ECJ legal challenge, now also supported by Luxembourg, which we have analysed here.

You can read the whole thing here, but the key points that struck us are outlined below:

• There are calls to clarify how collection of revenues would work in practice.

• The countries complain that the European Commission’s impact assessment “is not fully clear on how the taxation on government bonds would interact with the cost of national debt” and whether an increase in the cost “could be counterbalanced by the revenues of the FTT.”

• In addition, there are concerns about the impact on repurchase operations on sovereign bonds. "The tax will induce an additional cost that is not sustainable for the market participants,” according to the document. “Repo operations are very useful for managing the treasury liquidity, and the disappearance of this market combined with the lack of viable alternatives will induce serious problems about risk management.” Ever so worried about skyrocketing government borrowing costs, Italy seems particularly worried about this.

• Given the way ‘territoriality’ works under the Commission proposal in particular, each member state would not be allowed “to collect the whole EU FTT paid on the bonds issued by the same member state. As a result, the increase of cost of government debt…would not necessarily be compensated by the collection of the tax on the same instruments.” This sort of links to UK concerns that the tax would hit a firm based in one country, but be collected by (and therefore the revenue will be enjoyed by) a government in another. Taxation without representation some would say.

• The rate levied is also an issue: “The 0.1% uniform tax rate proposed by the Commission might create an inappropriate burden on short-term bonds…compared to long-term bonds.”

• And the concerns are not only limited to government bonds. The countries note that, “Businesses have expressed worries that the same effect described above for government bonds would replicate on the corporate issuers, with negative effects on the financing capability of companies.” As we've argued repeatedly, this is the risk that the tax will hit business at a time when these are already struggling to balance their books (and are facing particularly high borrowing costs in the south).

• Uncertainty over the impact of the FTT on high-frequency trading.

• The member states also ask the Commission to clarify a number of definitions in its proposal (e.g. ‘purchase and sale of a financial instrument’, ‘cancellation or rectification of a financial transaction’, and so forth).

In other words, even among its supposed champions, the potential impact and practicality of the FTT are shrouded in uncertainty and a lot of concerns, particularly when it comes to effects on the real economy at a time when the eurozone is desperate looking for growth.

For anyone with an ounce of grasp of economics, this internal memo strongly supports the accusation that the FTT has a lot more to do with politics than evidence-based policy.

When ideology meets economic reality.

EU tightens the noose on bank bonuses

As we noted in today’s press summary, a tentative EU deal was struck last night on bank bonus curbs, as part of the broader agreement on CRD IV (which implements Basel III). We’ve discussed this in detail before, so we refer you to that post for the background.

The deal looks much as expected, although a couple of changes have been added:

• Bonuses should be limited at a 1:1 ratio to salary, which can rise to 2:1 with explicit shareholder approval.
• Up to a quarter of variable pay can be discounted and issued in instruments deferred for more than five years, which could increase the ratio above 2:1.
• Bonuses in the form of long term equity or debt that can be bailed in if a bank fails will also be given more favourable treatment.

Surprisingly, the deal still includes plans to force subsidiaries of foreign banks in the EU to adhere to the bonus rules and, more importantly, forcing all subsidiaries of EU banks in the rest of the world to do so. This could hamper competitiveness and, we suspect, may still be subject to changes. This is also an area where the UK might have expected to receive a concession.

What happens now then? EU finance ministers meet next week and will discuss the proposals. Significant changes seem unlikely, which could mark a loss for the UK, which has vehemently opposed the rules from the start.

The real question for the UK is whether it should try to force a formal vote on the issue at the meeting of finance ministers. This would raise the prospect of voting down the UK on a financial services issue – that this has never happened before is often cited by the EU as a counterargument against UK concerns over EU financial regulation. If the UK is outvoted it would mark a potentially significant precedent for the UK's future relations with the EU.

It should be remembered though that this is only a small part of the large CRD IV package, which has been continuously delayed due to MEPs' demands for bank bonuses to be included. The UK has managed to secure favourable treatment on the key aspect of the legislation – the ability to adjust national capital requirements for banks.

As we have suggested before, the debate on bank bonuses seems slightly tangential in terms of the wider debate over bank capital and broader financial stability (indeed there are valid question about why it has been lumped in with CRD IV at all). For all the talk of needing bank bonuses to limit risk taking and moral hazard in banks, the EU has supported and approved €1.6 trillion in state aid to banks over the course of the financial crisis. Many countries have pushed for limits to capital requirements and supported the easing of the Basel III liquidity controls. The EU, and the eurozone in particular, has also consistently argued for and supported bank bailouts and refused to countenance imposing losses on bank creditors, instead shifting the burden to taxpayers.

Trying to limit moral hazard by tackling excessive bank bonuses is all well and good, but it is a drop in the ocean when it remains clear that states and central banks will continue to bailout banks at any cost.

EU caps on bankers' bonuses: the perfect regulatory storm?

The discussion over bank bonuses has been heating up inrecent days. Discussions between EU ministers, the European Parliament and the Commission (so-called trialogues) are restarting today as the three try to reach an agreement on the rules for bank bonuses to be included in CRD IV (the EU’s legislation implementing the Basel III rules and more).

The parliament is pushing for a stringent cap on bank bonuses of 1:1 ratio with fixed salaries, which could be increased to 2:1 with approval from a majority of shareholders.

There is a lot going on here, beyond the actual proposal, including:

• The UK is in a clear minority in categorically rejecting a cap, but unable to block a rule with disproportionate impact on the UK - courtesy of QMV and co-decision.
• Germany being the swing state - no surprises there - having first supported the UK's position, it has shifted as part of a wider political push to get tough on bankers, which strikes a chord with German voters. The revelation in December that Deutsche Bank hid $12bn worth of losses during the crisis and the growing Libor and Euribor rates scandals, haven't exactly helped...
• The European Parliament flexing its muscles, successfully managing to tap into the public mood, breaking the Council common position, which is unusual. (Don't worry, any favour EP thinks it wins with the electorate, would be ruined if it voted down Ministers' proposal for a reduced long-term EU budget).
• "Anglo-Saxon capitalism" in the docks - perception is one of a continental attack on British bankers (ironic since a large part of the talks have focused on making CRD4 more flexible to allow the UK and others pursuing tougher capital rules for banks). This will not make the City any more EU-enthusiastic.
• No one wants to be publicly seen to back bankers - even the UK government itself is keeping a low profile.
• Changing incentives as part of the eurozone banking union, with the club within a club dynamic again coming to the fore (see our December 2011 report to see what we mean). Looking forward, the question is, if a country decides to remain outside the banking union - therefore signalling that it will stand behind its own banks, come what may - should it not also have more discretion in getting the incentive structure in the banking sector right?

So what does the UK want?

On Friday the UK submitted a paper to its EU partners to put forward it’s case. We've seen the paper, and here are some thoughts / points - which also have been largely reported in the media:

• The UK argues against a firm cap. Any extended remuneration should be determined by shareholders (although the UK proposal does water down the size of the majority needed to approve remuneration slightly).
• The UK is pushing for a focus on non-cash deferred bonuses. This is included in the current proposal to some extent but the UK fears (with some grounding) that the current proposal will encourage an increase in fixed salaries and a focus on upfront cash bonuses - and reduce firms' ability to cut costs during a downturn, potentially leading to more lay-offs and less lending (on a bit less solid ground here, we think).
• It also argues that deferred non-cash bonuses (over three years) should not fall under any cap, while also rejecting the proposal that all employee benefits, above those mandated by law, should be categorised as a ‘bonus’.
• The government is also keen to see that subsidiaries of EU banks located in the rest of the world should not have to adhere to the rules. Furthermore, EU subsidiaries of banks headquartered outside the EU should not have to implement the rules (although their bonus plans will still need to be judged ‘prudential’ by the relevant financial supervisor).

So is this special pleading? Well, to some people in the City, the world will end if this comes into force - which is not quite the case. In fact, there's no surprise that politicians seize the opportunity to strike down on bankers' pay, given that many banks have been forced to seek taxpayer-backed bailouts and the rest of it. So the first message to the financial sector is: if you don't want to be subject to tougher regulations, stop screwing up.

But it could still be damaging and there are questions over how much difference a cap would really make on incentives and the distorting effects this could have across the board. Ultimately, the risk taken on and the decisions made by banks are dictated by much more than just bonuses - it is just a small part of a wider culture which needs to be reassessed. Targeting and correcting perverse behaviour still seems to be better done through more effective supervision and tighter regulation - the irony should not be lost that many of those pushing for a cap are also the ones advocating a maximum limit to capital levels and supporting watering down the Basel III liquidity requirements (see here for details). And there should be no doubt that this could make talent less likely to choose the EU over other part of the world, which clearly isn't in anyone's interest.

In the end, bank bonuses are also only a small part of the much larger CRD IV legislation. There is unlikely to be a formal vote on bank bonuses itself - and Ministers rarely vote in the Council - but the UK seems to be heading for a defeat on a pretty symbolic issue at a sensitive time.

On the other hand, if the UK government can pull this one off, it should be given a lot of credit. Ultimately, the final outcome of CRD IV as a whole will be the more important bellwether by which to judge UK success or failure.

The FTT debate rumbles on...

The FT reported today on the latest draft proposals for the EU financial transactions tax (FTT), which is proceeding under enhanced cooperation with 11 countries taking part. These are the highlights from the FT's report (since we are yet to get our hands on the draft proposal):

• The FTT is expected to raise up to €35bn.
• It will apply to any share, bond or derivative issued within the participating area or "with a clear connection to a participating member state" in an attempt to restrict relocation to avoid the tax.
• Target introduction date of January 2014.

Although the basic structure is the same, the most potentially controversial element is the extension of the scope of the FTT to apply to any share, bond or derivative "with a clear connection to a participating member state." This means that financial instruments which are traded outside of the participating countries could still be caught by the tax. This throws up a number of important questions and potential problems:

• This could ultimately result in participating governments imposing taxes within other government’s jurisdictions. This goes further than just other EU countries.
• It is not clear to where the revenue would flow (to the government where the trade is located or back to the FTT participants?) or how it would be enforced at a global or EU level. (This also seems to add massively to the complexity, a reduction of which is a cited benefit of the FTT).
• Surely, there are questions regarding how this cuts across the single market. As the press release on enhanced cooperation notes, the FTT will “respect the rights, competences and obligations of non-participating Member States” – stepping on the rights of non-participating government to determine which taxes are applied in their sovereign territory does not seem to fit this description. Some of the non-participating members could certainly be unpleasantly surprised and may well have some complaints to lodge.
• The new clause (to stop capital from flowing outside the FTT zone) seems to go against the key EU principle of free movement of capital in spirit, if not in law.
• For those involved, the tax will likely have some impact on their borrowing costs (for both governments and firms based in these countries). It will also increase the cost of instruments used to hedge against risk in these countries (certain derivatives). This may not be massive but will come at a time when it is not needed.

We do not know what form the final proposal will take but, if the reports are accurate, this FTT could not only pose practical difficulties of enforcement but also cut across the single market.

Update - 18:07 30/01/13:
 The FT has flagged up to us that, under latest proposal, the rules will only apply to exchange traded derivatives rather than all (over the counter) derivatives. This certainly makes the collection and policing of the tax easier and may limit any distortion on derivatives market somewhat. We'd note though that the general enforcement of the tax across borders and particularly outside the EU will remain tricky.

Easing of the Basel III rules - a test case on conflicts of interest?

A lot has been written over the past few weeks regarding the easing of the Basel III banking rules, which we've been meaning to cover but didn't get round to doing.

The specifics and details have been well covered so instead we'll look at some of motivations behind the changes. In our view, the change provides an interesting insight into the potential conflicts between monetary policy and financial supervision – something we have discussed at length with regards to the ECB being turned into the single financial supervisor for the eurozone (see also Felix Salmon’s blog for a wider discussion of this issue).

The changes, which are fairly technical and complex, focus on easing the burden of banks in creating what is known as the Liquidity Coverage Ratio (LCR). This is essentially a liquidity buffer which banks will be required to hold to ensure that they have enough cash (or cash like assets) on hand in a crisis to cover themselves for 30 days. The time frame in which the banks must have this buffer in place has now been increased by 4 years as well.

Again we won’t go into the detail of whether this change undermines the attempts to make banks safer but we would highlight that many banks already meet the adjusted standards, albeit with significant support from central banks (a point we’ll expand on in second) – given the on-going banking troubles in Europe and the US this is naturally a concern.

Monetary policy vs. financial regulation

More interesting from our perspective is the motivation for this change. As Bank of England Governor Mervyn King said:

“Most banks are completely overflowing with liquid assets…[Which] reflects the way in which central banks around the world have expanded balance sheets to provide economic stimulus. That won’t always be the case in the future.”

“Since we attach great importance to try to make sure that banks can indeed finance a recovery, it does not make sense to impose a requirement on banks that might damage the recovery.”

So it seems that the ultimate motivation for the move is to make it easier for central banks to remove themselves from non-standard monetary policy measures (such as QE or the LTRO) without fearing a massive drop in lending.

Clearly, both these concerns fall into the realm of monetary policy, rather than supervision or regulation. Obviously, a collapse in bank lending would be bad for everyone, so the measures are tied to some notion of short term financial stability, but surely these comprehensive Basel III regulations – which will set the basis for financial regulation over the next decade or more – should be taking a much more long term view than this. There are very real concerns that in the long term this could hamper the safety of banks and their ability to withstand future crises without taxpayer help.

A further motivation for the changes seems to be an attempt to encourage demand for a wider variety of assets by allowing them to be held as part of the LCR. Again this is all well and good, but it is the job of monetary policy to manage such demands and should not become ingrained in long term regulation. It is hard not to see this as a sop to the current crisis and immediate economic problems. (On the other hand we would note that this does help ease concerns that the requirements for banks to hold more sovereign debt would worsen the sovereign-banking-loop, although again increasing the risk on banks’ balance sheets is not a desirable trade-off.)

As mentioned above, the easing of regulations may make it much easier for central banks to exit their non-standard monetary policy measures without causing market distortions. The lack of a clear exit strategy is something which we have continuously warned of within regards to greater ECB intervention and the problem still applies. Obviously, finding the best way out is important but not at the expense of a safer banking system. Furthermore, taking such substantial action, such as that seen during the crisis, should not be done lightly and altering regulations to ease the potential problems or side effects of such actions could lead to a situation where the final cost of such actions are not fully considered. It is not hard to imagine similar pressure being applied to the ECB’s monetary policy, particularly if the eurozone crisis escalates again, while easing supervision would provide an easy out rather than managing the imperfect one size fits all monetary policy.

We must note that these regulations are produced by the Basel Committee and the BIS, not the ECB, so it is far from certain that the ECB will act in a similar way (although many of the central bankers involved do overlap). Additionally, the ECB will not be directly responsible for regulation but supervision, although there is substantial flexibility within this bracket and the people involved will still have a large say on regulation at the European Banking Authority (EBA). 

Our main point is that there will be very similar pressures and very similar powerful lobbies, which seem to have had a substantial impact here. This of particular concern for the ECB, where the Chinese walls could well prove insufficient, with the ultimate power for both supervision and monetary policy residing with the Governing Council.

We would suggest the previously mostly theoretical conflict of interest between financial supervision/ regulation and monetary policy just got a little bit more real.