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.

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.

The AIFM Directive: It's back!

Some of you may recall the AIFM Directive, tabled by the European Commission in 2009. The proposal was aimed at striking down on hedge fund managers, private equity firms, investment trusts and other so-called “alternative investment” funds (i.e. those that do not invest in stock, bonds or cash), in the wake of the financial crisis. That there was absolutely no evidence that these funds had much to do with the crash in the first place seems to have been a secondary concern. That Commission President Jose Manuel Barroso was seeking support from socialist MEPs for his re-appointment was likewise just a coincidence...

Now, as we argued in the first comprehensive impact assessment of the proposal, the industry does need more transparency and accountability, so in that sense, the Commission was correct in looking at new regulation for this sector. But the Commission’s original proposal was fundamentally flawed. Leaving aside the huge number of technical details involved (for a wider discussion see here and here), the original proposal would have paved the way for a world in which investors in these funds, the managers of them, their custodians (that hold the assets of the funds) and the funds themselves were all confined to a life either within the EU’s borders, or a life outside them. This was clearly contrary to best industry practice (for example by increasing concentration risk), the nature of modern finance (which is inherently mobile, global and cross-border) and would have also contradicted the 2009 April G-20 summit conclusions, which instructed world leaders to

“promote global trade and investment and reject protectionism, to underpin prosperity.”

To their credit, MEPs and national ministers, following 18-20 months of negotiations, adopted a far more sensible version of the proposal which kept many of the Directive’s transparency provisions while aligning most of the other rules with global economic realities and the need for inward investment into Europe.

But, as we also argued in 2009,

“The Commission is the dark horse in all of this. The way the Directive is written leaves the EU executive unusually large room for manoeuvre in deciding key aspects of the legislation – including leverage levels, valuation standards and restrictions on short-selling – either in the implementation phase or further down the road.”

This is because, in the so-called Comitology stage, the Commission has the power to lay down ‘technical’ or ‘supplementary’ standards when these are specified in the proposal, with limited involvement from MEPs and member states (for a background see here).

As reported by the FT this morning, this is precisely what the Commission is now seeking to do, in several ways, including

• Tougher liability rules for custodians (which would be liable for the safekeeping of assets, even if the custodian decided to delegate the responsibility to a third party). This could make EU-based banks far more hesitant to operate with partners in emerging economies, in turn undermining investment in those parts of the world.

• Stricter rules on leverage, i.e. how much money a fund manager is allowed to borrow. Interestingly, a recommendation for a more discretionary model of calculating leverage, put forth by ESMA – the EU’s markets supervisor – was rejected by the Commission.

• Fund managers based outside the EU, would face more obstacles before they could market their products to investors based in the EU. As Andrew Baker of AIMA put it,

  “This would be extremely problematic if not impossible to conclude if the regulation prescribes that the co-operation agreements ensure that third-country regulators enforce EU law in their territories.”

Now beyond the boring technical details, this is politically interesting for at least two reasons:

• The Commission is ignoring ESMA, begging the question, what exactly is Commission's relationship with ESMA and the other EU financial supervisors (ESAs), set up in 2010, meant to be. Specifically, whether “technical details” will be allowed to remain technical or become politicised with the ESAs being colonised by the Commission’s agenda.

• Via the Lisbon Treaty, the Commission has increased its powers in the so-called comitology procedure (for the full story, see here). This is an interesting test case for how far the Commission dares to push its luck.

This will go on for some time and we should not jump to conclusions – and clearly, the industry has its own agenda as well. But, the episode is a reminder of one thing: in EU politics, proposals and laws have a curious habit of always coming back.

The new gatekeeper

For quite some time, we have tried to highlight how the EU's new financial supervisors could eventually take on too much power for comfort - not least when viewed from the City of London. The European Securities and Markets Authority, in particular, looks set to become a force to be reckoned with. As we argued in our recent report on the subject, this is a bit peculiar since most of the commentary - such as the de Larosière report or the Turner review - which precipitated the creation of the new supervisors, related to cross-border supervision of large retail banks.

Over the last couple of weeks, negotiations over the AIFM Directive seem to be moving in the direction of giving ESMA powers, possibly exclusive, to supervise hedge funds and other types of funds based outside the EU and decide whether these should be granted EU-wide market access (a so-called passport). In other words, ESMA could become the sole 'gatekeeper' deciding who has the right to enter the EU market. This is no small power.

The UK could possibly accept such far-reaching powers for ESMA in return for keeping the passport provision in the AIFM Directive - a provision which the French don't like at all but that is popular with the industry.

From the City's point of view, the problem with this arrangement is that market access for the many funds which operate in the City but are domiciled elsewhere (i.e. Cayman or the US) could be decided in a forum where the UK has the exact same voting strength as Malta or Slovakia, as most decisions within ESMA will be taken by simple majority voting, meaning one country, one vote. The lack of safeguards in this voting arrangement could lead to this issue being hijacked by narrow commercial or political interests - or protectionist forces.

A blanket solution to market access, with ESMA calling the shots, would therefore be a mistake. As a leader in today's FT argues,

"Restricting this power to ESMA alone sparks concerns about protectionism. Keeping the state-level door open would also ensure that if ESMA proves inefficient, hedge funds can go directly to national bodies."

Quite right. The negotiations are now entering the final stretch - a break-through could even come today. The UK must resist calls to give ESMA exclusive powers over market access.

What are they thinking?

Things aren't looking great for the AIFM Directive. At least not from the point of view of developing countries, SMEs, European taxpayers, pensioners and assorted charities - all of which will be negatively affected if the Directive is passed in its current form. In fact, there has rarely been a law with so many losers and so few winners.

In addition, the City of London is clearly a vital national interest for the UK, and the AIFM Directive would land a blow to the square mile at a very critical time. EU leaders will make a serious political mistake by forcing through something like this only one week after the new British government has taken office. Despite the UK being home to the bulk of the industry in the EU, the Conservative-Liberal government has virtually no room to prepare for the negotiations (or even catch their breath). According to Angela Merkel, EU leaders simply intend to walk all over the Cameron government under majority voting rules. This is a clear break with conventional negotiation practice in the EU, where national interests are usually taken into account. (read our take on it here)

Frankly, what are they thinking? Undercutting a fragile coalition government for which 'Europe' is clearly a make or break issue is probably not the best way to ensure the UK's constructive long-term engagement with Europe. It also happens to be an attack on US interests, as funds and managers based offshore will find it far more difficult to access the EU market under the Directive - in turn increasing the scope for regulatory retaliation.

And from EU leaders' point of view, why put the Lib-Dems - the one remaining voice for EU-enthusiasm in the UK - in such an awkward position? This will seriously undermine the party's ability to defend its line against Tory backbenchers.

And, remember, Europe needs capital - governments and firms alike - in order to bounce back from the downturn (remember the €750 billion package agreed last weekend?). The AIFMD is a blow to an industry which can provide just that. Indeed, it's fully possible to introduce stricter rules for transparency and accountability - which the industry needs - without negatively affecting capital flows and growth (the Swedish EU Presidency came close to producing such a compromise proposal in December).

The story of the AIFM Directive is simultaneously an illustration of how poor the UK government and the City of London are at engaging with Brussels, and how difficult it seems to be for EU leaders to let political and economic reason prevail over ideological bias and short-term thinking.

An often repeated question is: imagine if this was a law threatening French agriculture or the German car industry...? We suspect that the game would have looked very different. For an example, compare the language coming out of the UK over the weekend on the AIFMD to the strong French defence of the agriculture sector in response to recent discussions on possible bilateral trade talks with other regions.

According to the Sunday Telegraph, a UK Government source said that "There is a majority in favour of the directive and we don't want to be in a position where we squander any negotiating capital we have for the future on an issue it doesn't appear we can win." (okay, but why allow it to get to this point in the first place).

In contrast, French Agriculture Minister Bruno Le Maire said today in response to why France is opposed to the EU re-launching trade talks with the Mercosur countries:

France is opposed to resuming negotiations [with Mercosur countries], because they would inevitably end in further concessions to the detriment of French and European farmers. I don’t see why agriculture has always to be the adjustment variable of trade negotiations in Europe.

No compromise there.

It's true, French farmers don't make for as convenient scapegoats for the failures of a certain Single Currency. But still, you would hope that EU leaders could see common sense and have at least delayed this vote to allow the new UK government some time to prepare.

At the end of the day, this would be in Europe's interest - economically as well as politically.

We've been here before

The Spanish EU Presidency yesterday decided to shelve a vote on the proposed AIFM Directive on hedge funds and private equity due to "a last-minute intervention by Gordon Brown", according to the FT. The talks apparently stalled on British concerns over the protectionist elements of the Directive, which could see barriers put up to non-EU funds trading in the EU.

We have estimated that the industry contributed €6.1 billion in tax revenues in the UK alone and €9.2bn overall - an amount that could be under threat if a flawed directive is passed. We have also consistently warned that the protectionist provisions entailed in the proposal would cut off offshore managers and funds from the EU market. This will have at least two negative consequences: less choice and value for money for EU investors (including pension funds and charities) and less capital for European firms struggling to rebalance their books in the wake of the economic downturn. Therefore, the British Government's focus on the protectionist dimension is in principle welcome.

The FT reports that Paris "agreed to defer a vote" in order to avoid appearing to inflict "a defeat on Britain". A vote could have been forced on the UK because this Directive will eventually be decided by qualified majority voting. The question is will anything have changed when ministers next look at the Directive in either May or June.

There are also worrying parallels with what happened with the Temporary Agency Workers Directive in 2007. Then, as today, the FT reported that Brown had "personally intervened to defend Britain’s flexible labour market" and delay agreement on the Directive when it looked as though the UK would be outvoted. However, within a year the UK had been out-foxed and was forced to accept the Directive with only minor concessions. In addition, the UK almost lost its separate opt-out from the EU's 48 hour cap on the working week, entailed in the Working Time Directive, as a horsetrading deal involving the two Directives came dangerously close to backfiring at the hands of the European Parliament.

The Government will no doubt portray yesterday as a victory. And although the postponement of the finance ministers' vote on the proposal leaves UK negotiators, the industry, investors and others with some extra room to find allies and bolster the case for a radically amended Directive, today's developments provide no guarantee that this is going to be straightforward. A vote in the Council is now expected at the finance ministers' meeting on May 18th, meaning that for the time being all eyes will be on the European Parliament (whose economic committee will vote on a draft proposal on April 22nd). The key for MEPs is now to resist protectionist urges.

The postponement of the Council vote also adds another dimension to what already is a very complex amendment process. The British general elections will take place on May 6th, meaning that should the Conservatives win, they will be faced with a major showdown in Brussels after less than two weeks in office.

Whether this is a good or a bad thing for the fate of the AIFM Directive depends on a number of factors, including how much energy and political capital a Conservative government considers it can spend on this (the Tory treasury team is not short of challenges as it is); and how willing European partners are to give concessions to a Conservative government early on, in order to secure its future constructive engagement in EU affairs. This, in turn, depends on what a Conservative government is willing to concede in return, i.e. future concessions on agricultural spending, social legislation and so forth. In Brussels, as ever, nothing is free.

One thing is for certain, this is not a good time for the UK government to let its guard down on the AIFM Directive. Indeed, we've been here before.

Rasmussen v. Lord Myners (and the rest of the City)

In case you missed it, Open Europe last week organised a debate on the EU's proposed new rules for hedge funds, private equity firms, and various other funds currently not regulated by EU law. In good-old Brussels fashion the proposal goes under the acronym AIFMD (Alternative Investment Fund Managers Directive), and has been recieved with some scepticism in the City of London - to put it mildly.

In a Guildhall filled to the brink with angry pin-striped suited City people, the AIFM Directive's key proponent, Poul Nuryp Rasmussen, fearlessly explained why he didn't think the proposal goes far enough. The arguments aside, you have to give Rasmussen credit for his dedication, courage and willingness to walk into what can only be described as a lion's den. And he certainly stood his ground. During the course of the debate, it became evident that Rasmussen knows more about the alternative investment industry than the industry itself perhaps feels comfortable admitting. It would be a mistake to underestimate him, particularly as he still - despite no longer being an MEP - has much input into what kind of amendments the socialists in the EP will put down on the draft Directive.

Rasmussen carries a lot of respect around Europe. During the 90s he took on the unions in Denmark in a bid to get the Danish economy up and running again - a point he was keen to make at the end of the debate. This, he said, highlights that he's a "pragmatic Scandinavian" and a "pro-growth guy" (in addition to being an economist). He's not out to get the City of London. A Scandianvian economist with pragmatist credentials is the nightmare opponent for the alternative investment industry, insofar as he'll draw a lot of sympathy from around Europe (and hedge fund managers aren't exactly the most popular kids on the block). However, notwithstanding his courage and the rest of it, the arguments are against Rasmussen on this issue - as we've outlined here.

The main counter-blast to Rasmussen's arguments did not come from any of the industry representatives, but from City Minister Lord Myners, who used surprisingly strong rethoric - no doubt mindful of his audience. In particular Lord Myners hit out at "the lamentable lack of consultation" which preceded the Directive, and said that the proposal amounted to "protectionism hiding as if it were protection".

One of the most interesting admissions from Rasmussen was that the Directive was designed to keep fund managers from the rest of the world out of the single market, unless they "pay a price". "No one can have my Danish passport", Rasmussen said. As we've argued many times before, this type of protectionist thinking remains one of the EU's greatest flaws. Whether it's raising barriers to global capital flows and investment, or free trade in products and agricultural commodities, this kind of approach leaves everyone worse off.

This flaw is more than enough reason to oppose the draft Directive in its current form.