Boris: EU reform the best option, but Brexit should not scare us

Boris Johnson today outlined his response to the report by his economic advisor - and Open Europe board member - Dr Gerard Lyons on the future of the UK’s relations with the EU and how they impact on London.

The report entitled 'a win-win situation' outlines four economic scenarios, with the best seen as staying in a reformed EU and the a close second being leaving the EU on good terms with growth-focussed policies towards Europe and the rest of the world:

• The best scenario is UK membership of a reformed EU, which could see London’s economy grow in size from £350 billion now to £640 billion over the next 20 years.
• The worst scenario would be where the UK leaves the EU on bad terms and does not produce a growth-focused policy. The report suggests the London economy would only grow to £430 billion by 2034 in this scenario, and see a shedding of about 1.2 million jobs. 
• If the UK left the EU, maintained good relations with the EU and adopted outward-looking policies, then the London economy would grow to £615 billion and see an additional 900,000 jobs created over the next 20 years. This is despite the near-term uncertainty that would follow from leaving.
• Being in an unreformed EU, London might see only an extra 200,000 jobs created and growth to £495 billion over two decades.

The key reforms - which draw heavily from Open Europe's work - proposed in the report are: addressing the relationship between euro ins and outs, liberalising the single market in services, safeguards on the single market in financial services and the position of the City of London, EU budget reform, reducing the burden of social and employment law, and halting over-regulation. The reforms go well beyond what David Cameron has set out so far.

If reform is not sufficient, the report concedes that withdrawal would create immediate economic uncertainty but this could be mitigated in the longer term if the right policies are pursued. The report suggests that the terms of a Brexit could be defined by the referendum result itself - a close result could prompt a re-re-negotiation rather than an immediate reach for the Article 50 exit clause - you can read the outcome of our 'wargaming' of Brexit here (which the report also references).

The report notes that financial services and insurance are key London industries, comprising 19.8% of GVA, the single biggest sector measured in these terms – how will this be affected in Brexit? The report notes that London has many attributes other than acting as a springboard for access to EU markets but adds that this market access is valuable and could face some extra barriers following withdrawal.

In summary, the report concludes that reform is the best option, but there is little to fear from Brexit.That last point - in addition, to the various reform proposals set out - will no doubt serve to put additional pressure on David Cameron to be more ambitious in his push.

Would a stand alone financial services commissioner be a curse or a blessing?

There’s a bit of a debate going on at the moment over whether splitting up the internal market portfolio in the next European Commission is a good or bad thing for UK interests. The idea is to separate financial services from the wider internal market portfolio, to create a more manageable brief and avoid a scenario whereby an activist Commissioner turns this portfolio into a financial services one anyway, neglecting the many other crucial single market issues such as professional services, energy and digital services.

The idea has been subject to a bit of push-back with some worrying that a new “financial services tsar” will turn against the City, while making it more likely that the Commission develops a Eurozone-bias in its financial services legislation. The British Bankers’ Association has come out against the idea, for example. 

There is undoubtedly a risk here: if a free-standing financial services brief goes to a candidate who is anti-free markets, doesn't get financial services and who wants to pursue Eurozone-tailored solutions at the expense of the single market, then of course, it would be a bit of a disaster. However:

• Remember, we’ve lived with a 'financial tsar' over the last fine years. His name is Michel Barnier. Though there are now those within the UK Government who say Barnier “wasn't that bad after all”, it was clear that he saw his primary mission as restricting and controlling financial activity. He focused almost all his energy on this to the detriment of wider internal market issues. 
• Under Barnier’s watch the integrity of the single market has been mostly protected – for example there are now non-discrimination provisions in laws such as MiFID and EMIR – however it has been and remains a daily struggle and most of these protections were inserted by member states during the negotiation process. Let’s not forget, this is the man who has played a leading role in the drive for a Financial Transaction Tax and the banker’s bonus cap. Furthermore, the original proposal for a eurozone banking union transferred huge amounts of power to the Commission and put a eurozone focused brief right at its core (to the chagrin of more than just the UK). 
• More importantly, however, while financial services is hugely important for the UK national interest, it’s not the only interest. The problem with merging financial services and the wider internal market is that the latter tends to get neglected given all the focus on the likes of banking union and regulating sprawling multinational financial institutions. An active Commissioner dedicated to liberalising the single market in services, digital and energy could be hugely beneficial at the moment, particularly since the appetite for a new push in some of these areas may be growing across Europe. Also, this will form a key plank in Cameron’s renegotiation strategy. 
• Splitting off financial services is the only chance the UK has of getting internal market – which even without financial services (for the reasons described above) would be a big prize. 
• While it is often said that keeping financial services inside internal market ties it to the single market, the point also runs both ways. For example, outside the internal market brief, more attention may be paid to the legal justification for financial services regulation rather than it simply being pushed through under a single market justification as is usually the case. 
• In terms of Eurozone-bias – we’re as concerned about it as anyone, as we flagged up as early as 2011 (though we don’t believe that the Eurozone will organise itself as a perfectly coherent entity any time soon) – the key for this is to keep financial services as far away from the Economic and Monetary affairs brief as possible, which for the most part looks to be taking place. 

So it could go go either way. However, you have to compare it against what has gone before and what the likely alternative is. Cameron would have to screw it up badly to make the de facto division of labour worse in this area than what was the case in the previous Commission.

Balance of Competences round-up: Part II

Further to our previous post on the Government's Balance of Competences report on free movement, below we pick out some of the key points from the other reports published today:

The report on the services stated that:

“Incomplete and ineffective implementation of existing services legislation has hindered the development of the free movement of services, but full implementation of existing legislation within the current level of EU competence may have implications for Member States’ ability to make decisions in this area.”

The report also echoes Open Europe's recommendation that if further liberalisation cannot be achieved at the EU28 level, a group of like-minded member states should push ahead using the so-called 'enchanced co-operation' mechanism.

“There is scope to go further on services liberalisation, extending the application of the country of origin principle, either within specific sectors or across the piece, and either at EU-level or within a smaller group of Member States through enhanced co-operation. Further liberalisation could also be achieved through a sectoral approach, focusing firstly on those sectors of greatest economic importance.”

The report on financial services noted the risks to non-euro member states from deeper eurozone integration - something Open Europe warned about back in December 2011 in our Continental Shift report:

“There were significant concerns that the advent of the banking union could have an unfair or damaging effect on Member States outside the euro area [such as] EU-wide regulation that is appropriate for the euro area but is not suitable for all Member States; the practice of caucusing and the development of a common euro area position on financial services issues which are at odds with a single market that is open internationally, dynamic, innovative and globally competitive; the fragmentation of the Single Market with barriers erected between its euro area and non-euro area constituents; the undermining of economic benefits associated with liberalised capital markets; and the marginalisation of non-euro area interests.”

The report warned that:

“The risk of discrimination against non-euro area Member States has already crystallised with the ECB location policy that euro-denominated financial instruments should be cleared only by a clearing house physically located in a euro area Member State.”

And recommended that:

“The creation of the banking union underlines the fact that the EU has become so large and diverse that ‘variable geometry’ is necessary.”

The report on the EU budget noted that:

"The value of expenditure in the budget, where in particular... on research and innovation, was seen as a priority for a greater share of the budget, although views were also heard in support of structural and cohesion funds, particularly in poorer Member States. The value for money of the Common Agricultural Policy (CAP) was questioned by a large proportion of respondents, with particular concerns about the value of Pillar One of the CAP."

The report on cohesion (regional) policy picked up on many of the points raised by Open Europe's seminal 'Off Target' report - which recommended limiting the structural funds to less developed member states - arguing that:

"support for the general principles of cohesion policy and the need to provide support particularly for poorer Member States, was shared by many respondents... The evidence as a whole is inconclusive but where significant positive impacts have been identified, they tend to have been in the poorer regions or Member States."

But adding that:

"A key question is whether structural funds should be used in richer regions of Member States, given the alternative sources of funding available, the more limited additionality and the goal of reducing disparities. This was sometimes expressed in terms of concerns about paying money into the EU only to get it back with conditions attached. Many respondents recognised that the UK might be better off financially if it did not contribute to cohesion policy in rich Member States or regions."

"Finally, it is important that funds available for cohesion policy are well managed. However, the complexity of rules and the perceived burdens of applying for, reporting on and auditing projects are potential barriers to the effectiveness of the structural and cohesion funds."

The report on agriculture also picked up on Open Europe's criticisms of the CAP, noting that:

“respondents put forward evidence that, notwithstanding the reforms, the CAP’s objectives remained unclear and that the criteria for allocation of funding were irrational and disconnected from what the policy should be aiming to achieve. The majority of respondents argued that the CAP remains misdirected, cumbersome, costly and bureaucratic.”

The report on fundamental rights noted that:

"There was mixed evidence on the case law of the ECJ; while some considered that the ECJ has simply upheld fundamental rights, others considered that some of its judgments have undermined national sovereignty and the EU’s legislative institutions... in comparison to other human rights protections in domestic law, fundamental rights can have a wider scope and can result in the disapplication of primary legislation. Therefore, with an increasing domestic awareness of EU fundamental rights, the evidence suggests that their impact will increase."

Compared to the first two stages of the BoC which were rather underwhelming, this third tranche of reports has at least been more explicit in identifying some of the most pressing challenges that need to be addressed while - for the most part - steering clear of setting out solutions.

Which Commission post should the UK push for (clue: not energy)?

When it comes to EU top jobs, if you snooze you lose, as
Gordon Brown discovered to his cost in 2009

In a new briefing published this morning we argue that after the row over Jean-Claude Juncker’s appointment, David Cameron can regain the initiative by sending a heavy-hitter - and not simply someone who happens to be available - to Brussels with the view to securing a top job in the new European Commission. But here is the crucial question - what job should the UK push for?

Here are the key points from our briefing:

• Even though conventional political wisdom says that it’s impossible for the UK to bag the internal market portfolio, this is precisely what David Cameron should ask for, not least given that Germany, in particular, may want to give the UK a quick win in order to reduce the risk of Britain leaving the EU.

• To boost the chances of this happening, financial services could be split off from the internal market portfolio. However, in this scenario, the key is for this portfolio to go to a country that actually has a meaningful financial services industry, or the strategy could backfire.

• The second best outcome for the UK would be to secure the competition portfolio. competition is by far the most powerful DG, with the power to impose multi-million euro fines, prevent mergers and restructure banks. The portfolio would allow the UK to ensure a business-friendly environment and ensure fair competition within the single market by preventing discrimination against non-euro member states. It also establishes a political link to eurozone - it’s impossible for eurozone leaders not to engage with the Competition commissioner.

• The Trade portfolio is often mooted as a good one for the UK, and on substance it certainly is. Being able to conclude the EU-US free trade deal (TTIP) would be a great scalp. However, it is important to remember that Commissioners’ ability to impact EU policy is not limited to their own briefs; many policy proposals are debated within the College of Commissioners offering every Commissioner the opportunity of raising any concerns at an early stage. Just as the EU’s High Representative for Foreign Affairs – currently held by Baroness Ashton - the Trade Commissioner is often absent from Brussels, thereby limiting the UK’s overall influence.

• The energy portfolio would be a relative disappointment for the UK. Yes, energy is a hugely important issue for Europe – and liberalised single market could help tremendously in both boosting energy security and keeping cost down. The Energy Commissioner could also play a key role in keeping the EU out of shale gas regulation – a key UK objective. However, the big push needed to change the political culture in Europe for this to happen won’t come from the European Commission and will take a long time to achieve anyway. This battle will first need to be won in national capitals. Taken together though, the Competition Commissioner probably has more sway over the EU energy market by being able to strike down attempts at creating national champions and new forms of intervention – as illustrated by the current stand-off between Germany and the Commission over Berlin’s rebate for energy intensive industries from its domestic renewable surcharges.

• Arguably, the social affairs brief would be better than the energy portfolio given how hugely important the rules on access to benefits for EU migrants are for the wider debate in the UK.

Just as important as the UK’s portfolio is the distribution of other key portfolios among reform-minded countries like the Netherlands and Sweden. Cameron needs to be far cleverer than Gordon Brown was in 2009, when France got internal market and Romania agriculture. This won’t be easy though. Having lost out on one of the three ‘top jobs’, France could push for either the competition or internal market brief. However, if France keeps the internal market, financial services should be split off as well.

Finally, the appointment of the new President of the European Council will also be crucial – in some ways just as significant as that of the Commission President – given that this will be the person in charge of brokering Cameron’s negotiations with other heads of state and government.

It's certainty all to play for.

ECJ throws out UK's FTT challenge, raising questions about whether it can be trusted to police the EU treaties

This morning’s ECJ judgement that the UK’s legal challenge against a proposed Financial Transaction Tax (FTT) is premature was what many had expected. The UK had challenged the decision to authorise the use of so-called ‘enhanced cooperation’ (where a smaller group of EU members can move ahead with legislation even if it does not have broader EU support) for the FTT. For the UK Government, today’s result is not what it had hoped for (an annulment of the decision to authorise enhanced cooperation), but neither is it the worst outcome.

Today’s ruling effectively said that the court could not rule on the UK’s substantive objections to the FTT since the final shape of the tax is unknown and subject to further negotiation between those taking part. This does not prejudice the UK’s ability to mount a second challenge once the final FTT has been agreed and its implications are clearer.

The ECJ judgement (in full here) said:

“It is clear that the objective of the contested decision is to authorise 11 Member States to establish enhanced cooperation between themselves in the area of the establishment of a common system of FTT with due regard to the relevant provisions of the Treaties. The principles of taxation challenged by the United Kingdom are, however, not in any way constituent elements of that decision.”

“The two pleas in law relied on by the United Kingdom in support of its action must be rejected and, accordingly, that the action must be dismissed.”

“Those effects are dependent on the adoption of ‘the counterparty principle’ and the ‘issuance principle’, which are however not constituent elements of the contested decision, as stated in paragraph 36 of this judgement.”

“That review should not be confused with the review which may be undertaken, in the context of a subsequent action for annulment, of a measure adopted for the purposes of the implementation of the authorised enhanced cooperation.”

However, while the UK will get a second stab at challenging the FTT, today’s ruling poses major questions about how ‘enhanced cooperation’ works and how it is used in the future. The EU Treaties stipulate that authorisation of enhanced cooperation (which is given by a qualified majority vote of all EU member states) is conditional on the proposed legislation respecting the integrity of the single market and not impacting on those not taking part – this is meant to be a legally enforceable safeguard for those countries not participating.

Enhanced cooperation is a relatively new phenomenon that has only been used twice before (for a European Patent Office and divorce law), but it could have huge implications for the future of the EU and Britain’s place within it. In an increasingly multi-tier EU, enhanced cooperation may be used more often by countries that want to integrate further. For those that don’t wish to follow suit, it is vital that their rights in the single market are respected.

Let us start with an analogy. Imagine you had agreed to let your neighbour build a new house based on a certain agreement and set of plans. Halfway through building it becomes clear that he has adopted a new plan which will hamper your view or infringe on your land. You appeal to the council but they rule that it is too soon to tell where the house will end up and that they can only rule when the house is built. Tearing down a house is much messier and more costly than stopping one being built in the first place. Hardly seems efficient or fair, does it?

Yet, in this case, this seems to be what the ECJ has done. It has effectively decided that it could not decide whether the decision to authorise the FTT proposal does respect the rights of those not taking part because the final outcome of the FTT negotiations cannot be known now. This is strange because this is by definition true in pretty much all cases of enhanced cooperation, since the countries involved negotiate the finer points of the legislation amongst themselves after getting approval to go ahead.

While this may seem legalistic and technical it raises a fundamental question: are the authorisation criteria for enhanced cooperation worth anything? Surely, any decision on the use of enhanced cooperation should be made on the basis of the proposal that is on the table, irrespective of whether it might change (for the better or worse) by the time it is finally agreed as a legal act, which could still be challenged in any case. The potential spill-overs should be examined before those member states not involved give those involved the go ahead. Otherwise they are ultimately authorising an unknown piece of legislation, which once it has built up a political head of steam could be much harder to challenge later on.

By its very nature, enhanced cooperation will be used for controversial proposals but today’s ECJ judgement has increased uncertainty surrounding this procedure (it was already uncertain) and undermines the logic of the process for authorising its use. We cannot know what the long term implications of this will be for the EU and the UK but they could be important.

As for the FTT, the UK will have another chance to challenge the final legislation (which may end up being watered down anyway due to concerns from those taking part) but by the time it gets to that point, there will be so much political capital invested in it, it may make it harder for the court to strike it down, even if the UK has good legal grounds.

The Battle of Londongrad? What does the data actually say?

On Friday afternoon Open Europe released a new flash analysis looking at the links between the City and Russia.

Much has been written on this issue – see NYT, FT and Economist for background.

While there is anecdotal evidence in these articles about City links to Russia, they fail to delve deeper into the data and, importantly, lack any context as to what Russian business means to a city and financial services sector the size of London.

The summary of the piece argues:

“Claims that the City of London would suffer major losses in case of financial sanctions against Russia are overblown. While it is true that there are some sizeable Russian investments in London, and it is home to a disproportionate number of Russian oligarchs, these are far from critical to a global financial centre such as London. The stock of Russian international investments in London is sizeable at £27bn, but it only accounts for 0.5% of total European international assets invested in London.”

“For all the talk of the large number of financial services provided to Russia, these only amount to 1% of total UK exports of financial services, business services and insurance. This would suggest that accusations that the UK Government is blocking tougher sanctions over fear of losses to the City don’t match the facts.”

“Sanctions related to financial or capital markets, for example severing access to credit for state-owned enterprises or Russian banks, might be an effective strategy to exert more pressure on Russia (given its reliance on external financing). Such move would be far more damaging to Russia than the City of London – though it may involve some losses for the latter. This should not, and does not seem to be, a big concern for the UK government. In any case, if things get to this stage, other EU countries may suffer far greater losses than the UK through wider economic sanctions hitting, for example, gas supplies and exports.”

There are plenty of factors to consider when looking at sanctions. While the City is one of them, in the scheme of the broader European links to Russia it does not seem huge (compared to some economies complete energy reliance). Furthermore, given the size of the City as a global financial centre the links to Russia seem to fall far short of the critical billing they seem to have been given.

Are MEPs about to take on the English legal profession?

English knights seeking to protect their estates were a driver behind 
the creation of English Trust law.

MEPs are set to vote this Thursday on the 4th Anti-Money Laundering Directive - which aims to shed light into who owns private companies. This sounds positive and innocuous and the sort of thing politicians, including David Cameron, often - and rightly - call for. But the devil is in the detail. Some MEPs are reportedly now proposing to extend this 'transparency' into Trusts as well as companies, which could have major impact on UK business.

Making a register of the beneficial owners of all private companies, based on millions of underlying arrangements, changing on a day to day basis, was already looking to be complex. But when it comes to Trusts, transparency runs into a serious intellectual and practical problems. Who is the beneficial owner of a discretionary trust? How do you report that a spouse has an interest in a property/company - something that may only become apparent in a divorce court?  Trusts encompass all manner of arrangements; trusts to protect children, trusts holding money pending a transaction, insurance policies, pensions, collective investment schemes etc. Without Trusts the UK's financial services industry would not be able to operate. Will MEPs really seek to have all this reported on a potentially public register? If it is indeed possible, reporting millions of ever changing arrangements could add a massive regulatory cost to everyone's financial affairs. Logic would dictate they would steer clear but lobbyists are already in full swing, pushing amendments that would radically increase the scope of the report.

This is also an important test for how the EU balances the interests of different member states. Trusts are a major innovation of the UK's, (particularly the English) legal system. Whereas continental legal systems traditionally tended not to look beyond the legal ownership of a property, the English legal system has taken a different approach, for better or worse dating back to the Crusades. Essentially, if you hand over the legal ownership of property to a relative in the expectation that you retain an interest (i.e when you come back alive from a Crusade) and it is not respected you could go to the King to receive justice - in the jargon you retained an 'equitable interest'. Other EU states have different set ups such as Stiftungs and Anstalts but these are not as widespread as UK Trusts.

What will happen? Well there are signs that some MEPs are aware of the problem, the EPP for one seems to be against, but David Cameron's ECR group (perhaps to save him embarrassment?) seems, for now at least, curiously undecided about coming out against these ideas.

This is not to say the English legal system should be exempt from transparency, but rather than EU politicians of all colours need to be acutelyy aware of the unintended consequences of regulating 28 different legal systems - with practices sometimes dating back centuries - with one broad brush.

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.  

UK lines up another court challenge against EU financial regulation

Last week, the UK launched another legal challenge at the European Court of Justice (ECJ) against an unwanted piece of financial regulation – this time, the bankers' bonus cap. This comes in the wake of some favourable legal assessment from a UK point of view, on short selling and the FTT (though both those cases are  still pending), as well as a win on benchmark regulation.

The details on the exact basis for the challenge remain vague but the key points of contention seem to be:

• The CRD IV legislation transfers power to the European Banking Authority (specifically the power to regulate wages in some form). When the EBA along with other supervisors was established there were clear limits put on the powers it can have, particularly ones transferred under the single market legal base (article 114). This was also a key point in the short selling case and one that the ECJ backed the UK on. Furthermore, the use of technical standards allows a significant amount of power to the EBA officials to set the boundaries of the cap.

• The second key issue is the legal base itself, should something such as a wage cap fall under the single market legal base? Furthermore, should it even be allowed under EU treaties? This may come down to a question of to the extent to which the cap actually play a role in regulating the financial system (we would say not much).

• The next issue is related to the above. The UK claims that the law is being enacted without any significant cost benefit analysis of its impact and that it remains unfit for purpose.

• There is also an extraterritoriality point to be made potentially, given that all banks headquartered in the EU will have to apply the rules across their businesses around the world, thereby setting rules outside the EU. However, this home vs. host interpretation of regulation is not unheard of. (This obviously makes the plan flawed from a practical perspective although how strong a point it is legally is not clear).

This could prove to be another important case for the UK for a number of reasons:

• It highlights a growing trend that the UK is aware it has significant legal recourse on EU issues which it does not agree with. Using this effectively will be a big part of future EU engagement.

• As we have noted before, the EU is increasingly trying to push through a wider range of measures using single market articles. Showing the limits of this approach, as was done with the short selling ruling, will be key in defining the limits to what the eurozone in particular can push ahead with under the current treaties (though the cap isn't itself a eurozone-specific issue).

• If the UK is able to secure a victory or even an adjustment in the rules it will be significant since this is the first financial services issue which the UK has been directly out voted on – making it a key symbolic point.

Having said all that, on this one, the UK will have a tough time.

Spotlight on Slovenia

Back in the spring, we looked at who might be next in the line of eurozone bailout requests. It's now looking increasingly likely that one of our predictions, Portugal, will require some form of further assistance to fully exit its current bailout. Now, suspicions are rising that our other tip, Slovenia, may need external aid in a not-too-distant future.

Today and yesterday, eurozone finance ministers have been meeting in Lithuania with aid for Slovenia (as well as Greece, Portugal and Ireland) top of the eurozone’s agenda.

Recap – What problems is Slovenia facing?

• The banking sector is nursing a possible €7.5bn (21% of GDP) capital shortfall. Although Slovenia’s government debt remains very manageable (at 54% of GDP) it could increase quickly due to a toxic combination of collapsing economic growth and spiralling costs of bailing out banks.

• As we noted back in the spring, provisions against this capital shortfall are far below the levels needed and covered at best half of the problematic loans. Since then, the level of bad loans has increased, while little progress has been made on recapitalising banks. The recent bailout of two small banks cost a combined €900m+, and included a bail-in of subordinated debtors. This could set the tone for the approach to the rest of the sector. Worryingly, this is also around the total amount previously estimated for the capital needs of the whole banking sector.

• The European Commission has pushed the independent bank stress test to be expanded to cover the whole banking sector. The results are expected at the start of next month, and could well reveal deeper holes in Slovenia banks. Filling these without external aid will be tricky.

• Non-financial corporations also continue to struggle under a mountain of debt, with a debt-to-equity ratio of around 200%. This will be a significant drag on the economy for some time as firms shrink and deleverage while many could well shutter for good. This of course has further knock on impacts for the level of bad loans at the banks and the level of unemployment.

• Austerity has been limited so far with the government deficit at around 8% of GDP (and possibly set to increase this year). Significant cuts will still have to happen and, as we have been at pains to point out before, the combination of bank deleveraging, fiscal consolidation and struggling domestic demand can create a very painful downward spiral.

• The privatisation programme has failed to get off the ground, with the only sizeable move so far being the €240m sale of retailer Mercator.

• Concerns also remain surrounding the significant amount of cronyism and corruption at play, particularly within state owned firms and within the financial sector. The government has recently moved to crack down on the shadow economy with wider taxes, although whether this will prove successful remains to be seen.

Despite these issues, German Finance Minister Wolfgang Schaüble struck a positive tone today, saying,

“I think if they stay strictly on course -- and they’ve said that want to do that; they’ve supplied two small banks with capital over the weekend -- then they’ll manage without it…So as long as Slovenia itself says they can manage it, we should encourage them in that.”

EU Economic and Monetary Affairs Commissioner Olli Rehn voiced similar sentiments. So far then, Slovenia seems to be happy to go it alone and (possibly with other things on their minds) Germany and others are happy to acquiesce. But with the ECB reportedly increasingly concerned about the state of the banking sector, the upcoming stress test results could be a turning point – assuming of course they are judged credible (far from a given). 

If any aid is eventually forthcoming, as we’ve argued before, it seems much more likely to take a similar form to that in Spain than in Cyprus or elsewhere.

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 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.

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?

Would an 'independent' UK get a better US trade deal than the EU?

Could the UK sucessfully negotiate a trade deal with the US?

Yesterday MEPs voted on a resolution to back defensive measures to exclude cultural and some agricultural products, such as genetically modified foods from a proposed free trade deal with the US (TTIP).

Understandably US farmers have already taken exception to what they see as EU protectionism. This raises concerns that the potential gain from an EU/US trade deal may be watered down, delayed or even blocked all together by vested interests on both sides of the Atlantic.

As a member of the EU the UK's foreign trade is governed by the EU's common commercial policy and so has to be done via an EU deal. After the EU the US is the UK's most important trading partner. Some involved in the UK-EU debate - particularly Outers - suggest that if the UK left the EU it could negotiate a deal with the US on better terms than it could potentially gain via the EU. But is that the case? Here are some of the factors that could be important.

UK exports to the US in £bn (ONS 2011) are big...

A mismatch in negotiating power. Although the UK exports a lot to the US, as a % of it's total exports, the US sends only 4% to the UK. So although a trade deal should be mutually beneficial, reaching a solution would be disproportionately in the UK's interests. Therefore, there would be an imbalance of negotiating power. For this the EU's weight could help on issues where the UK's interests are aligned with it.

Would the US want to go through the hassle? Given this asymmetry, and the relative small market the UK is for the US, one question is if the US would go through all the political hurdles -  approval in Congress, taking on the unions etc. Indeed, talk to people in Washington and there's some scepticism about this. (However, the US has signed agreements with 23 states, some very small, so perhaps it is more a matter of the terms you would get?)

But US exports to UK (US BEA 2011) are small...

Fewer protectionist hold ups. At the same time, the US and the UK are more compatible economies than are the US and EU. The UK negotiating on its own account would not be hindered by protectionist issues emanating largely from France and MEPs, that could hold up US agreement or require concessions, such as the protection of agriculture, genetically modified foods or geographical indicators. However the UK is still unlikely to wish to see the US allowed to subsidise its agricultural exports, so tough negotiations would still be required.

Access for financial services could be a tough negotiation. The UK negotiating with the US on financial services would come up against a powerful US lobby attempting to protect its banks from what is New York's main rival - London. However, the UK negotiating on its own would arguably have a better chance to strike a deal on 'reciprocity' with US funds, a more generous arrangement than that which currently exists under regulations such as the AIFM Directive or UCITS. Additionally the UK would not bear the burden of having risky eurozone banks getting in on the deal. In recent negotiations with Singapore the US gained a better deal than the EU on financial services, partly because while Singapore was happy with UK banks it was wary of giving access to all eurozone banks (a big untold story in all of this).

If the idea is that an 'independent' UK can automatically join some gigantic Transatlantic free trade zone, in place of its current EU membership, there will be plenty of hurdles and a good deal is by no means guaranteed. Added to that there's also the small matter of negotiating an equivalent free trade deal with the EU....

"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.

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.

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.