PLC Financial Services asked leading financial services practitioners to comment on the key financial regulatory developments planned for 2011 (see Article, Financial Services: Looking ahead to 2011). This article sets out their comments in full.
We are only a few days into February and consultation fatigue is already setting in. Firms are facing an unprecedented period of upheaval, with seemingly every facet of the industry subject to ever greater regulation and more intrusive supervision. In addition, there has been a distinct shift of regulatory and supervisory powers to Europe. The pace of EU proposals and initiatives for reform increases, often with little time allowed for consultation − a fact which has not gone unnoticed by the Treasury Select Committee. At the same time, our domestic tripartite supervisory regime is to be dismantled and replaced with an untested alternative model.
The issue for firms is whether they have the resource to cope with the scale and pace of regulatory change. They have to run their day-to-day business and keep it compliant with the existing rules, prepare for new rules that they know will soon be in force, and keep track of the vast range of proposals that might affect them in the future and try to contribute to the debate, so as to ensure that their business is not derailed by legislation prepared in ignorance of the industry viewpoint.
There must be a concern that the wave of onerous new legislation will mean that investment services are increasingly provided only by large firms and banks. All firms are having to assess how they will deal with change, but there is a huge burden on small and medium sized firms. It is little wonder that there is palpable anger at the vast interim invoices that they have recently received from the FSCS. Such firms feel that they try hard to be compliant and spend significant sums in doing so, in uncertain economic times they are keeping a close eye on their financial resources and trying to adhere to prudent budgets, then, completely out of the blue, a huge unforeseen bill arrives that threatens their entire financial calculations. This incident illustrates why many firms feel that they are in a regulatory whirlwind which they are powerless to control. To add insult to injury they will also be paying, through the FSA levy, for a reorganisation of domestic regulation that was essentially presented as a fait accompli and the benefits of which are not at all clear to them.
Of course there is little they can do about the cost of regulation, except complain about it. But firms must devote their own resource to understanding what is on the horizon for them- as to paraphrase an old saying, he who lives by the sword will die by the gun.
The coming year is another big year for the funds industry. For our private equity and hedge fund clients it will be the Alternative Investment Funds Managers Directive (AIFMD) that will continue to dominate.
The text of the Level 1 Directive itself was finalised at the end of last year − and, without a break, focus immediately shifted to the process of developing Level 2 implementing measures, technical standards and guidelines. In December 2010 the Commission delivered its hefty mandate to the Committee of European Securities Regulators (now the European Securities and Markets Association ("ESMA")) requesting technical advice on Level 2 measures for the Directive.
In the Commission's words, the request represents a "significant workload" and ESMA faces a "challenging programme of work" in developing its advice. This is something of an understatement. The list of all level 2 implementing measures, technical standards and guidelines (as appended to the Commission's mandate) runs to 99 separate topics. And in terms of timing, ESMA only has until 16 September 2011 in which to deliver its advice.
CESR issued its Call for Evidence in December, with consultation closing on 14 January 2011. It was an extremely short consultation period, particularly as it covered the holiday season (and indeed was originally planned to be one week shorter). The Call for Evidence covered a huge range of topics on which detailed rules will be produced in due course. These rules could have major implications for firms. In that context the time frame for responses was too short for the issues to be given proper industry consideration and whilst the trade associations responded, including the British Venture Capital and Private Equity Association (BVCA), the European Private Equity and Venture Capital Association (EVCA), the Alternative Investment Managers Association (AIMA) and the Investment Management Association (IMA), the exercise had to be rushed and was unsatisfactory.
Sadly short consultation periods on complex far reaching topics is becoming a theme, both at a European and domestic level. They threaten to turn the consultation process into a box ticking exercise, and undermine any idea that principles of good regulation are being followed. It doesn't seem that long ago when Lamfalussy's wise men and others were propounding the virtues of open and transparent consultation and the importance of cost benefit analyses in the development of European legislation. How quickly good intentions turn to dust.
In theory at least the Level 2 process ought to be an opportunity to bring to the process of implementation a degree of clarity, flexibility and − that seemingly rare commodity these days - good, old-fashioned common sense. I also hope that it turns out to be a less politically-motivated process than Level 1 proved to be.
I think there is a very real risk that we will end up with a highly prescriptive, inflexible and "buttoned-down" regime for an industry which simply does not have the degree of homogeneity which the politicians seem to think it has. There is a lot of talk about proportionality from Europe: it will be interesting to see to what extent ESMA will pay heed to the overwhelming and unanimous call from industry participants for a proportionate and pragmatic approach.
The marketing restrictions placed on non-EU AIFMs send unfortunate signals to the rest of the world − and particularly to the US.
Although the Directive purports only to regulate alternative investment fund managers, the provisions on depositaries will clearly have an impact upon the custodial and prime brokerage sectors. There is undoubtedly a business opportunity here for banks and investment firms to restructure their existing suite of services and to tailor them to fit the needs of their fund manager clients. But I think there is a risk that, unless successfully clarified at Level 2, the effect of the provisions regarding liability for loss may be to make depositaries assume and absorb some of the risks of investment which should properly remain with the investor, with a consequent risk for pricing and competition.
That leads on to another issue which arises from what is clearly a politically-motivated Directive rather than one resulting from any discernible clamour from investors for change. The view of European regulators increasingly seems to be that professional investors are no longer capable of looking after themselves and therefore need to be protected. This attitude is also evident in the MiFID Review proposals.
There is no doubt that the Directive will have a profound impact upon the alternative investments industry in Europe − and particularly in the UK, where the preponderance of European hedge fund managers and private equity firms are based. While I'm not sure I'm with the doomsayers in arguing that AIFMD will serve to drive the alternative investments industry offshore, I do believe that it will substantially raise compliance burdens and costs for the industry. The result will be less choice and higher costs for European investors.
With everything else going on and given the intervening Christmas and New Year break, firms may be forgiven for not having found much time to digest and respond to the Commission's highly-significant MiFID review consultation, which was published on 8 December 2010. This relatively short document contains some extremely wide ranging proposals which do far more than clarify and update MiFID. There are radical proposals which could have significant effects on the markets. Not only was the consultation period short and over a holiday period, the document is long on assertions and completely lacking in any technical analysis or cost benefit assessment of its most far reaching proposals. Many of us in the legal profession and industry are close to despair at the torrent of proposals flowing from the Commission, so many of which appear to be based on unsupported statements, rather than analysis.
For instance, there is a proposal to widen the scope of MiFID market structure regulation even further to include, in addition to regulated markets and MTFs, "organised trading facilities". The Commission sees these as hybrids between client order execution facilities and multilateral systems. Broker crossing systems and inter-dealer broker systems which bring together third party interests and order would be caught. The proposal represents a continuation of the Commission's ongoing battle against investment firms and broker-dealers which offer services which it sees as "exchange-like" and which it therefore thinks should be regulated like exchanges. However there is no definition of an "organised trading facility", little justification for the proposal or explanation as to what it is intended to combat, and apparently no realisation of the vast range of arrangements that might fall within scope.
As with the AIFMD, the view of regulators and the Commission is that even professional investors and eligible counterparties are no longer capable of looking after themselves and require protection. For instance, if the Commission's proposals are enacted, firms will no longer be able to assume that professional clients have the requisite level of experience and knowledge for suitability and appropriateness purposes; they will no longer be able to categorise any entity, however large or sophisticated, as an eligible counterparty for products considered to be complex (such as asset-backed securities and non-standard OTC derivatives); "non-financial undertakings" and "certain financial undertakings" will be excluded from the eligible counterparty regime altogether; and the "clear, fair and misleading" requirement will extend to remaining eligible counterparties.
In addition, the so-called "execution only" exemption to the appropriateness obligation will either be narrowed or removed entirely. Assuming the former, the range of "non-complex" instruments in respect of which execution-only brokers do not need to assess appropriateness will be narrowed to exclude things like shares in collective investment undertakings, convertible shares, debt instruments which embed a derivative - or even units in certain UCITS schemes.
The Commission wants to tighten up pre-trade and post-trade transparency requirements and extend the scope of the regime − this would include, amongst other things, a significant reduction in the time allowed for reporting, and extending the requirements to "equity-like" products (such as depositary receipts and ETFs) and certain non-equity products (such as bonds, structured products and derivatives eligible for central clearing).
There is also a worrying suggestion that MiFID could effectively ban certain types of OTC derivative: the proposal is that all trading in derivatives which are deemed eligible for clearing and which are "sufficiently liquid" (as determined by ESMA) would have to be carried out on a regulated market, MTF or a specific sub-regime of "organised trading facility".
Perhaps most controversially of all, the Commission is proposing that it should have the power to go over the head of a national regulator and ban specific services, products or activities where there are significant and sustained investor protection concerns or the product or activity threatens the financial markets or financial stability.
All in all, I think the Commission's proposals are another indicator of how real power is slipping away from the national regulators and transferring to the Commission and the European Supervisory Authorities.
Although the actual implementation of AIFMD is some way off yet, for the UCITS sector 2011 will see the transposition of UCITS IV − the deadline by which the Directive must be transpose in Member States is 1 July 2011. I would hope all affected firms are already involved in the process of digesting the joint consultation paper which was issued by H.M. Treasury and the FSA at the end of last year − responses are required by 21 March 2011. I would also wager that most UCITS management firms are not viewing the new Directive with anything like the trepidation with which hedge fund managers and private equity firms are eyeing the AIFMD. In fact, I get the impression that UCITS IV is generally being welcomed by the industry.
While UCITS IV undoubtedly contains a number of measures which should enhance the attractiveness of the UCITS product and facilitate operational efficiencies in the management of such schemes (including breaking down the barriers to the cross-border marketing of UCITS, the improved management company passport, the introduction of a fund merger regime and the ability to use "master-feeder structures"), this comes at a price for firms. There are new obligations under UCITS IV on UCITS management companies, in particular as regards prudential requirements, conduct of business rules and risk management processes.
As far as systems and controls and conduct of business measures are concerned, since UCITS management companies have effectively been subject to a range of broadly-equivalent MiFID rules in SYSC and COBS (albeit by way of guidance rather than binding rules) this should not represent a sea change for them. Likewise, UCITS management companies are already subject to the prudential rules in UPRU and BIPRU and the substance of these will not change under UCITS IV.
However, I would countenance against complacency and would expect firms to be reviewing their existing procedures and assessing what changes are required in order to comply with the additional rules requirements that will be introduced in transposition of UCITS IV.
In addition, UCITS IV introduces significant new risk management process requirements which are not simply based on MiFID measures, so there will be rather more work for firms to do in this area if they are going to be ready to comply with these. Firms will need to ensure they have got to grips with the proposed amendments to the Collective Investment Sourcebook (COLL) and review their risk management procedures and make changes where appropriate.
There will of course also be costs for firms in replacing the Simplified Prospectus with the new key investor information (KII) document − while I don’t think firms should underestimate the time involved in designing the new documentation and reviewing it from a legal perspective, at least they have until 30 June 2012 under the transitional period offered under the Directive in which to complete this exercise.
Even before we have got to transposition of the UCITS IV changes, the Commission is already consulting on a further set of changes to the legislative framework (UCITS V) with particular reference to the UCITS Depositary function and UCITS manager remuneration with a view to presenting a new Directive in 2011.
I think that many firms are likely to find it depressing that, against the backdrop of so many European initiatives which are already beginning to make a huge impact on the way they run their businesses (and will continue to do so over the coming years), they will also have to prepare for a major overhaul to the structure of the UK regulatory system .
We know that the government's intended timeline is ambitious − it wants to introduce the implementing legislation in "mid-2011", and is looking to get the primary legislation passed by the middle of 2012. The House of Commons Treasury Committee has recently expressed its concerns regarding the pace of these changes, but while I wouldn't be surprised if the timing slips, I still think things are going to move very quickly with the risk that we will end up with unsatisfactory legislation.
Obviously, we will need to wait to see the consultation paper and draft legislation − expected soon− before we can properly start to evaluate just how much of an impact this is likely to have on firms. Firms will need to engage in the process of trying to shape the new regulators. We have seen that robust and well-reasoned responses to consultations can work. For instance, in deciding to keep the UKLA within the CPMA's market division, the Government recognised the "strong arguments presented by many respondents" to the Treasury's high-level consultation paper last July. Because of the "weight of responses" it has also decided to keep the FSA's criminal powers in relation to market conduct within the CPMA, rather than transferring it to the new Economic Crime Agency. These decisions are to be welcomed.
From an overall structural perspective, there may be concerns about how smoothly the "twin peaks" model will be able to operate in practice, even with a period of shadow running from later this year. I'm afraid that it's difficult to share the government's optimism about there being effective coordination and cooperation between the new regulators through legislative requirements and "non-statutory protocols and arrangements". The fact is that there will be more than one entity involved in regulation and there will simply be greater practical obstacles to achieving efficiency and co-ordination because of this.
It remains to be seen as to what extent the substance of the rules with which firms are currently complying is carried forward or how different in practice "twin peaks" regulation will feel for firms on a day-to-day basis. Hector Sants has said that there will be a move towards more "rules-based approaches", so I think it is likely that we will see a return of more prescription. For some firms, this will mean potentially having to get to grips with two sets of rulebooks − but, again, we will have to wait to see how different this will be in practice.
Hector Sants has also argued that the CPMA should be given more powers of intervention and disclosure than it currently has − so I think we can expect even more intrusive supervision and ever more aggressive enforcement in the future.
One thing that will definitely have a practical impact on some firms in 2011 is the Remuneration Code. Subject to some limited transitional provisions, with effect from 1 January 2011 the FSA's Remuneration Code (which had previously only applied to 27 of the largest banks, building societies and investment banks) applied to an expanded "constituency" of approximately 2,500 firms, including asset managers, hedge fund managers, UCITS investment firms and others. Non-MiIFD and CAD exempt firms are not subject to the rules. This was in implementation of the remuneration rules required by the Capital Requirements Directive (CRD 3).
All other firms which are subject to the rules should already have assessed the application of the Code and the rules to their businesses − the FSA expected all firms to be broadly compliant with the Code from 1 January, except for the detailed "Principle 12" requirements relating to remuneration structures. They have until 1 July in which to comply with the Principle 12 requirements, provided they have taken reasonable steps to comply from the beginning of the year.
Amongst other things, therefore, this means that − technically - all such firms should already a full written remuneration policy in place.
Unfortunately, the process of implementation of the CRD 3 requirements was hugely unsatisfactory and frankly left affected firms in an invidious position. The FSA's final version of the Code and rules weren't published until the week before Christmas (not long after the CEBS guidelines on proportionality) leaving scant time for firms to be in a position to be compliant by the 1 January deadline.
The FSA has said that firms have until the end of January 2011 in which to identify any shortfalls in their compliance with the Code and to come up with a "time specific plan" to rectify matters. I think it is unlikely that, in the light of the rush in which the new requirements were implemented, the FSA would seek to criticise a firm which had not managed to adopt a full remuneration policy for 1 January 2011. However, it is absolutely essential that any such firm puts this right as soon as possible. Furthermore, I don't think the FSA will be at all forgiving of firms that have not prepared for implementation as best they could in the circumstances by, for instance, having mapped their existing pay and incentive arrangements against the then draft Code, identifying relevant staff, reviewing the use of guaranteed variable remuneration and at least preparing an initial remuneration policy, with a view to being able to comply with the detailed rules relating to remuneration structures by 1 July 2011 at the latest.
There is still a lot of work to be done in relation to the AIFM Directive. Many provisions in the final text, such as those dealing with third country issues, were the product of political compromise and are somewhat unclear as a result. The Level 2 measures will need to clarify the scope and operation of the Directive".
The Level 2 measures will focus primarily on the technical aspects of the Directive. There remain, however, some potentially contentious areas outstanding, such as the third party issue.
The planned revisions to MiFID are part of a wide-ranging package of EU financial services reform legislation, which includes the CRD 4, EMIR, and MAD 2 Directives. These reforms could have major implications at both the macro and micro levels. The macro implications of MiFiD II include the proposed standardisation of trading and monitoring of derivatives transactions (which could lead to the demise of OTC trading);
threats to the continued existence of certain business models such as HTF; greater transparency requirements, particularly in the derivatives market and increased consolidation of market information,
The micro implications include the effect of the new obligations on execution quality/best execution and the impact of the proposed changes on the eligible counterparty regime.
EMIR will overlap with some areas of MiFID Indeed, anyone looking to examine the potential impact of EMIR, MiFID, MAD or CRD IV should approach these developments as pieces of a larger regulatory jigsaw rather than standalone regulatory proposals.
There are, however, some aspects specifically in EMIR which market participants are currently concerned about. These include:
The segregation of collateral requirements and the extent to which they will protect buy-side participants against the insolvency of a counterparty.
The application of the Regulation to non-financial entities. At present, the Commission seems in favour of applying a threshold approach to determine which entities should be covered by the mandatory clearing requirement. This approach would differ from the criteria in Title VII of the Dodd-Frank Act in the US.
The authorisation structures for CCPs and repositories and the equivalence criteria for such institutions in non-EU countries.
It is difficult to escape the suspicion that the AIFM agenda was, at times, driven more by politics than by a rational assessment of the need for harmonised regulation of the alternative investment industry. And it is certainly possible that some of the details that will now need to be set out in the Level 2 implementing measures will be driven by similar considerations.
While it is undoubtedly the case that the operational freedom that this important part of the asset management sector has previously enjoyed is likely to be somewhat curtailed by AIFM, and while some of the measures imposed by the Directive may increase the industry’s operational costs, it is not all bad news.
Some of the most worrying aspects of the early drafts of the Directive were substantially smoothed and improved through the political compromise process; the “passporting” rights now provided for in the Directive should begin a process of improving the ease of access to European investors; and ultimately the alignment of national alternative investment regimes throughout the EU should reduce the industry’s costs and in theory should therefore generate increased returns for investors.
Some of the measures proposed in the Commission’s recent consultation on MIFID II are self-evidently cases of regulatory policy having to catch-up with market and technological developments. This cannot be objectionable.
More worryingly, though, some of the measures proposed indicate that the Commission is starting to adopt a much more prescriptive and rigid approach, and principally it seems in response to the perception or suspicion of investor detriment. This would be consistent (in policy terms, at least) with the ultimate expressed objective of the Commission to create a ‘Single European Rulebook’; but many of the reforms now being contemplated could in practice become very onerous, disruptive and even damaging for European investment firms and markets.
The absence of any clear justification in the Commission’s proposals, such as a cost benefit analysis or empirical evidence of wrongdoing or detriment, may leave the industry feeling that in some respects the Commission is forging ahead solely out of a sense that ‘something must be done’. One fears that legislating in haste will lead to many years of repenting at leisure.
Though many of the proposals floated in the consultation lack sufficient precision and clarity to assess their practical impact in the coming years, among the more worrying proposals I would include:
The suggestion that non-EEA firms located in jurisdictions which are not judged to be “equivalent” would be prevented from having access to European wholesale markets. Despite being an overtly protectionist measure, the Commission may not have appreciated that the equal and opposite consequence of barring access for third country firms is that European professional clients, i.e. large corporates, pension funds, asset managers etc, could be barred from direct access to non-EU banks, brokers and markets. This would seem likely to have a deeply negative effect on the ability of European investors to spread and hedge investment risk and, perhaps more importantly in the current climate, of European businesses to access key global funding sources, particularly in Asia.
The proposals for the Commission, ESMA and national regulators to move from a position of supervising markets to a position of being able to intervene in markets to halt particular activities or to ban particular products other than in purely exceptional circumstances. It does not seem to be consistent with the free and single market principles of the EU for national regulators to be empowered and encouraged to micro-manage financial markets in this way.
Putting the Bank at the heart of prudential regulation and financial stability seems to be a sensible and justifiable policy move. But at the same time, the reorganisation of roles, responsibilities and reporting lines are likely to give rise to significant practical difficulties in both implementation and application. The complex new structure of authorities and responsibilities will mean intensive cooperation between the Bank, the PRA and the CPMA, plus adequate resources, will be critical if the Government is to realise the desired improvements in regulation.
The creation of the Financial Policy Committee at the Bank, with wide powers of oversight and direction in relation to the day-to-day supervisory functions of the CPMA and PRA, highlights a shift in policy and a dramatic change in the concentration of responsibilities for the UK regulatory regime. Never before has the Bank of England been in a position to exercise power and influence across so broad a plain.
What is striking about this new regulatory structure is the multiple layering of governance and oversight functions; FSA regulators, until now able to pursue their intrusive supervisory approach with relative independence from Government, will themselves now be required to accept a more direct and intrusive level of supervision by the Bank. It is surely to be expected that this relationship may not be immediately harmonious.
A really pressing question is whether the Bank will have the right quantity and quality of resources, and a sufficiently nimble governance structure, to manage its many roles and responsibilities more effectively than its predecessors. One can also question whether the Bank is prepared in cultural terms to execute the additional responsibilities it is to be granted, ranging from the more familiar territory of macro-financial matters to the gritty frontline of micro-supervision.
The Bank is not traditionally an institution that has operated in a heavily rules-based regulatory environment and, however judgemental, outcomes-focused or principles-based the Bank might aspire to be in its supervisory capacity, it is clear that the ‘Governor’s eyebrow’ approach to supervision cannot return in its original form; the Bank will have to implement EU regulatory legislation in a transparent and consistent way. A new supervisory culture will therefore need to be developed within the Bank which combines the desirable features of judgement-based regulation with an ability to interpret and apply rules transparently and consistently. This may not be easy unless the Bank can retain and draw effectively on the accumulated skills and knowledge of current FSA staff; staff the FSA is itself currently struggling to retain.
All of this structural reorganisation will present a significant challenge for the regulated firms that will need to understand and comply with the new regime, and get to grips with new supervisory cultures at the PRA and CPMA as they develop. These challenges are likely to be greatest for firms subject to regulation by both authorities. Though some will continue to question whether the costs of establishing the new regime offer value for money in these more straitened economic times, most are now resigned to making the best of an unwelcome and potentially disruptive situation.
The new agencies, in particular the CPMA are likely to adopt an intrusive, proactive stance in terms of enforcement and supervision in line with the FSA's current "intensive" approach.
The FSA's old approach, which focused on "cleaning up the mess" after consumers had lost out, failed to prevent a number of regulatory scandals involving the miss-selling of financial products such as Payment Protection Insurance (PPI) and precipice bonds. In 2009, the FSA shifted towards a more intensive approach based on early identification and risk-mitigation. In a recent speech entitled, "Reforming Supervisory Practices: Progress to Date", Hector Sants noted that the CPMA will continue identifying and tackling risks at an earlier stage.
What this means for firms is that the FSA (and in due course the CPMA) are going to start intervening at a much earlier stage in the life-cycle of financial products, probably by focusing on the product approval stage and the processes surrounding that approval. This marks a significant shift in resources.
In future, the FSA and CPMA can be expected to take a more thematic approach leading to industry-wide interventions rather than making lots of routine inspection visits. From a firm's perspective, rather than seeing the FSA every year, some (larger) firms may see them more often and some (medium-sized smaller firms) may see them less. What does this all mean for compliance officers on a day-to-day basis? When new products are being launched, the FSA/CPMA is going to be breathing down the firms' neck at a much earlier stage in the product-life cycle rather than reacting if things go wrong.
The FSA is also likely to take an increasingly strict stance towards enforcement in 2011. The FSA overhauled its fining policy in 2010 and, as a result, with the expectation that average fines will be between two and three times higher than before. The new policy only became effective last year and its impact will start becoming more apparent as we start seeing more enforcement cases come through in 2011. These changes to the FSA's fining regime may cause a spike in the number of cases reaching to the tribunal because the stakes are much higher than before. If you are faced with a higher fine you may be more inclined to challenge it.
One of the main advantages of the FSA is the fact that it is a single unified regulator. The creation of three new bodies, each responsible for one aspect of the FSA's current remit, could be challenging for regulated firms in the initial stages. This challenge could be particularly acute for large financial institutions: Complex FSA-regulated firms such as large clearing banks will be regulated by the PRA in terms of their prudential and capital aspects and the PCMA in terms of their, often sizeable retail operations. Regulated firms could end up being unsure of which regulator to approach in the first instance if a problem arises ".
These changes will not happen overnight, they will take place gradually, but the overall direction of FSA enforcement is evident. While there is still some uncertainty about how the new regulatory bodies will interact and operate, the changes in direction on regulatory approach from a UK perspective are crystal clear.
The new European Supervisory Authorities will have greater powers than their predecessor CESR Level 3 committees coupled with ambitious agendas. However, at the moment, I am not sure that they are adequately resourced to do the jobs they are expected to do. Moreover, it is not as if you can recruit regulators off the street as it is a highly specialised skill-set. My expectation is that the ESAs will be highly dependent on secondees from national regulators such as the FSA and BaFIN to help them discharge their responsibilities in the early stages. .
Although it is early days, I am not sure whether firms are clear on how best to engage with these bodies. There is quite a lot of uncertainty on how to liaise with them on a day-to-day basis.
The ESAs will not interact with firms on a day-to-day basis. They will generally leave that to national regulators. They will, however, have the authority to intervene in certain circumstances, such as in the event of a major bank collapse, particularly if the EU felt that national authorities were not doing enough. One question that clients are quite interested in is whether this hypothetical intervention would actually work in practice actually and whether the ESAs would have the necessary legal power to act. If a UK bank collapsed and the EBA tried to intervene in the UK, I am not sure whether that could work. There are also issues with accountability and redress of grievances. FSA decisions can be challenged at the tribunal or through an application for judicial review, but the complaint-handling mechanisms in relation to actions by the ESAs are less clear.
Another issue is the direct effect of the rules and policies ESAs will be empowered to make. Up until now, you had the Lamfalussy which provided Member States with some clarity, consistency and some discretion regarding the implementation of EU financial services legislation into domestic law. However, ESAs will have the power to enact directly applicable rules with much less scope for local implementation. This is a massive change which could make the kind of heavily-fought political battles we saw prior to the enactment of the AIFM Directive commonplace.
There are also major questions about the UK's ability to influence this potential upcoming wave of directly applicable financial services legislation. The FSA has been a very influential representative of the UK financial services industry in Europe. Once the CPMA and Bank of England take up their new roles, the industry will no longer have a unified voice, which could make the UK's voice in European affairs less influential.
Basel III and its implementation in Europe through CRD IV are manifestations of the overwhelmingly important topic for all major firms, the inexorable rise of G20-driven macro-prudential regulation. A few years ago, UK financial regulation could be seen as subservient to the EU Commission. At present, however, national and EU regulators are becoming increasingly subservient to the G20 process. Last year's G20 summit in Toronto revealed the extent to which macro-prudential risk is being tackled at a G20 level. Basel III embodies the global drive to tune capital requirements to risk.
The regulatory developments that will make 2015 substantially different from 2010 relate mainly to the G20-led restructuring of regulation in relation to capital, banks' operation and reconstruction and resolution plans.
The effect of the Basel III reforms will be felt across the capital markets. Some of the potential consequences of the reforms include:
A dampening in issuance.
The growing importance of risk-weighting of instruments as a driver in the design of capital markets.
The establishment of new capital instruments where senior debt stands to lose on insolvency or convert into equity.
The enactment of primary legislation establishing these new bodies will be an important development but not a radical change" We can expect the new bodies to continue with the FSA's current flagship policies of credible deterrence and intensive supervision Moreover, as is the case with the FSA, a substantial part of the new regulators' role will be to implement EU legislation.
One area we might see a difference is in what I describe as greater economic interconnectivity. The BoE is staffed largely by economists skilled in identifying emerging macro-prudential risks. Transferring responsibility for prudential regulation and financial stability to the BOE could enable the new regulators to identify macro-risks more efficiently and act upon them earlier.
Effective communication among the three new regulators will be key to their future success. In some respects the new structure mirrors the 1988-1997 period, when financial supervision and regulation was divided between five bodies. One of the key concerns which prompted the abolition of the FSA was the perceived inefficiency of the tri-partite system of financial regulation. However, the Government has now replaced the former system with another type of tri-partite. The FPC, PRA and CPMA will have to communicate effectively and avoid regulating in silos.
For all its faults, the FSA was predictable and stable and this is exactly what market participants want. The proposed new system lacks both stability and predictability at present but hopefully the upcoming primary legislation will redress these shortcomings.