TABLE OF CONTENTS

TABLE OF CONTENTS. 2

Executive Summary.. 3

Chapter 1: Introduction.. 16

Chapter 2: Towards a financial system that delivers sustainable economic growth.. 20

2.1 The role and benefits of the financial system.. 21

2.2 Direct versus indirect financial intermediation channels. 22

2.3 Necessary requirements for a well-functioning EU financial system.. 23

Chapter 3: Lessons from the Crisis: The need for Reform... 25

3.1 A dysfunctional financial system and the causes of the global financial crisis 25

3.2 The underlying market and regulatory failures. 30

3.3 Additional problems revealed by the economic and sovereign debt crisis in Europe 32

3.4 The costs and consequences of the financial and economic crisis in Europe. 37

3.4.1 Losses in GDP.. 38

3.4.2 Losses in household wealth and income. 39

3.4.3 Unemployment 41

3.4.4 Costs to public finances. 43

Chapter 4: The objectives and Intended beneficial Effects of the REFORMs 46

4.1 Overview of regulations and objectives. 46

4.2 Stability and resilience of the banking sector. 49

4.2.1 Increasing bank capital and loss absorbency. 52

4.2.2 Improving liquidity buffers and preventing excessive maturity transformation. 64

4.2.3 Reducing pro-cyclicality and systemic risk. 67

4.2.4 Improving bank governance and risk management 70

4.2.5 Establishing crisis management and bank resolution frameworks. 72

4.2.6 Addressing "Too-big-to-fail". 79

4.2.7 Quantitative estimates of macroeconomic benefits of select banking reforms. 86

4.3 Stability and resilience of financial market infrastructures. 88

4.3.1 Improving trading in securities markets. 88

4.3.2 Improving derivatives markets and advancing central clearing. 95

4.3.4 Reducing the financial stability risks and enhancing the transparency of short-selling and credit default swaps. 107

4.4 Stability of shadow banking.. 110

4.5 Stability and resilience of the insurance sector. 119

4.6 Financial integration and the Single Market. 125

4.6.1 Towards a true single rulebook. 125

4.6.2 The establishment of the ESFS. 127

4.6.3 The Banking Union – towards more sustainable financial integration. 128

4.6.4 Additional measures aimed at boosting growth. 134

4.7 Integrity of financial markets and consumer and investor confidence. 135

4.7.1 Countering market abuse. 135

4.7.2 Protecting consumers and retail investors. 140

4.7.4 Enhancing accounting standards. 164

4.7.5 Improving the audit process. 165

4.8 Efficiency of the financial services sector. 167

Executive Summary

In response to the financial crisis, the EU has pursued an ambitious regulatory reform agenda that has been coordinated with international partners in the G20. The aim has been to restore financial stability on a global scale and build a financial system that serves the economy and can play its part in putting the EU back on a path of sustainable growth.

The Commission has followed a detailed roadmap in reforming the financial system. In 2009, the Commission set out the way forward for improving the regulation and supervision of EU financial markets and institutions.[1] Building on this roadmap, in 2010, the Commission announced further measures to bring about a safe and responsible financial sector which is conducive to economic growth and delivers enhanced transparency, effective supervision, greater resilience and stability as well as strengthened responsibility and consumer protection.[2] The subsequent emergence of specific risks which threatened financial stability in the euro area and the EU as a whole called for deeper integration to put the banking sector on a more solid footing and restore confidence in the euro. This led to the development of the Banking Union.[3]

As this Commission approaches the end of its mandate, this study provides an economic review of the EU financial regulation agenda.[4] Building on the individual impact assessments that have accompanied each reform proposal adopted by the Commission, the study examines the overall coherence of the reform agenda and the expected or actual economic impact, including the interactions and synergies between different reforms.

The full impact of the financial reform agenda can in principle only be assessed in the years to come, but even then it will be difficult to isolate regulatory impacts from other factors, such as the direct consequences of the crisis (e.g. increased risk aversion, uncertain market conditions, monetary policy interventions and low interest rates) and wider macroeconomic, technological and demographic changes. Pre-crisis market conditions cannot serve as the relevant benchmark, as it is precisely the boom-bust experience which much of the financial reform agenda aims to avoid being repeated.

In addition, there are severe data limitations that impede the quantitative assessment of many reform measures. For this reason, it would not be possible to come up with a reliable and comprehensive quantitative estimate of the total costs and benefits of regulation. This is also because available models simply do not allow the inclusion of key expected impacts, in particular certain categories of benefit. Therefore, the approach taken in this study is largely qualitative in nature, using quantitative evidence where available, relevant and appropriate.

The EU financial regulation agenda is gradually strengthening regulation and supervision to improve the stability and functioning of the financial system for the benefit of the economy. Legislative measures have only recently been adopted, and some are yet to enter into force. These measures now need to be implemented in full across the EU and systematically and effectively enforced. Many of them are subject to longer phasing-in periods and will be complemented with delegated and implementing acts. Accordingly, this study should be understood as a first step of a longer process of systematic review and evaluation of the reforms.

THE COST OF THE CRISIS AND THE NEED FOR REFORM

Financial institutions and markets play a vital role in any developed economy. They provide lending to households and businesses. They help individuals to save and invest for their future and channel savings to support the economy. They help corporations and households in better managing and insuring against risks. And they facilitate payment transactions. By performing these key functions, a well-functioning financial system contributes to economic growth and prosperity. Past experience has shown, however, that failure of the financial system can have profound negative consequences for the wider economy.

Misaligned incentives and other severe deficiencies in the financial system, combined with shortcomings in the regulatory and supervisory framework, were key contributors to the financial crisis. The multitude and severity of problems called for far-reaching financial reforms.

In the years preceding the crisis, the global financial system had grown significantly in size and become increasingly interconnected through long and complex intermediation chains, increasing systemic risks. The total assets of monetary financial institutions in the EU increased to more than EUR 45 trillion (or more than 350 % of EU GDP), with the largest EU banks holding more than EUR 1 trillion each. Leverage strongly increased as part of the active balance sheet expansion of banks, and banks relied more on short-term wholesale funding. The rapid growth of the financial sector was also facilitated by a surge in innovative but often highly complex financial products that allowed financial institutions to expand activities on and off their balance sheets.

Policymakers, regulators and supervisors failed to assess and adequately address the risks building up in the global financial system. They failed in macro-prudential surveillance and in keeping up with financial innovations. Many activities largely escaped any regulation and oversight. Moreover, while the operations of the largest financial institutions expanded significantly across borders and markets became increasingly integrated internationally, regulatory and supervisory frameworks remained largely nationally focused.

With the start of the financial crisis, all these deficiencies unravelled. What started as a sub-prime crisis in the USA in 2007 quickly spilled over into a full-blown global financial crisis. In Europe, the financial crisis later turned into a wider sovereign debt crisis with significant implications for the economy as a whole.

The financial and economic crisis caused large costs to the EU economy:

Between 2008 and 2012, European governments provided state aid totalling EUR 1.5 trillion to prevent the collapse of the financial system (i.e. more than 12 % of 2012 EU GDP). In addition, central banks had to provide significant liquidity support. For example, as part of its three-year long-term refinancing operations in 2011 and 2012, the ECB lent some EUR 1 trillion to banks in the euro area. Output declined sharply and, for some EU countries, GDP remains below pre-crisis levels. While the final costs associated with output losses are still unknown, the cumulative output losses, measured in present value terms, may amount to 50-100 % of annual pre-crisis EU GDP (about EUR 6-12.5 trillion, based on 2008 GDP). The crisis wiped out financial wealth, including wealth accumulated by households. The total net financial assets of households in the euro area declined by nearly 14 % between mid-2007 and mid-2009, but have since recovered. This average conceals major differences between Member States. Households' trust in the financial sector has been considerably damaged. More than 60 % of EU citizens surveyed in 2013 stated that they had lost confidence in the financial sector (as well as in the relevant authorities) as a consequence of the crisis. Trust can be quickly lost but is slow and difficult to restore. The crisis was accompanied by significant job losses in the EU and increased poverty and inequality. The EU unemployment rate increased from a pre-crisis low of 7.2 % in 2007 to 10.8 % in 2013, with unemployment rising to more than 25 % in Greece and Spain. Compared with the end of 2007, an additional 9.3 million people are now unemployed in the EU. Youth unemployment has risen more sharply, and there is a risk of social tensions and of a lost generation in some Member States. Between 2008 and 2012, the number of people at risk of poverty and exclusion in the EU has increased by 7.4 million.

THE OBJECTIVES AND THE EXPECTED BENEFICIAL EFFECTS OF THE REFORMS

The EU financial regulation agenda has been guided by the aim of creating a safer, more transparent, and more responsible financial system, working for the economy and society as a whole, and contributing to economic growth. The reform measures deliver on these objectives by:

· enhancing financial stability and the resilience of the financial system to reduce the likelihood and impact of future financial crises in the EU;

· restoring and deepening the EU single market in financial services.

securing market integrity and confidence in the EU financial system by protecting consumers and investors, countering market abuse and enhancing disclosure and transparency;

· improving the efficiency of the EU financial system and ensuring that transaction costs are minimised and financial services are priced correctly to reflect underlying risks.

Chart 1: Overview of the reform objectives

Financial stability

The EU took a comprehensive set of measures to strengthen the stability and resilience of the financial system. Taken together, the measures are expected to reduce the build-up and emergence of systemic risk across the financial system, thereby reducing the incidence and adverse effects of future financial crises.

In the banking sector, the crisis proved that existing rules were inadequate and needed to be adjusted, in order to:

Enhance deposit guarantees: Only weeks after the Lehman failure in 2008, the Commission proposed to increase the coverage level of deposit guarantee schemes (DGS), which led via an interim step to a harmonised coverage of EUR 100 000 since 2010. This measure immediately increased depositor confidence and helped mitigate the risk of bank runs across the EU.[5] Decrease the probability of individual bank failure: The new Capital Requirements Directive and Regulation (the CRD IV package) increase the level and quality of bank capital, thereby improving banks' capacity to absorb losses. They are also enhancing individual banks' resilience to liquidity shocks and limit the over-reliance on short-term funding. Combined with rules on better internal risk management and governance, these measures are expected to significantly reduce the probability of individual bank failure. Reduce pro-cyclicality and systemic risk: The CRD IV package requires banks to build additional capital buffers in good times that can be used in periods of stress. It also introduces additional capital requirements for systemically important banks and other measures to reduce the interconnectedness and systemic risk in the banking sector. Facilitate crisis management and resolution: a new Directive for bank recovery and resolution (BRRD) was proposed and has been agreed between the co-legislators in order to reduce the impact of bank failures on the economy and in particular to help ensure that the costs of failure are not borne by taxpayers. The BRRD entrusts national authorities with crisis management and bank resolution tools, including specific powers to impose losses on shareholders and unsecured creditors (bail-in) so as to reduce the likelihood of taxpayer-financed bail-outs. Address the ‘too-big-to-fail’ problem: The BRRD ensures an orderly resolution of EU banks in general, reducing systemic risk and hence the need for state aid to maintain financial stability. The complex structure of certain heavily interconnected and systemically important banks makes them harder to resolve. The expectation of state support leads to an implicit subsidy for these banks. The Commission’s proposal on structural measures, including the proposed prohibition of proprietary trading and eventual separation of trading from deposit-taking and commercial banking activities, would further facilitate their resolution and mitigate the distortionary effects of the implicit subsidy.

To effectively reduce systemic risks across the financial system as a whole, the banking sector reforms have to be complemented with reforms to improve the functioning of financial markets and increase the stability and resilience of financial market infrastructures.

More resilient securities trading: The revised Markets in Financial Instruments Directive (MiFID II) strengthens organisational requirements and safety standards across all EU trading venues and extends trade transparency requirements to bond and derivatives markets. It also introduces regulatory safeguards to control the risks related to algorithmic and high-frequency trading. Less risky and less opaque derivative markets: Global derivatives markets had grown exponentially prior to the crisis (to more than USD 700 trillion in notional value or more than 12 times of world GDP in 2008) and were largely outside the perimeter of regulation. In coordination with the G20, EU reforms improve the transparency of derivatives that are traded over-the-counter (OTC) and reduce counterparty risk. The European Market Infrastructure Regulation (EMIR) requires all standardised derivative contracts to be cleared by a central counterparty (CCP), and all derivatives transactions to be reported to trade repositories. MiFID II further requires those derivatives to be traded on multilateral trading venues. More risk-reflective margins and improved risk management for non-centrally cleared trades will help reduce bilateral counterparty risk. In addition, new requirements to report trades to trade repositories will allow supervisors to better monitor risks and exposures. Stronger settlement systems: By imposing common prudential, organisational and business conduct standards, the Regulation on central securities depositories (CSDR) will increase the resilience of central securities depositories (CSDs), which settled about EUR 887 trillion worth of transactions in the EU in 2012. The regulation will also enhance the safety of the settlement process, in particular for cross-border transactions, and ensure that buyers and sellers of securities receive their securities or money on time and without undue risk.

Together, MiFID II, EMIR and CSDR form a framework in which systemically important market infrastructures are subject to common rules at a European level. A regulation was also adopted to address specific concerns raised by short-selling and credit default swaps.

All financial markets, products and participants need to be adequately regulated and subject to appropriate oversight. Shadow banking (i.e. the system of credit intermediation that involves entities and activities outside the regular banking system) presents an important source of finance but can raise systemic risks. In the pre-crisis years, the shadow banking sector had grown significantly in size (to USD 31 trillion in total assets in the EU, according to estimates of the Financial Stability Board) and was largely unregulated. It had also become highly interconnected, with strong links to the banking sector. In coordination with the G20, the EU reform agenda therefore includes a number of key measures to reduce systemic risk associated with shadow banking, although work in this area continues.

Requirements are imposed on regulated banks and insurance companies in their dealings with the shadow banking sector. A harmonised framework for alternative investment funds managers (AIFMD) has been introduced to properly supervise hedge funds and other alternative funds and particularly their leverage and counterparty risk exposures. The proposed regulation on money market funds (MMFs) will enhance the resilience of MMFs by requiring adequate liquidity and capital buffers. The proposal on transparency and reporting requirements for securities financing transactions will reduce the opacity of shadow banking activities and allow better supervision and monitoring of those activities.

Stability is also reinforced by a new regulatory framework for the insurance sector. Well before the crisis, it had become apparent that the prudential regime for insurers was no longer adequate. From 2016, a new prudential framework (Solvency II) will be applied that is risk-based and market-consistent to increase the resilience and stability of the European insurance sector.

Financial integration and the EU single market in financial services

In response to the crisis, a number of Member States took action on their own and adopted regulatory reforms aimed at curbing financial stability risks at national level. National responses were however often divergent and, given the integration of markets, risked being ineffective and creating arbitrage opportunities. A key benefit of regulatory and supervisory intervention at EU level therefore derives from a coordinated and consistent response to the crisis across the EU and better coordination with international partners in the G20.

Previously, EU financial services legislation was largely based on minimum harmonisation, allowing Member States to exercise considerable flexibility in transposition. This sometimes led to uncertainty among market participants operating across borders, facilitated regulatory arbitrage and undermined incentives for mutually beneficial cooperation. The Commission has therefore proposed to establish a single rulebook, providing for a single set of uniform rules for the financial sector throughout the EU. The single rulebook will ensure a single regulatory framework and its uniform application across the EU.

The creation of the European System of Financial Supervisors (ESFS) — and in particular the three European supervisory authorities: the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA). These EU agencies, operating since 1 January 2011, are important to further develop the single rulebook and ensure consistent supervision and appropriate coordination among supervisory authorities in the EU. In addition, the European Systemic Risk Board (ESRB) monitors macro-prudential risks across the EU and can issue warnings and recommendations to call for corrective action.

The reform agenda is underlined by a new horizontal approach to sanctioning regimes to improve enforcement through more effective and sufficiently deterrent sanctions across the whole spectrum of financial sector legislation.

Banking Union

The financial crisis revealed weaknesses in the institutional structures supporting economic and monetary union (EMU). The crisis abruptly halted financial integration, and fragmentation threatened the integrity of the single currency and the single market. While banks had diversified geographically and engaged in significant cross-border activities, they remained closely linked to the Member State in which they were headquartered, contributing to the negative sovereign-bank feedback loop that weakened banks and sovereigns in some Member States.

Building on the single rulebook, the first pillar of the Banking Union is the Single Supervisory Mechanism (SSM), which transfers key supervisory tasks for banks in the euro area and other potential participating Member States to the European Central Bank (ECB). The ECB will fully carry out its new supervisory mandate as of November 2014. In preparation for its new supervisory role the ECB is currently conducting an asset quality review and a stress test, in coordination with the EBA, which will be vital for restoring confidence in the European banking system and ensuring a smooth transition towards the SSM.

The second pillar of the Banking Union - the Single Resolution Mechanism (SRM) – will achieve an integrated and effective resolution process at European level for all banks in participating Member States. A Single Resolution Fund, funded through bank contributions, will be set up, but recourse to the fund is only possible after appropriate burden-sharing by shareholders and creditors.

The Banking Union is expected to ensure high and common standards for prudential supervision and resolution of banks in the euro area and other participating Member States. It will also improve financial integration and support the transmission of ECB monetary policy.

Market integrity and confidence

Integrity is about trust and confidence in the financial system, which largely depends on transparent and reliable information flows, ethical and responsible behaviour of financial intermediaries and their fair treatment of consumers. Failures in these areas were highlighted by the crisis and by more recent scandals of abusive market practices, including the manipulation of interest rate benchmarks (LIBOR and EURIBOR) and the alleged manipulations of benchmarks in foreign exchange and commodity markets. While the damage is difficult to quantify, it is likely to be large and in excess of the billions of euros of record fines that banks had to pay.

The financial regulation agenda secures greater market integrity and confidence by:

Countering market abuse: the revised Market Abuse Regulation and Directive on Criminal Sanctions for Market Abuse (MAR/CSMAD) will establish tougher rules to better prevent, detect and punish market abuse. Also, the Commission’s proposal for a regulation on financial benchmarks would enhance the robustness and reliability of benchmarks and counter their manipulation. Improving the protection of consumers: Several proposals seek to ensure that consumers have fair access to financial services and benefit from the required protection, irrespective of whether they consume banking, insurance or investment products and services. The measures provide for: the establishment of EU-wide responsible mortgage lending standards (Mortgage Credit Directive, MCD); better information disclosure and higher standards for financial advice and distribution (MiFID II, MCD, the Payment Accounts Directive (PAD), the revised Insurance Mediation Directive (IMD II), and new rules on packaged retail and insurance-based investment products (PRIIPs) and undertakings for collective investment in transferable securities (UCITS)); enhanced protection of the assets of consumers (DGS, rules on asset safekeeping in UCITS, AIFMD and MiFID II); a prohibition of some surcharges (regulation on multilateral interchange fees); more secure alternative payment methods (Payment Services Directive II); and more transparency of bank account fees, easier bank account switching procedures, and access to basic bank accounts (PAD). Enhancing the reliability of credit ratings and financial information: The rules on credit rating agencies (CRAs) should increase the independence and integrity of the ratings process and enhance the overall quality of the ratings. Audit reforms aim to improve the quality of statutory audits within the EU and, combined with reforms of the international accounting standards that apply in the EU, should help enhance confidence in financial statements, in particular those of banks, insurers and large listed companies.

Efficiency

By addressing underlying market and regulatory failures, the financial reform agenda improves the efficient functioning of the financial system. The main efficiency benefits are expected to come from the following:

Enhancing transparency: Improved disclosure and reporting requirements in various reform initiatives will not only provide vital information for supervisors but also reduce information asymmetries in the system for all market participants. Furthermore, various transparency and disclosure requirements in retail financial services help to better inform consumers, thereby enhancing the competitive functioning of the market. Reducing distortions in the single market: Banking Union, the establishment of a single rulebook and other measures supporting financial integration contribute to efficiency by levelling the playing-field and facilitating cross-border activities. Reducing the implicit subsidy: Systemically important banks often benefited from a credit rating uplift due to an implicit bail-out guarantee. The total implicit subsidy has been estimated by the European Commission to be in the range of EUR 72-95 billion in 2011 and EUR 59-82 billion in 2012, based on a sample of 112 EU banks. This amounts to 0.5 % to 0.8 % of annual EU GDP and between one third and one half of the banks’ profits. The CRD IV package, the BRRD and proposed restrictions on the activities of large, complex and interconnected banks (i.e. structural reform) will reduce competitive distortions by reducing the implicit subsidy and help to correct mispricing of risks. Ensuring that risks are properly reflected in prices: The improved prudential framework for banks and the new risk-based capital requirements for insurers in Solvency II, combined with improved risk management standards, will encourage financial institutions to internalise the risk of their activities and contribute to more efficient, risk-adjusted pricing. Enhancing competition and efficiency along the securities trading chain: The access provisions contained in MiFID II, EMIR and the CSDR reduce access barriers to financial market infrastructures and promote competition along the whole securities trading chain. These initiatives can also increase efficiency by improving transparency and prepare the ground for further initiatives (e.g. the Target 2 Securities project which will consolidate settlement across Europe). Promoting market entry: The revised CRA Regulation and the audit reforms aim to promote competition by facilitating market entry and increasing the visibility of new entrants.

Efforts have been made to strike a balance between strengthening requirements to ensure financial stability and allowing a sufficient and sustainable flow of finance to the economy.

The reform measures devote particular attention to small and medium-sized enterprises (SMEs), given their particular difficulties in securing external finance and their important role in EU employment and growth. The EU financial framework has been adapted considerably over the last three years, on the basis of an action plan adopted in December 2011.[6] The measures include: reducing the administrative burden and reporting requirements for SMEs (Prospectus Directive, Transparency Directive, Accounting Directive, MAR); creating a dedicated trading platform to make SME capital markets more liquid and visible (MiFID II); addressing the issue of risk weights in the bank capital framework to make SME lending relatively more attractive (CRD IV package); and introducing new EU frameworks for investment in venture capital and in social entrepreneurship funds. The proposal on European long-term investment funds further aims to ensure the long-term financing of SMEs and key infrastructure investment. Additional measures to facilitate the long-term financing of the EU economy are currently being developed, as set out in the March 2014 Communication on long-term financing of the European economy.[7]

Complementarity of reforms

The large number of regulatory reforms at EU level, and their broad scope, is a reflection of the battery of underlying problems that needed to be addressed. No single reform would have been capable of achieving the four objectives of greater stability, integrity, efficiency and integration to improve the functioning of the financial system overall and facilitate sustainable economic growth.

The combination of different reform measures helps the four objectives to be achieved more effectively and at lower cost. For example, if higher capital requirements were used as the only regulatory tool to enhance stability in the banking sector, the capital levels required might need to be set so high that it would be difficult for banks to raise sufficient capital, given the size and leverage of their balance sheets. The consequent costs from disruptions to the efficient flow of financial services to the economy could then outweigh the stability benefits. Complementing the new capital requirements with further measures (in particular the BRRD and structural reform) helps to meet the stability objective while limiting disruptive effects.

Many of the reform initiatives contribute to delivering more than one key objective of the reform agenda. The objectives themselves interact and can only achieve a well-functioning financial system when combined. For example, financial integration needs to go hand in hand with a strong regulatory and supervisory framework to avoid cross-border capital flows becoming a source of financial instability. Reforms to the institutional framework to strengthen the single market and the functioning of EMU (ESFS, single rulebook and SSM) therefore target both financial integration and stability. Also, financial stability is of little benefit to the economy if this is achieved by unduly hindering the efficient functioning of the financial system. This is why the reform agenda focuses on correcting market failures. Measures which target information asymmetries (e.g. transparency and disclosure requirements) or which align private incentives with public interests and facilitate risk-reflective pricing in the market (e.g. the package of measures to reduce the implicit subsidy to banks) contribute to both financial stability and efficiency.

There are cross-sectoral synergies between some reforms. For example, there are synergies between the CRD IV package in banking and the EMIR reform on derivatives markets. The former imposes higher capital and collateral requirements on banks concluding derivative contracts that are not centrally cleared under EMIR. This will encourage a critical mass of contracts to be cleared through CCPs and thereby effectively enable central clearing to mitigate counterparty risk (as intended by EMIR), contributing to financial stability overall. As a second example, the CRA regulations are strengthened by measures in all EU sectoral legislation to reduce the mechanistic reliance on credit ratings. Finally, requirements for risk retention, due diligence and monitoring of securitisation positions were first introduced in the new bank capital framework and then extended in a consistent manner to Solvency II, AIFMD and UCITS. This cross-sectoral approach reduces the opportunities for circumventing the requirements by shifting exposures to less regulated sectors.

THE COSTS AND NET IMPACTS OF THE REFORMS

Financial reform imposes costs on financial intermediaries (and their shareholders and employees) as it introduces compliance costs and requires adjustments in the way business is conducted. The compliance costs have been estimated as part of the impact assessments of the various legislative initiatives and are laid out in more detail in the main body of the study. A part of these costs are temporary adjustment costs during transition to a more stable and responsible financial system. The recurring costs that financial intermediaries will incur on a regular basis to meet the stricter regulatory requirements after the transition period are the costs that matter more in the long-term. These costs are expected to be more than offset by the benefits of enhanced stability and integrity of the financial system.

Costs to financial intermediaries are inevitable and, to a certain extent, are a sign of the effectiveness of the reforms. For example, a reduction in the implicit subsidy for certain large, complex and interconnected banks will increase their funding cost, but this cost is matched by future taxpayer savings and wider financial stability benefits. Similarly, the reforms induce a re-pricing of risks, which again creates costs, but these costs are matched by the benefits of avoiding excessive risk-taking due to underpriced risks in the market. Thus, costs to financial intermediaries often do not present costs from a societal perspective and are offset by wider economy benefits.

For economic welfare, the aggregate societal costs and benefits are relevant, i.e. the impact on all stakeholders in the economy, including users of financial services (e.g. depositors, borrowers and other consumers of financial services), taxpayers and the wider economy.

The impact assessments conducted for the individual reform proposals predict (and in some cases quantify) benefits exceeding costs. Attempts have also been made to produce quantitative estimates of the macroeconomic impact of reforms.

Based on simulations by the Commission, higher bank capital requirements (as per the CRD IV package) combined with the bail-in and resolution fund (as per the BRRD) are estimated to deliver macro-economic benefits of around 0.6-1.1 % of EU GDP per year (or about EUR 75-140 billion per year, based on 2013 EU GDP). In comparison, the macroeconomic costs of the same banking reforms have been estimated in a separate model and show a long-term negative output effect of about 0.3 % of EU GDP per year. These results are consistent with results from other studies by public authorities. For example, the long-term economic impact assessment of bank capital and liquidity regulations prepared by the Bank for International Settlement (BIS) confirms significant net benefits. The 2013 study by the BIS macroeconomic assessment group on derivatives estimates that the macroeconomic costs of OTC derivatives regulatory reforms would range between 0.03 % and 0.07 % of annual global GDP. The estimated gross benefits from OTC derivatives reforms are 0.16 % of annual global GDP, exceeding the costs more than twofold.

While these estimates show net benefits, they are subject to modelling uncertainty. Also, not all dimensions of reform impact can be included in the available quantitative models. The models are usually static and do not capture the transition to a more stable financial system.

The transition to a more stable financial system is particularly challenging and needs to be managed carefully. The reform process has been mindful of the potential costs of regulation and in particular the interaction of the new rules with the current difficult conditions in financial markets and the wider economy:

Longer phasing-in periods have been granted in the transition phase to minimise costs and potential disruptions during the transition (although the market itself often requires tighter standards ahead of regulatory deadlines). Where significant adverse effects were anticipated, the rules have been adjusted (e.g. trade finance in the CRD IV package or the long-term guarantee package in Solvency II) or, under certain circumstances, exemptions have been granted (e.g. for pension funds and non-financial corporates in EMIR and for SME growth markets in CSDR). Where rules entered uncharted waters, observation periods have been applied (e.g. with regard to the leverage ratio and liquidity regulation of banks). Review clauses have been introduced in all major pieces of legislation.

There are areas of concern where the reforms may contribute to creating new risks or have unintended consequences if left unaddressed. These include, in particular, the risk of increases in the cost of financial intermediation, in particular for long-term finance, disorderly deleveraging, regulatory arbitrage, the complexity of regulation, a concentration of risks at the level of CCPs, potential collateral scarcity and increased asset encumbrance of bank balance sheets. These risk areas are either the subject of ongoing work and addressed through careful implementation or are not considered, at this stage, to require immediate policy action, but they will nonetheless be subject to continual monitoring. Ongoing monitoring and review of all reforms is required to ensure that they deliver their intended benefits while avoiding the undesired effects.

OVERALL ASSESSMENT

The EU financial regulation agenda addresses the regulatory shortcomings and market failures that contributed to the crisis. The reforms should reduce the likelihood and impact of financial crises occurring in the future. In addition to enhancing financial stability, the reform measures will help meet the other key public policy objectives of market integrity (including consumer protection), efficiency and financial integration.

The total benefits of the financial regulation agenda, if fully implemented, are expected to outweigh the costs. Individual impact assessments showed net benefits, and many of the rules create considerable positive synergies when combined. The reforms are expected to improve the functioning of the financial system and make it more stable, responsible and efficient, to the benefit of the EU economy.

Some important reforms still need to be adopted (e.g. on bank structural reform, shadow banking, financial benchmarks). Also, work in a few remaining areas is still under preparation. In particular, work on a resolution framework for non-banks and to address concerns in shadow banking is ongoing at EU and international level.

In addition to full implementation of the reforms, regulatory attention is focusing on tackling long-term financing and developing a more diversified financial system with more direct capital market financing and greater involvement of institutional investors and alternative financial markets. As set out in the March 2014 Communication on long-term financing, addressing these issues is a priority to reinforce the competitiveness of Europe’s economy and industry.[8]

While the reforms address the problems revealed by the recent crisis, the risk of future crises cannot be regulated away. The Commission will remain vigilant and proactive, monitoring financial innovations and identifying new risks and vulnerabilities as they emerge.

Chapter 1: Introduction

In response to the financial crisis, the EU has pursued an ambitious regulatory reform agenda, coordinated and linked with the G20 reforms. The aim has been to strengthen regulation and supervision of the financial sector to restore and safeguard financial stability and to ensure that the financial sector can play an effective part in putting the EU back on a path of smart, sustainable and inclusive growth, creating jobs and enhancing competitiveness.

The Commission has followed a detailed roadmap in reforming the financial system. In 2009, building on the recommendations of a group of high-level experts, chaired by Mr de Larosière,[9] the Commission laid down the way forward for improving the regulation and supervision of EU financial markets and institutions.[10] Building on this roadmap, in 2010 the Commission further developed its vision of a safe and responsible financial sector which is conducive to economic growth and delivers enhanced transparency, effective supervision, greater resilience and stability as well as strengthened responsibility and consumer protection.[11] The emergence of specific risks which threatened financial stability in the euro area and the EU as a whole called for deeper integration to put the banking sector on a more solid footing and restore confidence in the Euro. This led to the development of the Banking Union.[12]

As this Commission approaches the end of its mandate, this study provides an economic review of the EU financial regulation agenda, with a view to assessing its overall coherence and the ongoing and expected economic impacts.

Each Commission reform proposal has been accompanied by a thorough impact assessment that evaluates in detail the associated costs and benefits.[13] This staff working document does not replace or supersede the individual impact assessments. Rather, the study seeks to evaluate the overall coherence and consistency of the reform package and to review whether the different reform measures have delivered (or can be expected to deliver) their objectives and intended benefits. It also considers the potential interaction between different rules, including any synergies between rules that may reinforce the positive effects but also unintended consequences. The document examines the potential costs and adverse impacts of the rules, including arguments expressed by the financial services industry, that the new regulations may be going too far and reducing the ability of the financial sector to channel finance to the real economy and thereby hinder recovery, growth and employment in the EU economy.

No study has yet attempted to assess comprehensively the total impact of the full set of the newly adopted EU financial services legislations. The available studies often focus on the costs of (a subset of) the regulations.[14] Often, these studies focus mainly on the direct costs of regulation to financial intermediaries, whilst ignoring the benefits and wider economic effects. From the public policy point of view the focus should be on the benefits and costs for society, including the impact on consumers, investors, SMEs and the economy as a whole.

Regulatory reform is driven by a number of key objectives, but the resulting benefits are very hard to quantify. For example, the monetary benefit of increased market confidence or the creation of a level-playing field can be very hard to correctly quantify. Any quantitative assessment risks overemphasising the costs of regulation to the extent that they are more easily quantifiable than the benefits.[15]

Many of the legislative measures taken as part of the financial reform agenda only recently entered into force. Moreover, several key measures are subject to phasing-in periods. EU Directives also need to be transposed into national law, and a large number of delegated and implementing acts need to be developed.[16] Thus, the implementation phase over the next few years will be critical.

Implementing the financial reform agenda is not a one-off exercise but a gradual process to restore financial stability and develop a financial system that better contributes to economic welfare and facilitates growth. In addition to phasing in the requirements over time and allowing extended observation periods before some rules are finalised, the reform package comes with explicit commitments to review legislations and allow adjustments to specific rules when this is deemed necessary.[17] In many ways, this study is therefore only the start of a longer process of systematic review of the reforms.

The full impact of the financial reform agenda can, in principle, only be assessed ex-post, but even then it will be difficult to isolate regulatory impacts from other factors, such as the direct consequences of the crisis (e.g. increased risk aversion, uncertain market conditions, monetary policy interventions and low interest rates) and wider macroeconomic, technological and demographic changes. Pre-crisis market conditions cannot serve as the relevant benchmark, as it is precisely the boom-bust experience which much of the financial reform agenda aims to avoid being repeated.

In addition, there are severe data limitations that impede the quantitative assessment of many reform measures. For this reason, it would not be possible to come up with a reliable and comprehensive quantitative estimate of the total costs and benefits of regulation. Any such estimates would not be sufficiently robust and indeed could deliver false conclusions, which could derail implementation of ongoing reforms and misguide future policy. This is also because available models simply do not allow the inclusion of key expected effects, in particular certain categories of benefit. Instead, the approach taken in this study is largely qualitative in nature, using quantitative evidence where available, relevant and appropriate.

The study takes an EU-wide perspective. However, it is likely that the impacts of the reforms will differ across Member States, partly due to differences in economic conditions and market structures but also due to differences in national implementation of EU legislation. While the aim is to move to a single rulebook for EU financial services, there remains flexibility in transposition and scope for going beyond EU requirements.

The financial regulation agenda was only part of the EU response to the financial and economic crisis in Europe. Important wider measures were taken, but are not considered in the study. These include, for example, the control of state aid provided to the financial sector, monetary policy, taxation (including the proposed financial transaction tax), structural measures and changes in the economic governance frameworks.

Given the wide-ranging nature of the regulatory reforms of financial services, this study is necessarily selective. While annex 2 provides an overview of all the measures taken, the main part of the study focuses on the key impacts of the EU financial regulation agenda, in particular the important elements of the policy response to the crisis. The study covers Commission proposals adopted by April 2014.

The study is structured as follows:

· Chapter 2 reviews the main functions of the financial system and the required characteristics for the financial system to serve the real economy and contribute to sustainable economic growth.

· Chapter 3 summarises the problems that characterised the financial systems in the years leading up to the financial and economic crisis and that called for wide-ranging reforms of financial regulation.

· Chapter 4 looks at the intended benefits of the financial reform agenda. It presents the main objectives of the reforms and how the different measures help to meet these objectives.

· Chapter 5 discusses the overall coherence and complementarity of the financial reform agenda.

· Chapter 6 considers the potential costs of the reforms, focusing in particular on potential adverse impacts on the provision of finance to the economy.

· Chapter 7 highlights a number of potential new risks and unintended consequences arising from the financial reforms, including those that arise from potential inconsistencies between the reforms. This emphasises the need for ongoing monitoring and review to minimise undesired consequences.

· Annex 1 provides a review of existing studies that seek to examine the costs and benefits of the reforms, focusing mainly on the studies that cover more than one set of rules.

· Annex 2 contains an overview of the legislative measures adopted or proposed as part of the financial regulation agenda since 2009. Annex 3 lists upcoming review reports required in these legislations.

· Annexes 4 and 5 presents estimates obtained from quantitative models of the benefits and costs of certain rules affecting the banking sector.

Chapter 2: Towards a financial system that delivers sustainable economic growth

The financial system enables welfare-enhancing allocation of resources over time. Households save money for future use (e.g. retirement savings) and pay for large expenditures by borrowing money (e.g. home purchase). Companies fund new investment projects and hedge against future risks. Among other things, governments raise money for infrastructure investment and social programs. A well-organised, efficient, and smoothly functioning financial system is hence an important component of a modern economy.

As a result of financial innovation, deregulation and globalisation, the scale of the financial system has increased over the last decades in the EU and across the world both in absolute size and relative to the real economy. This important phenomenon, characterised by significantly increased leverage and interconnectedness, financial innovation, complexity, and higher trading volumes, is referred to as the financial deepening or financialisation of the economy.[18]

However, there does not appear to be a straight-forward causal relationship between the financial intensity of an economy and the annual rate of economic growth in advanced economies.[19] As discussed in chapter 3, the strong financial system growth contributed to imbalances that culminated in an unprecedented and global financial crisis, the consequences of which will be felt for several years to come.

This raises important questions about the financial system. What is the contribution or value added of the financial system towards greater economic well-being? How does the financial system improve capital allocation, economic growth and consumer welfare? What are the characteristics of a well-functioning financial system? Will the financial system, if left to itself, select the levels of debt, leverage and maturity transformation that are optimal from society's point of view, or will it give rise to systemic risk? What should and can be done about it through government intervention (taxation, regulation, institution building) and what can be done when government intervention fails?

The overriding objective of the EU financial reform agenda is to create a financial system that serves the economy and enables sustainable economic growth. This chapter presents a short overview of the key functions of the financial system and its desirable characteristics. This shapes the framework for the analysis presented in subsequent chapters, since the overall effectiveness of the reforms needs to be assessed with respect to achieving a better functioning EU financial system that is capable of performing its desired role in the economy.

2.1 The role and benefits of the financial system

The financial system is critically important for the economic well-being of households and corporates, as it fulfils different functions through which it serves the economy and facilitates sustainable economic growth.[20]

First, the financial system performs the important function of "financial intermediation". The financial system intermediates between ultimate providers of funds and ultimate users of funds. Ultimate providers of funds are lenders, savers, or investors (households, firms, or governments), whereas ultimate users of funds are borrowers, entrepreneurs, or spenders (again households, firms and governments). There are reasons why this bridge function is important and welfare-enhancing for the real economy. Financial intermediation, or the channelling of funds between ultimate lenders and borrowers, facilitates productive investment and efficient capital allocation in the economy. The entrepreneur needs control over the funds for some time to realise ideas, but cannot issue a safe promise. The retired person could release control over such funds, but wants them back later and is not in the position to monitor and control the borrower. The financial system brings them together, making both of them better off, but also benefiting the wider economy through higher economic growth by allocating capital to its most productive uses. In addition, the channelling of funds enables life-cycle consumption smoothing and inter-generational resource transfers. Consumers can time their purchases better, by making use of the financial system, which is welfare-increasing. Without the financial system that allows people to transform some of their future human capital in available cash today, they would not be able to buy a house until late in their lifetime. This objective yields welfare benefits to users and providers of funds, but does not necessarily give rise to greater investment and economic growth.

Second, the financial system performs risk transformation and provides insurance services to risk-averse households and firms, enabling the latter to achieve superior risk-reward outcomes compared to a situation without a financial system. Insurance companies play an important role in managing risks as they allow households and corporates to share their liability by pooling the individual risks and providing coverage in the event of loss. In addition, risks can be tranched, packaged and traded on financial markets. Derivative instruments allow hedging against different risks.

Third, the financial system organises the payment system and provides payment and transaction services (retail and wholesale) and thereby eases the exchange of goods and services. Consumers want to obtain simple and reliable payment services, such as storage and withdrawal of money, money transfers, ATMs, internet payments, and card services. These services are considered "essential-utility services" and billions of electronic payments are processed each day. The processing of electronic payments requires robust and reliable hardware, software, communication links and communication networks. The payment system provides convenience, trust and reliability to households and firms, which in turn support economic growth. If these services broke down and customers were no longer able to withdraw money from banks, a systemic crisis would arise instantaneously.

Fourth and finally, the financial system creates markets (e.g. for derivatives, asset-backed securities) thereby allowing the trading and pricing of financial instruments and their risks. The availability of prices facilitates the allocation of scarce resources and risks, whilst secondary markets allow individuals to reverse investment decisions, thereby enhancing economic welfare. Some welfare-increasing markets would not exist without a vibrant financial system (e.g. the market for safe, simple and robust securitisations, covered bonds, derivatives for hedging against interest, foreign exchange and other risks).

2.2 Direct versus indirect financial intermediation channels

Focusing more on the key function of financial intermediation, there are two distinct approaches to channelling funds from savers as the ultimate providers of funds to entrepreneurs or other ultimate users of funds.

Direct intermediation is the channelling of funds through financial markets without an intermediary, notably when savers purchase the debt or equity directly from the borrower that has issued these financial securities (in capital markets: equity markets, corporate debt markets, government debt markets). Indirect intermediation is the channelling of funds through financial intermediaries, notably banks, but also insurers, pension funds, hedge funds, mutual funds[21]. A highly simplified presentation of financial intermediation is depicted in chart 2.2.1.[22]

Chart 2.2.1: Stylised illustration of financial intermediation channels

Source: Commission Services

Direct and indirect intermediation differ in their relative importance, strengths and weaknesses. It turns out that in the EU significantly more funds are being channelled from ultimate savers to ultimate borrowers through indirect finance, i.e. through financial intermediaries. A significant part of the funding of non-financial corporates in the EU takes the form of bank loans (see section 4.2).

It is useful to recall why intermediaries are used and what the economic advantages are of indirect finance over direct finance.

· Cost savings: pooling savings by using intermediaries allows the realisation of economies of scale and scope and lowers transaction, contracting, and search costs for savers. Without intermediaries the latter costs would prevent otherwise mutually beneficial transactions taking place;

· Risk diversification and liquidity insurance: pooling savings by using intermediaries allows investing in more illiquid, but more profitable securities, while preserving desired liquidity. It also allows households to smooth their intertemporal consumption pattern and is hence welfare enhancing;

· Information production: intermediaries act as specialist delegated monitor for lenders and ensure that borrowers use the funds effectively and efficiently. Without intermediaries it would be prohibitively costly to monitor borrowers;

· Asymmetric information: intermediaries actively reduce information problems by creating long-term customer relationships, requiring collateral, screening ex ante, and monitoring ex post. Asymmetric information between relatively unknowledgeable savers and knowledgeable borrowers may otherwise give rise to market collapses or missing markets.

2.3 Necessary requirements for a well-functioning EU financial system

In order to adequately perform effectively its main functions, the EU financial system should fulfil a number of requirements that define the characteristics of an “ideal” benchmark:

· Financial stability: The EU financial system needs to be resilient against external shocks and should not be prone to systemic risk and contagion. The probability of another financial crisis occurring and the resulting costs must be reduced;

· Market integrity and confidence: The EU financial system needs to operate in a fair and transparent manner, in the absence of fraud and market abuse. Disclosure should be fair, adequate, accurate and timely. There should be adequate consumer and investor protection to ensure trust and confidence in the financial system;

· Efficiency: Financial services should be priced adequately such that their true costs are reflected, and the expected returns on financial securities and instruments should adequately reflect their (systemic) riskiness. When the market fails and underprovides or overprovides certain goods or services, regulatory intervention is justified (see also section 3.2);

· Financial integration: The EU financial system should ensure that rules or market conditions for similar services and products do not vary significantly across countries or markets. The EU economy benefits from a single market where financial services and transactions are not constrained to the domestic market but can be undertaken across borders.

These characteristics link back to the earlier Communications setting out the Commission’s objectives and roadmap for the regulatory response in the crisis aftermath (see chapter 1). They are discussed further as part of the detailed review of the individual EU legislative initiatives and their complementarities in the subsequent chapters of this study.

As illustrated in chart 2.4.2, the EU financial system will only be functioning well, if it is stable and efficient, displays integrity, and fosters financial integration. Then will it be able to perform its critically important role and functions, such as financial intermediation, organising risk transfer, providing payment services, and adequately pricing risk.

Chart 2.4.2: The desirable characteristics and key functions of the financial system

Source: Commission Services

Chapter 3: Lessons from the Crisis: The need for Reform

In the years leading up to the financial and economic crisis, the financial system had moved further away from the "ideal" benchmark set out in chapter 2 – i.e. a system that provides what is needed for the economy to function efficiently and deliver sustainable growth. The financial system was characterised by a number of fundamental problems that have become visible since the eruption of the crisis more than six years ago and that called for fundamental reform of financial regulation.

This chapter provides a short reminder of the causes and consequences of the crisis so as to provide the context in which much of the financial regulation agenda was shaped. It summarises the main underlying problems – both the directly crisis-related ones and others – that justified the regulatory measures taken, as analysed in more detail in the following chapters.

3.1 A dysfunctional financial system and the causes of the global financial crisis

Until 2007, financial markets in Europe had been booming and financial institutions thriving, risk was not properly appreciated and underpriced in the market, funding and market liquidity was abundant, and credit was available at low interest rates. However, these conditions turned out to be unsustainable and contributed to significant and rapidly growing imbalances. The crisis triggered massive state aid intervention, a severe economic recession and enormous costs to public finances, economies and citizens. Its legacy continues to pose financial stability risks and is delaying economic recovery.

The crisis had a number of intertwined causes, which have been analysed in numerous studies.[23] While other factors have played an important role, including global macro-imbalances and accommodating monetary policy, the deficiencies in the financial system and shortcomings in the supervisory and regulatory framework are generally considered key contributors to the crisis. Many of these problems were global in nature, rather than specifically European.

In the years preceding the crisis, the financial system had undergone major changes. There had been significant asset growth (on and off balance sheets) of financial institutions, far outpacing the growth of the economy (see chart 3.1.1). Global banking groups – including those with EU headquarters – had grown ever bigger in size and scope (see chart 3.1.2).[24] They had become increasingly interconnected through long intermediation chains of claims and correlated risk exposures arising from increasingly similar investment strategies. Leverage had strongly increased as part of an active balance sheet expansion, and bank reliance on short-term wholesale funding had significantly increased. Thus, solvency and liquidity shock absorbers of the large banking groups had declined, despite their growing systemic importance.

Chart 3.1.1: Growth in total assets of EU monetary financial institutions || Chart 3.1.2: Total assets of a sample of large EU banks, 2013

||

Source: ECB || Source: SNL Financial, ECB.

New savings alternatives to bank deposits, such as money market funds, proliferated and new opportunities for borrowing, in addition to bank loans, emerged. An entire "shadow banking" sector developed, partly with the intention to circumvent prevailing rules, comprising a chain of non-bank institutions which were able to provide similar financial intermediary services as traditional banks.

Trading activities of the large banks increased, contributing significantly to the growth in balance sheets as the banks built up large asset inventories to conduct these activities. In addition, commercial banking moved increasingly away from customer relationship-based banking, where loans are granted and then held to maturity, towards the "originate and distribute" model (or transaction- and fee-oriented model), where granted loans are pooled, then securitised and sold to investors. This shift increased traditional banks' connections to the shadow banking sector and made them become part of the long intermediation chains that are characteristic of shadow banking. Shadow banking activities such as securitisation allowed banks to tap wholesale markets and institutional investors to grow more quickly than was possible by merely relying on relatively slowly growing insured deposits. Banks were increasingly funded by money market funds and other sources of short-term wholesale funding. Previously illiquid loans were being liquefied through securitisation.

The increasing influence of an investment banking-oriented management culture also spurred a focus on short-term profits in commercial banking, which was reinforced by shareholder pressure and short-term performance-based managerial compensation schemes.

The rapid growth of the financial sector was facilitated by the low interest rate environment and a surge in innovative, but often highly complex financial products that allowed financial institutions to expand their activities on and off their balance sheets. This was also helped by the general underpricing of risk in financial markets. Inadequate regulation, including undue reliance on self-regulation, and inadequate supervision failed to stop and in some ways even reinforced adverse developments in the market.

The excessive asset growth in the financial sector during the pre-crisis boom was accompanied by asset price bubbles in many markets, such as the housing markets in some EU Member States (see chart 3.4.3). It was also accompanied by the accumulation of excessive levels of debt – not just among financial institutions but also in the wider economy (see charts 3.3.3 and 3.3.4). As further discussed below, there was unbalanced growth in some Member States, which was based on accumulating debt (fuelled by low interest rates and strong capital inflows) but often associated with disappointing productivity developments and competitiveness issues.

The financial system had become much more complex, concentrated, interconnected, and large, i.e. much more prone to systemic risk. Systemic risk can be measured by the financial sector’s complexity, its interconnectedness and exposure to common shocks, its cross-border activity, and the lack of readily available substitutes for the services or infrastructure provided. The larger the financial sector, the larger the impact of systemic risk on the rest of the economy. Other network industries also have the capacity to create systemic risk and face similar challenges. However, exposure to rare events with a devastating impact (in statistical terms called “tail risk”) is particularly pronounced in the financial system, because it can be created and amplified within the system itself (i.e. it can be endogenous). Moreover, financial companies benefit from public safety nets (e.g. deposit guarantee schemes, implicit bail-outs, lender of last resort facilities), unlike most non-financial sectors.

The following provides a short summary of the main problems that were revealed by the pre-crisis financial boom and subsequent bust, focusing only on those that relate to deficiencies in the financial system and can be addressed by financial regulation reform.[25]

Inadequate (micro- and macro-prudential) supervision and regulation—Policymakers, regulators and supervisors did not adequately appreciate and address the risks building up in the financial system. Among other shortcomings, there was a lack of macro-prudential surveillance which allowed uncontrolled and excessive asset growth in the financial sector and the emergence of asset bubbles. Financial regulation was inadequate, often relying on self-regulation, and it did not provide an adequate level of consumer and investor protection. Regulation worked procyclically, i.e. allowing banks to expand their balance sheets during the boom period when there are less capital constraints but then to contract in the recession when capital requirements rise and insufficient capital buffers have been accumulated during the good years. Moreover, while the operations of the largest financial institutions expanded significantly across borders and markets became increasingly integrated internationally, regulatory and supervisory frameworks remained largely national and could not adequately deal with these market developments.

Leverage and limited ability to absorb losses—the expansion of the financial sector and bank balance sheets in particular was accompanied by an increase in leverage. Banks' capital base shrank compared to the level of risk taken, and by the time the crisis hit, a number of important institutions had an equity capital base that amounted to less than 3 % of their balance sheets (see chapter 4.2 for data on bank capitalisation). This allowed banks to record high rates of return on equity, but the increased leverage led to a lower resilience and reduced banks' ability to absorb shocks and losses, as evidenced when the crisis hit. It also turned out that a large part of banks' capital stock (including so-called hybrid capital) was of poor quality and could not absorb losses.

Limited ability to absorb liquidity shocks—Banks increasingly relied on short-term funding to finance their balance sheets, tapping in particular the interbank and wholesale markets in repurchase agreements (repo). The increased reliance on unstable short-term wholesale funding (and the resulting increased maturity mismatch between these short-term liabilities and longer-term loans or other assets) made banks vulnerable to liquidity shocks, in particular when combined with increasingly small buffers of liquid assets. When the crisis hit (in particular after the Lehman failure in September 2008) and liquidity evaporated from bank funding markets, large-scale liquidity injections by central banks around the globe became necessary. For many banks, these were not sufficient, because the banks had run out of collateral for central bank operations. In fact, liquidity problems masked imminent solvency problems of many banks. The direct consequence was unprecedented state aid, including public capital injections to strengthen banks' capital base, guarantees on newly issued bank debt to help banks retain access to wholesale funding, and purchases or guarantees of impaired assets to help reduce the exposure of banks to large losses.

Absence of frameworks to facilitate orderly winding-down of financial institutions—EU Member States did not have an adequate crisis management mechanism for the resolution and winding down of financial institutions, and there was no common framework at EU level to deal with failures of cross-border financial institutions. When the crisis hit, many banks were considered to be too big (or too important and interconnected) to be allowed to fail. They therefore had to be rescued with large-scale taxpayer-funded bailouts to prevent a worsening of the systemic crisis and to cushion adverse effects on the economy. Due to the absence of adequate resolution tools, even relatively small financial institutions were deemed too big or too important to fail and hence bailed out.

Too big to fail—Banks effectively benefit from an (implicit or explicit) public subsidy to their funding costs. This in turn results in numerous distortions (over and above the costs to public finances). In particular, public safety nets and an expectation of being bailed out incentivises banks to expand and take excessive risks beyond what would be possible if risks were properly priced in the banks' funding costs, giving rise to a "moral hazard" problem. The subsidies also distort competition and raise entry barriers to the extent that: (i) small and medium-sized banks are less likely to benefit from such subsidies than the large ones; and (ii) banks in Member States with significant financial problems are less likely to enjoy subsidies than banks in Member States that are perceived to be in a better position to stand behind their banks.

Weak governance and risk management—Weak governance structures and poor risk management frameworks reinforced the problems, as financial institutions were taking risks that were insufficiently monitored in the market and inadequately controlled internally. Moreover, remuneration policies rewarded management and other staff for maximising returns to shareholders without due consideration of risk, and in some cases they incentivised excessive risk-taking.

Chart 3.1.3: Growth in international derivatives markets

Source: BIS.

Deficiencies in derivatives markets—Derivatives markets had grown exponentially in the pre-crisis years, in particular those traded over-the-counter (OTC) as opposed to those traded on exchanges (see chart 3.1.3). The former remained largely outside the scope of regulation. A specific derivative market, namely that for credit default swaps (CDS), contributed significantly to the spreading of the financial crisis through a complex web of interconnections. Their inherent opaqueness made it difficult to detect the risks building up at individual institutions and in the system as a whole, and to assess the consequences of a default of a market participant (as was the case in the Lehman failure, for example). The opaqueness fuelled suspicion and uncertainty during the crisis, contributing further to the spreading of risk. Given the limited use of central counterparties for clearing derivative trades and inadequate collateralisation, the counterparty credit risk associated with OTC derivatives turned out to be much higher than both market participants and regulators previously thought. The financial crisis also revealed specific problems in OTC commodity derivatives markets, which were reinforced by more recent scandals linked to speculation in both physical and financial markets for commodities.

Chart 3.1.4: Growth of assets of non-bank intermediaries

Notes: Shows assets of non-bank financial intermediaries as a proxy for global shadow banking activities, in % of GDP (left-hand scale, LHS) and in USD trillion (right-hand scale, RHS). Source: FSB (2013)

Systemic risk stemming from shadow banking—Alongside the growth of derivatives markets, there was a rapid growth of the shadow banking system at global level – i.e. credit intermediation outside the scope of bank regulation and public safety nets (chart 3.1.4). Many banks shifted from making loans and keeping them on their books to selling loan portfolios and shifted the risks off balance sheet via securitisations.[26] Thus, many types of asset-backed securities (ABS) contributed to the intermediation of non-bank credit, ranging from asset-backed commercial paper to credit default obligations (CDOs). Unlike traditional bank lending, the non-bank credit activities were not funded by deposits but relied on wholesale funding (e.g. money market funds and securities financing transactions). Given the short maturity of the funding, the difficulty to assess their value and the absence of an explicit public safety net, this made them prone to the liquidity runs experienced during the crisis.

Inadequate regulation of credit rating agencies and audit firms—CRAs played a negative role in the crisis by failing to properly assess the risk characteristics of complex financial products. For example, many ABS tranches originally had triple-A ratings, which many investors in these products relied on as meaning 'risk-free'. Ratings for complex securities, which were issuer-paid and very profitable for the rating agencies, often relied on inaccurate models and assumptions, leading to unreasonable analyses of the underlying securities. Moreover, the evaluations frequently lagged behind material market developments. Investors relied on those evaluations without carrying out their own due diligence. Regulation failed not only in providing adequate oversight of CRAs but also in overly relying on credit ratings for prudential regulatory purposes. Concerns about the value of audit reports and their quality, independence and consistency were already present before the crisis, but these were amplified in the crisis when a number of financial institutions failed only months after they had been given clean audit reports.

These deficiencies unravelled with the start of the financial crisis. What started as a sub-prime crisis in the USA quickly spread into a full-blown global financial and economic crisis, with serious consequences for the European economy and detrimental impacts for consumers and investors, as summarised below in section 3.4.

3.2 The underlying market and regulatory failures

The deficiencies revealed by the financial crisis stem from fundamental underlying problems, or so-called "market failures" in standard economic theory, which upset the operation of the financial system. Market failures explain why the market, if unregulated or poorly regulated, delivers outcomes that may be profit-maximising for financial intermediaries but detrimental from a societal point of view.

Market failures, coupled with regulatory failures, explain why the financial system had moved far from the ideal benchmark discussed in chapter 2 and why, without regulatory intervention, the system would always be prone to instability, inefficiencies and abusive practices. Indeed, leaving the financial crisis aside, there are many examples to illustrate how unregulated or poorly regulated markets and market participants fail to behave in an efficient and responsible manner. This includes recent scandals such as the rate-rigging of the LIBOR/EURIBOR interest benchmark rates and the manipulation in foreign exchange markets, cases of fraud or large scale losses of individual traders, and mis-selling of financial products to consumers.

While market failures are present in all markets, nowhere are they more pervasive, or have as profound consequences for the broader economy, than in the financial sector. The main market failures can be summarised as follows:[27]

Asymmetric information: The financial system has significant imbalances of information, between those who buy financial services and products and those who sell them, between those who invest in financial intermediaries and the intermediaries which seek that investment, and between financial intermediaries and their management or other staff. Indeed, the complexity of financial information, of financial products, services and transactions, and of the operations of financial institutions reinforces the opacity. Asymmetric information explains some key risks and provides the basis for undesirable incentive effects, such as moral hazard, resulting in excessive risk-taking. Excessive risk-taking was a key contributing factor in this crisis and was exacerbated by a general underestimation of risk and an expectation of public safety nets (bail-outs), which limited down-side risks. Information asymmetries also give scope to conflicts of interest, which is another key risk in the financial system given the nature of the financial intermediation process – the entrusting of one's savings and investments to banks and other financial institutions. They also result in insufficient monitoring of market participants and explain the observed lack of market discipline. Externalities: Negative externalities or spillovers arise when the costs of individual actions do not incorporate potential broader social costs that may be imposed on others as a result of those actions. For example, individual financial institutions, when deciding on how leveraged and interconnected to become and what financial risks to take, may not consider the systemic implications of their actions. In fact, they may even wish to maximise the externality and create systemic risk problems because that increases the likelihood of a bailout. Externalities explain the potential instability of financial systems and markets, whereby confidence can quickly evaporate and lead to a panic and runs for exit, amplifying the costs for all concerned. These systemic risks became highly visible in this financial crisis. Without the massive state aid and liquidity support that was provided (see Box 3.4.1), a much more severe systemic crisis could have materialised. Market power: As with other economic sectors, imperfect competition may lead to market power abuses, including excessive pricing, inappropriate products being sold, or agreements being made on unfair contractual terms. The abuses are reinforced given the asymmetric information problem in financial services, which places financial institutions at an informational advantage compared to customers. Market abuse: There is a risk of abusive market practices, whereby customers may be taken advantage of and deprived of savings and investments or find themselves with grossly unfair and abusive contractual terms. This could occur for example through deceptive marketing practices, the inappropriate use of customer funds by the financial institution and unfair pricing. Abusive market practices also include the manipulation of share prices or other prices, as was the case in the recent scandals around the manipulation of LIBOR/EURIBOR and other benchmark rates (see chapter 4.3). Such abuses create particular problems for the financial sector since the system relies fundamentally on trust and confidence. Market abuse can, if sufficiently problematic and uncorrected, cause widespread reputational damage and undermine the functioning of the financial system.

A combination of different market failures, coupled with regulatory failures, was at work in the run-up to the crisis and the events that followed. These have been widely examined in the literature[28]. The role of regulation is to correct market failures or reduce their impacts in the market. Regulation may, however, create or exacerbate problems. The crisis has been a painful reminder of the fact that the cost can be huge when regulators and supervisors get it wrong.

The financial reform agenda is to a large extent a direct response to the financial crisis and the deficiencies it revealed in the financial system. However, more generally, the reforms of the last few years must be understood as part of a wider agenda to move the financial system closer to a system that is capable of conducting its key functions in a stable, efficient and responsible manner, and for the benefit of the economy. The reforms aim to correct market failures as well as previous regulatory failures.

3.3 Additional problems revealed by the economic and sovereign debt crisis in Europe

In addition to the deficiencies in the financial system, which were largely global in nature and not specifically European, a number of additional problems were specific to Europe. They turned the financial crisis into a wider economic and sovereign debt crisis, in particular in the countries of the euro area periphery.[29] Adverse developments in the economy and poor public finances had repercussions for the banking sector and increased banking risks. This in turn reinforced stresses in sovereign debt markets and spilled over to the economy. A negative feedback loop due to intertwined relationships between the banking sector, sovereign debt markets and the economy arose, which required policy action on different fronts.

The loss of substantial tax income, massive amounts of state aid measures required to support banks, as well as the cost of automatic stabilisers (such as unemployment benefits) and fiscal stimulus spending, had a significant impact on the level of public debt (see chart 3.4.6 below), but helped stabilise the economy in the early phase of the crisis.

When the Greek government revealed the true size of the country's deficit and debt in November 2009, sovereign risks in the euro area grabbed the headlines. Subsequently, Greece and a number of other countries in the euro area (Ireland, Portugal, Spain, Cyprus) required financial assistance. The growing sovereign risks spilled back over to the banking sector, since European banks were heavily exposed to sovereign debt holdings, in particular to debt issued by the domestic sovereign. The high public debt burdens also called into question the sovereigns' ability to continue standing behind their domestic banks, further linking the risks of banks to that of the sovereign (see chart 3.3.1 illustrating the close correlation between bank and sovereign risks, based on CDS spreads).

In addition to the weaknesses in the banking sector and poor public finances, the crisis exposed a number of structural problems that had been building up in the euro area for some time. The competitiveness of the vulnerable countries in the euro area had eroded over time, and large current account imbalances had built up (see chart 3.3.2). These were financed (and indeed fuelled) by free capital flows that had expanded massively given the absence of exchange rate risks since the introduction of the euro. The strong cross-border capital flows often went into the non-tradable sector (e.g. real estate) and financed demand rather than supply (and imports rather than exports), leading to macroeconomic imbalances that turned out to be unsustainable. As current account deficits in the vulnerable countries of the euro area widened, these countries became increasingly dependent on foreign capital inflows. With the start of the crisis, private capital flows to the countries reversed and financing constraints became more apparent.

Chart 3.3.1: Correlation of bank and sovereign debt risks, based on 5-year CDS spreads (basis points) || Chart 3.3.2: Current account balance (in % of GDP)

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Notes: 5-year CDS spreads, showing the average for a small sample of banks per country and the sovereign. High CDS spreads for Greece are omitted. Measured as of end-November 2011. Source: Bloomberg || Source: Eurostat

In the pre-crisis boom years, there was also a sharp increase in private sector debt. Low interest rates and easy access to credit allowed households (chart 3.3.3) and non-financial corporates (chart 3.3.4) to accumulate high debt levels.[30] The crisis revealed debt levels to be unsustainable with respect to income prospects and assets in a number of EU Member States. In the euro area periphery, but also in other parts of the EU, a significant part of the credit growth was being financed with capital inflows from abroad, in particular via cross-border lending between banks.

Chart 3.3.3: Household debt in % of GDP || Chart 3.3.4: Non-financial corporate debt in % of GDP

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Notes: Consolidated data. Debt includes loans for households (HH) and loans and securities other than shares for non-financial corporates (NFC). 2001 data missing for Luxembourg and Malta. Vertical axis cut at 150% of GDP, not showing the higher levels of debt in 2012 for NFCs in Ireland and Cyprus. Source: Eurostat.

The high debt levels in the private (and public) sector that built up in the pre-crisis years are hindering economic recovery in the stressed countries. They have also reinforced problems for the banking sectors in those countries, because debt-servicing problems – along with a weak economic environment – led to an increase in nonperforming loans (chart 3.3.5), worsening the quality of the assets on bank balance sheets. In turn, weak banks have been reinforcing problems for the economy in stressed countries by tightening credit supply and increasing interest rates on new loans (chart 3.3.6). At the same time, the restructuring frameworks of many EU Member States are still inflexible, costly, and value destructive and thus inadequate in addressing the debt overhang problems.[31]

Chart 3.3.5: Growth in non-performing loans (% of total loans) || Chart 3.3.6: Bank buffers and interest rates on corporate loans

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Source: ECB || Source: IMF Global Stability Report 2013.

Financial integration in Europe had progressed significantly in the years prior to the crisis, in particular in wholesale markets. The adoption of the euro and, shortly afterwards, the Financial Services Action Plan were major milestones in the integration process. Financial integration brought significant benefits, contributing to the convergence and decline in financing costs and the opening up of investment and diversification opportunities across Europe.[32]

However, the crisis has shown that financial integration - if not backed by the appropriate institutional framework and economic policy coordination - can also carry financial stability risks, especially in a single currency area. Free credit and other capital flows contributed to the build-up of imbalances in the euro area and helped fuel the boom-and-bust cycles observed in several Member States. Many cross-border capital flows turned out in hindsight to be excessive and ultimately unsustainable.

Moreover, the integration process was incomplete and uneven. Debt markets and in particular interbank markets had become most integrated (also reflecting the pre-crisis excesses in credit growth), while cross-border flows in foreign direct investment and equity portfolio investment remained more limited. Table 3.3.1 shows the relative magnitude of different types of incoming capital flows for EU and euro area Member States and, for comparison, emerging and developing markets. It highlights the significant share of debt in capital inflows in European countries, especially prior to the crisis. Whilst the share of debt has since come down, it is still significantly above the share it represented, for example, in emerging market economies prior to the crisis.

Table 3.3.1: Gross capital inflows expressed as a percentage of its total by type of capital flows.

Charts 3.3.7 and 3.3.8 further illustrate the point. They show the net issuance of liabilities by the whole EU financial sector as a percentage of GDP. The charts display the significant increase in the liabilities issued by EU financial institutions, in particular following the introduction of EMU. However, chart 3.3.8 provides the breakdown by type of financial instrument and shows how the amount of loans and shares issued remained roughly stable in terms of GDP throughout the period. Instead, the sharp increase prior to the crisis was driven by 'currency and deposits' led by wholesale interbank deposits and 'fixed income securities'.

With capital flows in the boom years largely taking the form of interbank lending and debt, this exposed the recipient countries in the euro area periphery to significant rollover risk; when the crisis hit, the capital flows stopped or reversed, resulting in significant economic and financial disruption.

Chart 3.3.7: Net issuance of liabilities of financial institutions in EU (% of GDP). Source: Eurostat || Chart 3.3.8: Net issuance of liabilities of financial institutions in EU, by type of liability (% of GDP). Source: Eurostat

There were significant shortcomings in the institutional frameworks. Financial integration was not accompanied by adequate regulatory and supervisory oversight and the required governance frameworks. For example, there were no appropriate tools to monitor cross-border capital flows and related risks, to control credit supply and to prevent the build-up of debt-driven imbalances. The decentralised system of supervision prior to the crisis, based on loose cooperation between national supervisors, did not allow this. Furthermore, tools did not exist to coordinate crisis management and resolution.

The crisis halted to the integration process. In particular, there has been a decline and in some cases a reversal of cross-border credit flows; banks have increasingly focused on their home markets and on meeting domestic lending commitments; and wholesale financing costs and retail interest rates differ between countries in the euro area. Chart 3.3.9 shows the decline in the total foreign exposures of European banks to other parts of the EU; and chart 3.3.10 shows the increased dispersion of interest rates on loans to non-financial corporations in the euro area. Moreover, partly because of the absence of a meaningful ability to resolve cross-border banking institutions to date, there is evidence that national supervisors have increased firewalls to trap capital and liquidity at a national level. Banks and other financial institutions have also been encouraged to invest in domestic debt.

Chart 3.3.9: EU bank exposures to other parts of the EU (USD billion and annual change in %) || Chart 3.3.10: Dispersion in lending rates to non-financial corporations (basis points)

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Source: BIS || Notes: Dispersion is measured by the standard deviation in lending rates across euro area. Source: ECB

Market fragmentation is economically inefficient. In particular, it has reinforced the adverse feedback loops between weak banks, sovereigns and the economy in the stressed euro area countries. It has also entrenched significant differences in the financial and economic conditions within the single currency area. Reforms in the governance and institutional frameworks were therefore needed to restore and preserve financial integration and stability, especially in the euro area.

Many of the more fundamental problems touched upon in this section cannot be tackled by financial reform alone. Rather, they demand a wide range of fiscal, monetary and structural measures, which are not within the scope of this study. The blueprint for a deep and genuine EMU emphasised the importance of the different measures.[33] The main point here is that the financial regulation agenda in Europe was shaped and enacted in a difficult economic environment. Alongside restoring financial stability, policymakers face the challenge of correcting macroeconomic imbalances, dealing with high private and public sector debt levels, addressing financial fragmentation and ultimately facilitating growth and jobs.

3.4 The costs and consequences of the financial and economic crisis in Europe

The financial and economic crisis was (and continues to be) associated with significant costs. While not all of the adverse consequences since the onset of the crisis can be attributed to failures of the financial sector (and the way it was regulated and supervised), the financial sector had a key role to play. Enhancing financial stability and thereby reducing the expected costs of similar crises occurring in the future is therefore a key objective of the financial reforms. This is further discussed in chapter 4.

The effects of the crisis have been wide-ranging, and it is beyond the scope of this study to provide a comprehensive review of all of the negative economic consequences. The below highlights some of the consequences known to date: output losses, reductions in household income and wealth, unemployment and related effects, and huge costs to public finances.

3.4.1 Losses in GDP

The crisis triggered a steep decline in output and a severe economic downturn in the EU (and globally), with weak growth expected to continue into 2014 and possibly beyond (chart 3.4.1).

Chart 3.4.1: Real GDP growth rate in the EU (in %)

Notes: Shows the annual real GDP growth rate (right-hand scale) and the corresponding index starting at 100 in 2001 (left-hand scale, LHS). Source: Eurostat data.

While the observed decline in GDP reflects some of the losses associated with the crisis, it does not capture the cumulative losses from the crisis. This requires an estimation of the cumulative shortfall between actual GDP over time and estimates of GDP had the crisis not occurred.

Experience from previous systemic crises suggests that the overall output losses can be significant, even if the estimation is inherently difficult and dependent on assumptions, such as those of the path of future GDP and about the counterfactual GDP in the absence of the crisis. In a 2010 study, a working group of the Basel Committee on Banking Supervision (BCBS) reviewed the literature estimating output losses; the median estimate across all studies reviewed is 63 % of pre-crisis GDP (measured cumulatively in present value terms and as the deviation from trend GDP). Considering only the studies that assume a permanent level change in output, the median is 158 %. Laeven and Valencia (2013) estimate that the output loss of a crisis amounts to about 32 % of GDP on average in advanced economies, measured cumulatively but only over the first four years since the start of the crisis. Atkinson et al (2013) examine the costs of the 2007-09 financial crisis in the USA and conclude that a conservative estimate suggests cumulative output losses of 40-90 % of pre-crisis GDP. Haldane (2010) suggests that the output loss resulting from this crisis could amount to anything between 100 % to 500 % of GDP, depending on assumptions about how permanent the drops in output will be.

ESRB (2014) calculates the EU output loss to amount to about 50 % of one year's GDP, if measured as the deviation of actual from trend GDP from mid-2008 to the third quarter of 2013.[34] Looking beyond 2013, estimates prepared for this study suggest that output losses in the EU may end up as high as 100 % of EU GDP, measured cumulatively in present value terms going forward (see annex 4). This assumes that about two third of the initial GDP reduction due to the crisis will be recovered in 5 years, while the remaining third is assumed to be a permanent loss. Thus, depending on output losses going forward, the total cumulative losses are at least 50 % of annual GDP but may well be as much as 100 % of annual EU GDP (or EUR 6-12.5 trillion) or indeed more, according to other estimates.

Reinhart and Rogoff (2014) report that, based on a sample of 100 banking crises across the globe in the period 1857-2013, it took about 6.5-8 years on average to return to pre-crisis output levels. Almost six years into the crisis, most EU countries have returned to pre-crisis levels in real per capita GDP, but some continued to contract in 2013. Reinhart and Rogoff argue that, unless measures are taken, this crisis may ultimately surpass the depression of the 1930s in a large number of countries.

The ultimate costs of output losses in the EU as a result of the crisis are still unknown. However, based on the above discussion, the present value of cumulative output losses across the EU may amount to 50-100 % of annual pre-crisis EU GDP (about EUR 6-12.5 trillion)[35] or indeed more according to some estimates.

GDP is of course an imperfect proxy of overall social welfare. Moreover, these estimates mask the significant variations in output losses between EU Member States. They also do not reveal the distributional impacts of the crisis, and the fact that the costs fall disproportionately on certain social groups.

3.4.2 Losses in household wealth and income

The crisis wiped out an enormous amount of financial wealth, including wealth accumulated by EU households (chart 3.4.2). In some EU Member States, a lot of this was driven by broad collapses in house prices (chart 3.4.3