COMMISSION STAFF WORKING DOCUMENT Economic Review of the Financial Regulation Agenda Chapters 1 to 4 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF THE REGIONS A reformed financial sector for Europe
Date: 2014-05-15
Institutions: European Commission
Subjects: consumer protection, financial institution, financial legislation, financing policy, market supervision, small and medium-sized enterprises













EUR-Lex - 52014SC0158 - EN











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52014SC0158

COMMISSION STAFF WORKING DOCUMENT Economic Review of the Financial Regulation Agenda Chapters 1 to 4 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF THE REGIONS A reformed financial sector for Europe /* SWD/2014/0158 final */









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) 
 || 
 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 
 || 
 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 
   ||   
 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) 
 || 
 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) that involved some homeowners
losing substantial equity because home values declined faster than mortgage
debt. Declines in the value of household financial assets also contributed to
the reduction in wealth.  
 Chart 3.4.2: Evolution of household wealth in euro area (change on previous year, in EUR billion) || Chart 3.4.3: Evolution of house prices (index, 2000 = 100) 
 || 
 Source: ECB || Source: OECD 
As with trends in output losses, it is
difficult to determine how much of the changes in household wealth can be
attributed to the financial crisis rather than to other factors. In particular,
many valuations before the crisis were inflated and unsustainable, so it may
not be appropriate to judge the full amount of the overall decline as crisis
driven. 
Nonetheless, sharp declines in household
wealth, combined with an uncertain economic outlooks and less secure jobs and
income stream, can cause consumers to reduce their consumption, which – all
else being equal – in turn reduces aggregate demand and real GDP. 
 Chart 3.4.4: Gross disposable income of households in the euro area (% change on previous quarter, seasonally adjusted) 
 Source: ECB 
The household income levels (measured by
gross disposable income, chart 3.4.4) fell for many households. Moreover, as is
evident from the increase in the number of arrears, repossessions and
non-performing loans, the crisis affected households' capacity to service
existing loans, at least in some EU Member States.[36] This is particularly problematic
given the high levels of household indebtedness in many countries (see chart
3.3.3 above).
During the crisis, income inequality in the
EU as measured by the GINI index and the S80/S20 quintile ratio did not rise
significantly overall (0.1 percentage points in EU-27 between 2008 and 2011),
but there were sizeable increases in a number of Member States, particularly in
 Southern Europe. In the euro area, income inequality increased by 0.3 points.
Significant variations in the inequality trends were observed between different
Member States with changes in the GINI coefficient between 2008 and 2011
ranging from decreases of over 2 percentage points for Romania, Latvia, and  Netherlands to increases of 2.7 percentage points for Denmark and Spain.[37]
The crisis damaged households' trust in the
financial sector and in those charged with forming policies, supervising and
regulating the sector. 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 result of the crisis.[38] In addition to the
declines in their wealth and income, trust was negatively affected by the
public perception that, in the years leading up to the crisis, financial
intermediaries lacked discipline and accountability, generated high profits and
paid huge staff bonuses in the years before the crisis, but then proved largely
immune to the downside of the excessive risks that they took when they were subsequently
bailed out by taxpayer funds. 
3.4.3 Unemployment 
The crisis was accompanied by significant
job losses in the EU. The unemployment rate increased from a pre-crisis low
of 7.5 % in 2007 to 12 % in 2013 in the euro area, and from 7.2 % to 10.8 % in
the EU. Compared with the end of 2007, 9.3 million more people are now
unemployed in the EU.[39]
These averages and the total conceal sharp differences across Member States,
with the unemployment rate falling over the period in Germany but rising to more than 25 % in Greece and Spain (chart 3.4.5). 
 Chart 3.4.5: Increase in unemployment rate in the euro area, EU and the Member States (in %) 
 Source: Eurostat 
Structural unemployment and labour market
mismatches have been growing. Net job destruction has been coinciding with an
increase in precarious jobs even though, compared to before the crisis, the
share of temporary contracts has fallen in the EU. Part-time, especially
involuntary part-time, jobs have been increasing. 
Young people have been hit particularly
hard by the crisis, and the
threat to the future of many young people remains acute given the high levels
of youth unemployment. [40]
In 2013, nearly 6 million people in Europe under the age of 25 were unemployed
and a total of 7.5 million were not in employment, education or training.[41] Youth unemployment
rates in Europe stood at 23.4 % at the end of 2013, more than twice the (already
very high) rate for the EU population as a whole.[42] In Greece and Spain, more than half of the young people in the youth labour force are unemployed. 
Persistent, high unemployment has a
range of negative consequences for the individuals affected and the economy as
a whole. For example, displaced workers often suffer declines in their
earnings potential. Spells of unemployment (and the stigma attached to it)
reduces employment and earnings prospects. Skills erode as individuals lose
familiarity with technical aspects of their occupation. Moreover, unemployed
people tend to be physically and psychologically worse off than their employed
counterparts, and their children tend to have worse educational opportunities.
The high levels of youth unemployment are particularly damaging, as they affect
the longer-term employment prospects for young people, with serious
implications for future growth and social cohesion. For example, studies show that
young people who graduate in a severe recession have lower life-time earnings,
on average, than those who graduate in normal economic conditions.[43] Moreover, spells of unemployment deteriorate the capacity of
households to service the mortgages and other debt they had previously taken
out.  
Poor labour market conditions affect not
just the underemployed and unemployed, but also the employed. For example, a
higher unemployment rate decreases job security and diminishes the belief that
another job could be found if a layoff occurred. Thus, high unemployment has
wider psychological effects, with consequences for social welfare that are
difficult to quantify.[44]
Finally, persistent high unemployment also
increase budgetary pressures as expenditures on social welfare programs
increase and individuals with reduced earnings pay less taxes. Nearly a quarter of the EU population is at risk of poverty or
exclusion. In absolute terms, in 2012 this amounted to almost 125 million
people in the EU, an increase of 7.4 million compared to the onset of the
crisis in 2008.[45]
In-work poverty has also risen, partly reflecting the fact that those who
remain in work have tended to work fewer hours and/or for lower wages. Children
in such households are also exposed to increased poverty. Growing social
distress in employment and poverty are the result of the crisis and the lack of
resilience of the labour market and social institutions.[46] As discussed in the next section, these problems further strain public
finances.
3.4.4 Costs to public finances 
Since the onset of the crisis, European
governments have used a total of EUR 1.5 trillion of state aid to support the
financial system during 2008 and 2012 (which amounts to 12.3 % of 2012 EU GDP),
in the form of guarantee and liquidity support, recapitalisation and asset
relief measures (see Box 3.4.1). This response was deemed necessary because,
without such intervention, a systemic crisis with more serious consequences for
the economy would have materialised. 
Notwithstanding the cases where such state
aid has been fully or partly repaid, these state aid payments have generally contributed
to the increased public deficit and debt levels in the EU. Other crisis-related
contributing factors included reduced tax revenues (in part driven by declines
in taxable income for consumers and companies), increased spending on
unemployment benefits and other social assistance provided to individuals
affected by the recession, and fiscal stimulus spending provided to prevent economies
sliding into depression.[47]
 Chart 3.4.6: General government debt levels (% of GDP) 
 Notes: Shows government consolidated gross debt in relation to GDP. Source:  Eurostat 
Chart 3.4.6 reports the significant
increase in public debt levels across Europe. On average, general government
debt in the EU increased by 26 % of EU GDP between the end of 2007 and 2012.
Because the impact of the crisis continues to be felt across Europe, the total
impact on public debt cannot yet be evaluated. Past financial crises have
generally been very costly. When analysing a subset of 49 crisis episodes from
the 122 systemic financial crises that occurred since 1970 around the world,
one finds that net direct fiscal outlays to rehabilitate the banking system
averaged 13 % of GDP, including the values recovered from assets acquired by
the public sector. However, increases in public debt ratios – the most
comprehensive measure to capture fiscal implications from financial crises –
went far beyond the direct costs attributable to tackling the financial sector
problems and amounted to 20 % of GDP, on average[48]. Given the adverse
feedback loops between the banking crisis and the sovereign debt crisis in Europe, the total costs to public finances may well be higher this time round. 
As witnessed recently in the euro area,
public debt levels can rise to a point where investors lose confidence in the
ability of the government to repay debt and sovereigns themselves may then become
vulnerable to crises. Because of the sharp increases in borrowing costs for
both the sovereign and private businesses and households, the costs of such
sovereign debt crises are massive, and this in turn reduces the chances to grow
out from the problems.  
More generally, while deficits during and
after a recession can support economic recovery, higher public debt levels
have negative effects on economic growth. For example, public debt can
"crowd out" private investment in productive capital as the portion
of savings that is used to buy government securities is not available to fund
private investment. Also, higher debt results in higher interest payments,
which must subsequently be funded by future generations. 
As noted above, clearly not all of the cost
to public finances can be explained by the crisis, and even less should be
attributed to failings in the financial system. Nonetheless, taxpayer funds would
not have been required to address the crisis and bail out financial
institutions had there not been the crisis and failures in the financial
system.   
Going forward, if debt levels remain high,
there will be much less room for manoeuvre to respond to another crisis or
economic contraction with fiscal measures. Equally, because the near-zero
interest rates attributable to the crisis may hinder the effectiveness of conventional
monetary policy, there may be less scope for effective monetary policy. Box 3.4.1
also summarises the central bank support provided to the financial sector
during the crisis. 
While the large-scale interventions were
deemed necessary to restore confidence in the financial system and avert a more
severe crisis, the unintended consequences and related costs of these
interventions cannot be discarded. From a financial regulation perspective, one
key concern is that the support measures may have encouraged market
participants to expect similar emergency actions in the future (i.e. moral
hazard may have increased).  Thus, while considered necessary at the time in
order to fight the crisis, an ongoing dependency of the financial sector on public
support – beyond explicitly agreed backstop measures – would clearly be
undesirable. Thus, exit from public support measures is needed to restore
normal market conditions.  
Box 3.4.1: State aid measures and central bank support
Between 1 October 2008
and 1 October 2013, the Commission took more than 400 decisions authorising
State aid measures to the financial sector. In the period 2008-2012, the
overall volume of state aid used for capital support measures alone
(recapitalisation and asset relief measures) amounted to EUR 591.9 billion,
which equals 4.6 % of 2012 EU GDP (Table 1). 
Table
1: Total amounts granted for recapitalisation and asset relief measures
Source: European
Commission state aid scoreboard as of end 2013.
Significant aid was also
granted in the form of guarantees and other form of liquidity support (Table
2). These reached their peak in 2009 with an outstanding amount of EUR 906
billion (7.7 % of EU 2012 GDP). The crisis intensity has gradually weakened in many
EU countries since then, so the outstanding amount of liquidity support has
dropped to EUR 534.5 billion in 2012 (4.14 % of 2012 EU GDP). However, during the first five years since
the guarantee on liabilities programs were introduced, only EUR 2 billion of
the total guarantees provided have actually been called. 
In return for their
financial support, the governments have received a total of EUR 125 billion
(0.97% of 2012 EU GDP) in revenue in exchange for their support to banks, e.g.
comprising fees received from guarantees. 
Table
2: Total aid outstanding amounts for guarantees and asset relief measures
Source: state aid
scoreboard as of end 2013.
The ECB and other
European central banks provided significant amounts of liquidity support to
banks. Eurosystem lending to euro-area credit institutions related to monetary
policy operations (MPOs) surged as a result of the large take-up in the 3-year
longer-term refinancing operations (LTROs) in December 2011 and February 2012, when
some EUR 1 trillion was allotted (although the net liquidity added amounted to
about EUR 520 billion). Total Eurosystem lending related to MPOs has since
declined again, mainly due to voluntary early repayment of the 3-year LTROs. 
Chart
1: Liquidity providing operations of the Eurosystem (EUR billion)
Source: ECB data
Chapter 4: The objectives and Intended beneficial Effects of the REFORMs 
In response to the financial and economic
crisis, the European Commission and the EU co-legislators pursued a far-reaching
financial reform agenda to strengthen the regulation and supervision of the
financial sector. This includes the reform measures agreed at international
level as part of the G20 commitments that present a direct response to the
financial crisis and will be implemented throughout the world. It also includes
the wider set of measures taken at European level to create a stable, efficient
and sound financial system and a single market in EU financial services. This
chapter revisits the objectives of the reform programme and reviews the
expected benefits.  
4.1 Overview of regulations and objectives
The reform measures have a number of key
objectives, and the overall benefits of the reforms can be evaluated with
respect to their appropriateness and effectiveness in achieving these
objectives collectively. To allow a comprehensive review, the objectives are
consolidated into the following four general categories: 

 Enhancing financial stability and
     the resilience of financial intermediaries, markets and infrastructures to
     reduce the probability 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 enhancing disclosure and
     transparency, countering market abuse and protecting consumers and
     investors;
 Improving the efficiency of the EU
     financial system to ensure that capital is allocated to its most
     productive uses, financial services are priced to reflect risks,
     transaction costs are minimised and the competitiveness of the EU economy
     is enhanced.

These
objectives relate back to the desirable characteristics of a financial system,
as set out in chapter 2—i.e. financial stability, financial integration, integrity
and efficiency. Put differently, the overriding objective of the reforms is
therefore to create a financial system that serves the economy and facilitates
sustainable economic growth (chart 4.1.1).
Chart 4.1.1: Objectives of the EU financial
regulation agenda
Source: Commission Services
As set out in chapter 3, in the years
leading up to the financial crisis, much of the financial system had become
self-serving. The financial sector grew faster than the economy as a whole, and
profits and salaries ballooned in that sector compared to other parts of the
economy. The excessive risks taken in the sector endangered financial stability
and ultimately imposed large costs on taxpayers and contributed to the deep
recession. 
Much of the focus in this chapter is on the
financial stability objectives of the financial reform agenda. As evidenced in
the crisis, financial stability is a pre-condition for sustainable economic
growth. Based on the range of available estimates, the total cumulative output
loss of this crisis may amount to 50-100 % of pre-crisis annual EU GDP (about EUR
6-12.5 trillion) or more according to some studies, with potential permanent
effects on the growth rate (especially if unemployment remains high, labour is
underutilised and skills are lost). One of the key goals of the financial
reform agenda is to reduce the probability of future crises occurring, and to
minimise the impact on society if they do. Only a one percentage point
reduction in the probability of a systemic crisis occurring could deliver
significant benefits amounting to 0.5-1 % of annual GDP, based on the above range
of output losses.
If this is achieved, regulation which
promotes financial stability helps increase economic activity and growth over
the cycle. Sustainable economic growth is what counts, not temporarily
boosted artificial growth that results in booms and subsequent busts. Moreover,
as further discussed below, the financial stability measures contain a number
of rules that improve incentives and reduce excessive risk-taking activities in
the financial sector. 
Table
4.1.1 presents the overview of this chapter, which is organised by objective
(and in the case of financial stability also by sector). It maps different
reform measures against the objectives and also indicates the relevant chapter
section. The table illustrates that no single rule achieves all the objectives
by itself. Even the regulations which appear to pursue the same objective are
needed if they are complementary and jointly required to achieve that objective.
   
The remainder of this chapter reviews the
financial regulation agenda against the different objectives. The overall
coherence and synergies between the different reform measures in achieving
those objectives are also reviewed in further detail in chapter 5.
Table 4.1.1: Overview of chapter by
objective and reform
 Objectives || Main reforms || Section 
 FINANCIAL STABILITY ||   || 4.2 – 4.5 
 Banking sector ||   || 4.2 
 Increasing loss absorbency || Capital Requirements Regulation and Directive IV (CRD IV package), Bank Resolution and Restructuring Directive (BRRD) || 4.2.1 
 More adequate liquidity and maturity matching || CRD IV package || 4.2.2 
 Reducing pro-cyclicality and systemic risk || CRD IV package, European System of Financial Supervisors (ESFS), structural reform || 4.2.3 
 Improving risk management and governance || CRD III, CRD IV package, structural reform || 4.2.4 
 Improving crisis management, recovery and resolution || BRRD, Single Resolution Mechanism (SRM), structural reform || 4.2.5 
 Correcting "too big to fail" || Structural reform, BRRD, CRD IV package || 4.2.6 
 Financial markets and infrastructures || Markets in Financial Instruments Directive II (MiFID II), European Market Infrastructure Regulation (EMIR), Central Securities Depositories Regulation (CSDR), Short-selling and CDS regulation, regulations on credit rating agencies (CRAs), Prospectus Directive, accounting reforms, audit market reforms, benchmark regulation, regulation on securities financing transactions (SFTs) || 4.3 
 Shadow banking || Alternative Investment Fund Managers Directive (AIFMD), Money Market Fund (MMF) regulation, SFT regulation (and other measures) || 4.4 
 Stability and resilience of the insurance sector || Solvency II, Omnibus II || 4.5 
 FINANCIAL INTEGRATION ||   || 4.6 
 Enhancing the single market || All reforms, in particular the single rulebook, ESFS, European venture capital funds (EuVECAs), European social entrepreneurship funds (EuSEFs), European Long-term investment funds (EuLTIFs) || 4.6.1, 4.6.2, 4.6.4 
 Banking Union to improve the functioning of EMU || Single Supervisory Mechanism (SSM), SRM || 4.6.3 
 MARKET INTEGRITY AND CONFIDENCE ||   || 4.7 
 Countering market abuse || Market Abuse Regulation and Directive on Criminal Sanctions for Market Abuse (MAR/CSMAD), benchmark regulation || 4.7.1 
 Consumer and investor protection || Deposit Guarantee Scheme (DGS) Directive, Mortgage Credit Directive (MCD), Packaged Retail and Insurance-based Investments Products (PRIIPS), Insurance mediation Directive (IMD), Undertakings for Collective Investment in Transferable Securities (UCITS) Directive V, MiFID II, Payment Services Directive (PSD) II, Payment Account Directive (PAD) || 4.7.2 
 Improving the reliability of ratings and financial information || CRA regulations, accounting and transparency rules, audit market reforms || 4.7.3 – 4.7.5 
 EFFICIENCY || Single rulebook, CRD IV package, BRRD, structural reform, Banking Union, Solvency II, MiFID II, EMIR, CSDR, CRA regulations || 4.8 
Notes: See the glossary for the list of abbreviations.
Not all reforms taken are listed in this table. For a full list of the
different financial regulatory measures proposed by the Commission during 2009
and 2014 (up to April), see annex 2. Detailed descriptions and references to
the legislative initiatives are provided in the relevant sections.
4.2 Stability and
resilience of the banking sector 
Banks are at the core of the EU financial system. Households, non-financial corporates and governments rely significantly on banks
to fulfil their funding needs (see Box 4.2.1). The fact that more than half of the assets of the financial system in the euro area are held
by banks illustrates their key role in the financial system (Table 4.2.1). 
Table 4.2.1: Relative size of banks and
other financial institutions in the euro area
   || EUR trillion || % of total 
 Regulated banks || 28.0 || 51.5 
 Insurance corporations and pension funds || 6.8 || 12.6 
 Regulated investment funds other than MMFs || 5.6 || 10.3 
 Other intermediaries || 10.8 || 19.9 
 Eurosystem || 3.1 || 5.8 
 Total assets of euro area financial institutions || 54.4 || 100.0 
Source: Bakk-Simon et al. (2012),
showing data for end 2011.
Unlike most non-banks, banks are
characterised by a high risk of instability and fragility due to the
maturity mismatch and liquidity mismatch between their assets (often long term
and illiquid, such as loans) and their liabilities (often short term and liquid,
such as deposits). They are hence vulnerable to confidence crises as
their predominantly short term creditors may decide to withdraw their funds or
stop rolling over their short-term debt paper. To avoid disruptive runs and
confidence crises, banks benefit from explicit and implicit public safety
net coverage, including deposit guarantee schemes, lender of last resort
support by central banks, but also implicit subsidies. Safety nets have
important benefits for financial market stability, preventing bank runs,
self-fulfilling prophecies and various forms of contagion. Thereby, safety nets
prevent wide-scale collapse of the intermediation services of the banking
sector. However, due to the presence of these public safety nets, banks also
have incentives to take excessive risks ("moral hazard"), expand
their balance sheet and leverage up (i.e. fund their activities with more
debt rather than equity). Given the artificially low and risk-insensitive
funding costs that result from the public safety nets and given the limited
liability status of shareholders and bank managers, it is rational for banks to
leverage up and take more risks by issuing more debt.[49] The banking sector is indeed more highly leveraged than any other
sector in the economy, and the presence of public safety nets is a key driving
factor.[50] Whereas the percentage of equity finance of non-banks often exceeds
40 % of the balance sheet for many sectors in the economy, it is often less
than 5 % for the banking sector. 
To control and curtail risk-taking and
excessive leverage incentives, banks have long been heavily regulated and
supervised.  However, the financial crisis showed that the regulatory and
supervisory framework of banks was inadequate. Banks were at the heart of
the crisis. Whereas several large EU banking groups have weathered the
crisis well, the EU financial system as a whole would have likely imploded due
to a system-wide cascade of banking failures without the extraordinary and ongoing
government and central bank support. 
When the financial crisis started, the EU
acted quickly and increased already in 2009 the protection levels of deposit
guarantee schemes (DGS) from a minimum of EUR 20 000 to EUR 50 000 and, in
2010, to a harmonised level of EUR 100 000 per depositor per bank. This
reinforced depositor confidence in public safety nets and thereby averted the
risk of runs on banks across the EU. The DGS measures are further discussed in
section 4.7.2, as they are critical also for consumer protection.
In order to enhance the stability and
resilience of the banking sector and reduce the likelihood and costs of future
banking failures (including calls on the deposit guarantee scheme and wider
taxpayer support), the financial regulation agenda includes a number of
important bank reforms which: 

 increase the ability of banks to absorb
     losses by increasing the level and the quality of bank capital (section
     4.2.1);
 improve the ability of banks to absorb
     liquidity shocks (outflows) and ensure adequate asset-liability matching
     (section 4.2.2): 
 reduce the pro-cyclicality in the regulatory framework ((section
     4.2.3):
 improve banks' risk management and
     governance  (section 4.2.4);
 facilitate crisis management and bank resolution
     (section 4.2.5);
 correct the "too big to fail" problem
     (4.2.6).

Results of quantitative models estimating
the potential (net) benefits of bank reforms are presented in section 4.2.7. 
Over and above the reforms listed above,
the EU took decisive steps towards establishing a Banking Union. This reform
strand is discussed separately in section 4.6.3.
Box 4.2.1: The importance of banks in financing the
economy
Businesses,
governments and households finance their activities from different sources,
including bank loans. Data from national accounts shows how financial
liabilities (or the funding mix) differ widely from one economic sector to the
other (Chart 1).[51] Households finance almost exclusively
through bank loans (almost 80 % of liabilities), while NFCs also use a variety
of other sources. With EUR 10.4 trillion or almost 40 % of financial liabilities,
unquoted shares and other equity is the main source of funding used by NFCs.
Bank loans represent almost 16 % of NFCs source of funding (EUR 5.3 trillion)
and securities issued in the markets, about 19 % (EUR 1.1 trillion of debt
securities and EUR 4.2 trillion of quoted shares).
Besides
the collection of taxes, governments finance their activities mainly through
the issuance of bonds (70 % of financial liabilities or EUR 7.6 trillion), but
loans are also significant (21 % or EUR 2.3 trillion).
Chart 1: Source
of financing by sector in the euro area (2013 Q3, EUR billion) and percentage
of total liabilities
Note: Equity of NFCs: EUR 14.6 trillion
includes quoted shares (EUR 4.2 trillion) and other equity (EUR 10.4 trillion).
The chart omits the net worth of households (EUR 43.0 trillion). For
government, bank loans include also other loans.
Source: ECB:
Euro area accounts and own calculations.
Overall,
banks provide up to EUR 12.0 trillion financing in the form of loans to these
three sectors (households, NFCs and governments), accounting to more than 25 %
of their financing sources.
As
shown in chart 1, on top of equity, bank loans and securities, other sources
are also relevant. For instance, they represent almost 30 % of all funding for
NFCs (EUR 8.0 trillion). 
Chart
2 provides a more granular breakdown of financing sources of corporates,
showing the percentage of small versus large corporates that have used the
relevant source of financing (rather than actual volumes). 
Chart 2: Source of financing for euro area non-financial
corporations (percentage of companies having used the source of financing in
2013 H1)
Source:
ECB Survey on the access to finance of SMEs in the Euro Area.
4.2.1 Increasing bank capital and loss absorbency
As explained below, the financial crisis
demonstrated that existing bank capital regulation was inadequate. Following
calls from the G20 and the Financial Stability Board (FSB), the global standard
setter for the prudential regulation of banks – the Basel Committee on Banking
Supervision (BCBS) – agreed in 2010/11 on new rules requiring banks to hold
more and better quality capital. At EU level, the new global standards are reflected
in the Capital Requirements Directive (CRD IV)[52] and Regulation (CRR)[53] (henceforth, the CRD IV package) that entered into force in July
2013.  
The role of bank capital 
The first (ex post) purpose of bank
capital is to deal with “unexpected” losses. Expected losses should be
covered by provisions and the income generated by the institution. Bank capital
is the guarantee of a bank’s financial soundness. It ensures that the bank can
absorb higher than expected losses. Thus, bank capital protects the taxpayer
from losses and minimises negative consequences of bank failures. 
A second (ex ante) purpose of bank
capital is to ensure that the bank takes less risk because shareholders
have more “skin in the game”. 
Important market failures (negative
externalities) arise when bank capital reaches low levels. First, externalities
may arise from fire-sales. When a bank under stress needs to liquidate its
assets rapidly, it will be ready to do so at below market prices to expedite
the process. This will also affect negatively the value of similar assets held
by other banks. Thus, a sell-off by banks under stress impose costs on other
market participants, putting pressure on their capital position and forcing
them to liquidate their assets, too, which pushes the asset prices further
down. This process might end in a vicious cycle where market participants are
forced to liquidate (fire-sales). The fire-sale problem is exacerbated when a
bank faces liquidity problems (short-tern funding) in addition to capital
constraints (see below section 4.2.2). Second, credit supply may be
constrained. In a stress situation, banks prefer to reduce illiquid assets,
because they require more capital to hold for the associated risks. Banks cut
therefore the supply in new loans to non-financial firms or adjust the risk
premium on existing loans, hampering in this way investments and economic
activity.
Given these market failures, regulators
need to establish minimum levels of capital for banks to absorb potential
losses, preventing banking problems spilling over to the economy. However, a
regime with flat, non-risk based capital requirements brings inevitably
potential for distortion, because it incentivises banks to invest in high-risk
assets, which has a negative impact for the sector and the economy (in extremis
this could crowd safe borrowers out of the credit market). To avoid these
distortions, the regulatory framework has to take the riskiness of assets into
account when setting minimum capital requirements. 
The benefits of a well-capitalised banking
system in terms of lower probability and cost of financial crises and the resulting
lower macroeconomic volatility are well recognised and have been analysed in a
number of studies (see also section 4.2.7 below). 
Changes
in bank capital requirements – towards the CRD IV package
The financial crisis highlighted the
problems with the existing EU framework for bank capital regulation, which was
embedded in the Basel agreements at international level (see box 4.2.2 for a
short overview). In particular, it proved unable to ensure that adequate levels
of sufficient quality capital were put in place to deal with solvency shocks.
It became clear when the crisis struck that what is needed in the banking
system is more and better capital and less leverage. Also, the regulatory capital
ratios had not always been able to signal individual bank distress[54]. The risk weighting system inherent in capital regulation was
allowed to become highly complex and turned out to be a poor proxy for the
actual risk of an institution. Moreover, regulation was unable to account for
the impact of financial innovation. At times, the latter has also been motivated
by the simple wish to circumvent prudential rules and minimise the applicable capital
requirements. 
The regulatory framework had a number of
other shortcomings, which are separately discussed in the subsequent sections.
It was funding liquidity problems that triggered the crisis, but liquidity was
largely left outside of the regulatory framework (see section 4.2.2). Moreover,
the risk weighting system turned out to fuel the natural procyclicality of
banking, amplifying the boom and the bust when it eventually occurred. Also, its
microprudential focus was ill-suited to take account of the increasing systemic
risk (see section 4.2.3).
Box 4.2.2: Changes in bank capital regulation 
In 1988, the Basel I international accord was signed. It was a landmark agreement: “International
Convergence of Capital Measurement and Capital Standard”, as it was the
first-ever genuinely international prudential regulatory agreement. More than
100 countries adopted the recommendation. The goals of the agreement were to
(i) improve the resilience and stability of the financial system and to (ii)
ensure a competitive level playing field internationally (between Japanese, US,
European and other banks). The accord consisted of merely 30 pages and defined
“capital adequacy rules” for banks at a global level. It specified the
calculation of the total minimum capital requirements for assuming credit risk
(later also market risk, see amendment below). The regulatory capital
requirements are expressed as a ratio and are hence composed of three elements:
(i) the numerator of the ratio defines regulatory capital; (ii) the denominator
of the ratio defines risk weighted assets (RWA); (iii) the ratio was expressed
as a minimum level: 8 % (the so-called “Cooke ratio”), i.e. per 100 units of
RWA, 8 units of capital are required. In 1996, a market risk amendment was
added to Basel I, covering market risk and recognising the internal risk models
used by banks (“Value-at-Risk” – VaR models).
The definition of bank
regulatory capital was more conservative than the accounting definition of
capital and consisted of Tier 1 and Tier 2 capital. “Tier 1” capital is going
concern loss absorption capital and mainly consists of common shares and
retained earnings. “Tier 2” is gone concern loss absorption and mainly consists
of hybrids, subordinated debt, and undisclosed reserves. Tier 2 could not be
larger than Tier 1 capital. Risk weightings (RW) and risk weighted assets (RWA
= RW x Assets) depend on issuer and location of issuer. There were 5 broad
categories of risk weights only: 0 % for cash and OECD government debt; 10 %
for loans to domestic public sector entities; 20 % for loans given to banks
incorporated in an OECD country; 50 % for loans fully secured by a residential
property; and 100 % non-OECD government debt, loans to the private sector,
non-OECD banks, real estate investments. RWA could be considerably smaller than
total assets, given the above weighting. For the same reason, regulatory
capital could hence be significantly smaller than 8 % of total assets. 
The Basel I framework
was very successful in levelling the playing field internationally, but also
displayed a number of shortcomings: risk categories were quite arbitrary (RW on
sovereigns used a blunt OECD versus non-OECD country split; RW on corporates
were always 100 % irrespective of the credit rating); there was ample scope for
regulatory arbitrage (364-day facilities were treated significantly different
from full one-year facilities, broad RW categories per issuer, etc.); there was
no portfolio approach despite obvious diversification gains across asset
classes and instruments; no rules for credit derivatives and securitisation
existed; and risk management advances (VaR models) were not incorporated. 
In response to these Basel I framework shortcomings, the Basel II agreement was reached in 2004. Greater detail
characterised this fundamental overhaul of capital adequacy regulation.
Internal models were extended to credit risk exposures and risk management
advances were further encouraged. Basel II was a much more risk-sensitive
framework. External and internal credit ratings were allowed. It was based on
three pillars (i.e. two additional pillars were introduced): minimum capital
requirements (”pillar 1”); supervisory review (“pillar 2”); and market
discipline (“pillar 3”). It was meant to be a “total risk” approach: credit,
market, and operational risk were all covered and a portfolio approach was
used. 
In direct response to
the financial crisis, early revisions to Basel II (known as Basel 2.5) in 2009 addressed
risks the exposed by the crisis that were related to trading, derivatives and
securitisation activities. The Basel 2.5 agreement introduced important changes
to the trading book capital requirements and the treatment of securitisation
exposures, including an incremental risk capital charge to reflect the risk of
large, but less frequent losses and the potential for large long-term
cumulative price movements. 
Following a more
extensive global effort, Basel III was agreed in 2010/11. Its application was
scheduled for January 2013, with the transition period to full implementation stretching
out to 2019. Basel III is the attempt by the regulators to learn the full set
of lessons from the financial crisis, acknowledging the shortcomings and
insufficiencies of the Basel II regulatory framework. It was obvious that banks
held insufficient capital and that more and better capital was needed in the
system. New definitions of capital components have been introduced. A shift of
focus towards higher quality "core Tier 1" capital instruments took
place. New targets for minimum capital requirements were set. The minimum
regulatory capital that a bank needs to hold remains at 8 % of RWA, but the
portion of capital of the highest quality that can fully absorb losses (common
equity Tier 1, CET1) has been increased from 2 % to 4.5 % of RWA. Moreover, to
be considered of the highest quality and therefore qualify as CET1, capital
instruments now need to satisfy a number of additional, more stringent
conditions. Additional capital buffers were introduced. This includes a capital
conservation buffer of 2.5 % of RWA, which raises the total capital requirement
to 10.5 % of RWA as well as an additional countercyclical capital buffer, a
surcharge for systemically important financial institutions and a systemic risk
buffer (see section 4.2.3 below for a discussion of the additional buffers).
Capital charges were changed to cover derivatives counterparty risk and trading
book related risks. 
The BCBS is driving the
international Basel framework agreements, but is not a legislator. Hence, the
EU and its Member States need to reflect in EU law any recommendations agreed
at Basel. Several pieces of EU legislation have given effect to the various Basel agreements in EU law, the latest being the CRD IV package.
In the run up to the global financial
crisis, banks’ balance sheets increased significantly, but on a very thin
capital base (chart 4.2.1). The trend to expand balance sheets prior to the crisis
was associated by an optimisation of risk models, suggesting low risks and
consequently low required minimum regulatory capital. The crisis demonstrated
not only the insufficient capital to absorb losses, but also the inability of
the regulatory ratios to  provide timely recognition of emerging bank weakness
so as to open the way to early corrective action by supervisors just before the
crisis (Carmassi and Micossi, 2012). Chart 4.2.2 shows that shortly before the
crisis the regulatory capital ratios (measured by Tier 1 capital in relation to
risk-weighted assets) were at 8 % for most banks and did not signal any
vulnerability; there was no difference in the evolution of the average capital
ratios of "crisis" banks (that ultimately needed government bailout)
and "non-crisis" banks. One reason for this are the shortcomings with
risk weights and internal models, as discussed below. 
 Chart 4.2.1: Total assets and equity of euro area monetary financial institutions (EUR billion) || Chart 4.2.2: Tier 1 capital ratios (%) 
 || 
 Source: ECB || Notes: sample of the 30 biggest EU-banks; "crisis" refers to those banks that received direct state aid during the crisis. Source: Capital IQ. 
Moreover, regulatory capital ratios
reported by banks did not reflect their true capacity to absorb losses. The
crisis made evident how several elements of what was considered
(high-quality) capital to absorb losses did not work out as they were supposed
to. For example, debt securities issued by banks that, in principle,
should have been able to absorb losses (so called hybrid securities) did not
perform as expected. Such securities were counted as capital, because they were
meant to reinforce a bank's balance sheet by stopping cash flows from exiting
the bank at times of distress. Unfortunately, the possibility to differ or
cancel such payments during the crisis was not used.[55] As a result, governments had to inject massive amounts of public
money into banks and provide guarantees in order to maintain essential
financial services for citizens and businesses (see Box 3.4.1). 
Chart 4.2.3 illustrates the changes in EU bank
capital requirements brought about by the CRD IV package (reflecting the global
Basel III agreement), including the new buffers (some of which are
discretionary or apply to some banks only, as further described in section
4.2.3 below).
Chart 4.2.3: Overview of the new CRD IV capital
requirements compared to previous standards
Notes: The new requirements only phase in
over time, with full implementation from 2019. The chart illustrates maximum
requirements, since some of the buffers only apply selectively (e.g. to
systemically important banks) or on a discretionary or temporary basis (e.g.
depending on the cycle). Note that in some cases higher buffers can be applied.
See section 4.2.3 for more detail on the buffers.
Source: Commission Services
Addressing trading, derivatives and
securitisation risks
A number of EU (and non-EU) banks in the
crisis incurred significant losses in relation to their trading and derivatives
activities, in particular in relation to traded credit (e.g. mortgages,
asset-backed securities, credit derivatives, structured credit). Substantial
losses were also incurred in relation to loan origination and syndication.[56] Many of the losses related to risks carried in the banks' trading
books as opposed to the banking book.
 Chart 4.2.4: Cumulative losses on the trading book relative to capital requirements 
 Source: Chart 3 in Haldane (2011). 
The crisis demonstrated that trading book
risks were not supported by appropriate levels of capital to deal with the
losses that eventually materialised (see chart 4.2.4 with UK evidence). The Basel II capital framework did not adequately capture risks related to
trading, derivatives and securitisation activities, allowing these activities
to balloon (see chapter 3.1) without appropriate capital charges to reflect the
risks. 
In direct response to these problems, early
revisions to Basel II (known as Basel 2.5) during the crisis addressed such
risks with an incremental risk capital charge to reflect the risk of large, but
less frequent losses and the potential for large long-term cumulative price
movements. Banks are now also required to estimate risks based on stressed
market situations that may lead to significant losses ("stressed
value-at-risk"). As regards securitisations, firms that repackage loans
into tradable securities are required to retain some risk exposure to these
securities, and investors in such securities to make their decisions only after
conducting comprehensive due diligence. Banks are also required to publicly
disclose more information and to hold more capital for re-securitisations. As
regards derivatives, further revisions (as part of Basel III) introduced an
additional capital charge for possible losses associated with the deterioration
in the creditworthiness of a counterparty of a derivative (to address
derivatives counterparty credit risk).[57]  
In May 2012 the Basel Committee launched a
fundamental review of market risk and trading book capital requirements. In
essence, the purpose of this review is to further strengthen capital standards
regarding the trading book as well as to achieve further comparability and
compatibility of required capital outcomes across banks (see below)[58].
In addition, in Europe, the Commission
adopted Regulatory Technical Standards prepared by the European Banking
Authority (EBA) to set out criteria for assessing when the specific risk of
debt instruments in the trading book is ‘material' enough to trigger an
evaluation by the competent authority. After this evaluation,
competent authorities will determine whether banks should incorporate specific
risk in their internal models for the purpose of capital requirements.
Improving
risk weights and internal models  
Minimum capital requirements are calculated
with respect to risk-weighted assets, which banks can calculate using their internal
risk models. While this is supposed to better reflect the true risk profile of
the banks, it can also lead to considerable divergences in the calculation of
risk-weighted assets for institutions with similar risk profiles. Concerns have
also been expressed about risk-weight optimisation of banks.[59] 
 Chart 4.2.5: RWA to Total Assets: G-SIFIs vs. Non G-SIFIs. 
 Source: Figure 1 in Blundell-Wignall, Atkinson and Roulet (2013). 
Chart 4.2.5 shows the ratio of RWA to total
assets (TA) for a sample of banks, distinguishing between banks classified as
global systemically important financial institutions (G-SIFIs and others). The
chart shows that during the period under consideration (2002-2012) the ratio
drastically decreased, and also that the G-SIFIs tended to have lower RWA to
total assets. Bank assets increased without a corresponding rise in
risk-weighted assets and hence without a corresponding higher capital
requirement. As noted above, lower risk-weights and hence lower required
capital allows banks to expand their balance sheet and increase the recorded
return on equity.  
 Table 4.2.1:  Development of capital ratios of Dexia 2006-2010. 
 Source:  CEPS (2011). 
Dexia is a prominent example to demonstrate
that high regulatory capital ratios, measured as capital in relation to
risk-weighted assets, did not automatically imply that the bank is safe. As
shown in Table 4.2.1, the bank recorded a core Tier 1 ratio as well as a
capital adequacy ratio that was well in excess of the minimum regulatory
requirements at the time (4 % and 8 %, respectively),[60] and this although the bank needed to be bailed out in 2008 and its
orderly resolution was approved in 2012.  At the same time, the ratio of total
equity to total unweighted assets was very low (1.9 % in 2010), indicating high
leverage that was not revealed by the risk-weighted regulatory capital ratio. 
There are significant differences between
banks when it comes to risk weighting of assets. This can be due to differences
in the approach to risk-weighting but also reflects differences in bank
business models. As illustrated in chart 4.2.6, banks with a greater focus on
more traditional retail business tend to have higher-risk weighted assets in
relation to total assets than banks with large wholesale banking and trading
activities. The latter also tend to be more leveraged. 
Chart 4.2.6: Risk weighted
assets over total assets and Leverage. 20 large EU banks. 2012.
Source: SNL
Financial, Leverage is estimated as amount of total assets to total equity
A negative relationship between
risk-weighted assets (in proportion to total assets) and leverage (expressed as
the ratio of total assets to total equity) is also evident in chart 4.2.7.[61] In general, it
tends to be the large banks with significant trading book activities that
display relatively high leverage, but low risk-weighted assets. 
Chart 4.2.7: Risk weights
versus leverage, for the biggest 20 EU banks 2012
Source: SNL
Financial, Commission Services calculations. 
The CRD IV package improves the
risk-weighted capital requirements along key dimensions, by raising the level
and quality of the capital requirements and by better reflecting the underlying
risks, in particular those linked to the trading book and derivative
activities. 
Moreover, as part of the fundamental review
of the trading book, the BCBS has put forward a revised framework that
addresses concerns about the inherent modelling risks and measurement errors of
risk-weighted capital requirements that are calculated by the banks using
internal models. In particular, it introduces a revised internal models-based
approach, which encompasses a more rigorous model-approval process and more
consistent identification of material risk factors; banks' ability to reduce
capital requirements by recognising hedging and diversification is also
constrained and must be based on empirical evidence that such practices are
effective during periods of stress. In addition, as an alternative to internal
models, a revised standardised approach is put forward that is sufficiently
risk-sensitive and appropriate for banks that do not require sophisticated
measurement of market risk. Moreover, the revised framework establishes a
closer calibration of the two approaches, requiring mandatory calculation of
the standardised approach by all banks, and requiring mandatory public
disclosure of standardised capital charges by all banks, on a desk-by-desk
basis.[62] More generally, the BCBS has established comprehensive review
programmes to ensure the timely and consistent adoption of Basel III as well as
consistency in the treatment of risk-weighted assets both in the trading book
and the banking book. [63]
At European level, EBA is also addressing
such concerns.[64] In particular, following its stress test and recapitalisation
exercise in 2012, questions were raised as to why there were significant
differences in the denominator of the capital ratios (i.e. risk-weighted
assets) and material differences in banks' regulatory parameters (probability
of default – PD and loss given default – LGD). While differences in risk
parameters and capital requirements between banks are not a sign of
inconsistency per se, a substantial divergence between similar portfolios may
signal that the methodologies used for estimating risk parameters require, in
some cases, further analysis. The BCBS has also established comprehensive
review programmes. 
In this regard, the overall results of the
review on RWAs will inform the work EBA is conducting in parallel on the
validation of internal models, which will also contribute to better
harmonisation of supervisory and banks' practices and to enhancing consistency.
A deeper understanding of what drives differences in RWAs will allow the EBA to
explore a number of options to address specific concerns. These include using
existing guidelines, where appropriate, to enhance convergence in the
computation of RWAs, and to improve Pillar 3 disclosures, as well as the
validation and ongoing monitoring of internal models.[65] 
Leverage ratio to complement risk-based
capital requirements 
The leverage ratio is proposed in the CRD
IV package as a new complementary tool to enhance the prudential regulatory
framework. It is primarily intended to restrict the build-up of leverage in the
banking sector and to complement the risk-based capital requirements with a
non-risk based "backstop" measure. The leverage ratio should also
present an extra layer of protection against model risk and measurement error. 
Leverage ratio as proposed by Basel[66]
The BCBS defines the leverage ratio as the
proportion of Tier 1 capital to a so called "exposure measure".
Whilst the numerator is clearly defined, the "exposure measure" that
generally follows the accounting rules for the value of assets is more complex.
It includes special rules for some asset classes. For example, for the
on-balance sheet items, "exposure" refers to the book value of
assets, except for derivatives and securities financing transactions (repos)
which are measured at their market value. In addition, specific rules allow
limited netting of repos and special treatment of credit derivatives. However,
netting of loans and deposits is not allowed. The off-balance sheet assets are
weighted according to the risk weights in the standard approach, so that the
"exposure measure" is not entirely risk-free. Some opponents of the
leverage ratio argue that it is too complex and might give rise to creative
solutions to reduce the leverage ratios and to potential for arbitrage.  
In December 2013, the BCBS proposed a
leverage ratio of 3 %. For many EU banks, a rate which is higher than 3 % would
make the leverage ratio the primarily binding capital requirement. This might
have adverse effects on asset allocation and pricing of "low risk"
exposures, such as of SME loans and mortgages. While the leverage ratio is an
important backstop, it should not become the major instrument for loan pricing
and allocation of financial activities in the economy. 
Since the leverage ratio is a new
regulatory tool in the EU, there is a lack of information about the
effectiveness and the consequences of implementing it as a binding measure. It
is therefore important to gather more information before making the leverage
ratio a binding requirement. The Commission therefore proposes a step by step
approach. Banks are required to calculate a leverage ratio and disclose it
starting from 2015. Data is gathered on the leverage ratio as of 1 January
2014, and a report is prepared by end of 2016 including, where appropriate, a
legislative proposal to introduce the leverage ratio as a binding measure as of
2018. The observation period will allow gathering information to understand
better the implications of introducing binding leverage ratio requirements and
to be able to calibrate these requirements appropriately. The period will also
be used to monitor possible unintended consequences and in particular risks
related to disorderly deleveraging (see also chapters 6 and 7).
Recent improvement in banks' capital
ratios
The CRD IV package entered into force in
summer 2013. Institutions are required to apply the new capital rules as of 1
January 2014, but there is a gradual phasing in, with full implementation on 1
January 2019. As such, it is too early to observe the full effect of the
measures in the market. 
However, European banks have already made
progress in boosting their capital positions and thereby strengthening the overall
resilience of the European banking system. The process has been uneven and some
banks still need significant repair of their balance sheet. 
The general improvements in bank
capitalisation are in part a response to market pressures following the lessons
learned in the financial crisis as well as early convergence to the new capital
rules. Moreover, the EBA conducted a one-off bank recapitalisation exercise in
2011/2012 in the context of a series of coordinated policy measures to restore
confidence in the EU banking sector. Against the developments in the markets
and the deterioration of the sovereign debt crisis in Europe, the EBA reviewed
banks' actual capital positions and sovereign exposures and requested them to
set aside additional capital buffers. It called on national authorities to
require banks to strengthen their capital positions by building up an
exceptional and temporary capital buffer against sovereign debt exposures to
reflect market prices as at the end of September 2011. In addition, banks were
required to establish an exceptional and temporary buffer such that the core
Tier 1 capital ratio reaches a level of 9 % by the end of June 2012. With this
recapitalisation exercise and a number of other EU-driven remedial actions,
more than EUR 200 billion has been injected into the European banking system.[67]
Based on aggregate EU balance sheet data,[68] the level of total equity of EU banks was EUR 1 818 billion at the
end of 2008 and EUR 2 310 billion at the end of 2012. Thus, the increase in the
total equity of EU banks for the period 2009-2012 was EUR 492 billion, which
represents a 27 % increase in total equity. 
The improvements in bank capitalisation
since the crisis are also visible in regulatory capital ratios. The median Tier
1 capital ratio of banks in the euro area increased from 8.7 % in 2008 to 12.7
% in 2012, as estimated by the ECB.[69] According to the ECB study, this increase has been mainly achieved
through a reduction in RWA by deleveraging and decreasing exposures with higher
risk weights. In other words, banks have achieved higher capital targets by
downsizing regulatory capital-intensive activities and selling assets, in
particular those that are non-core or those that do not meet profit targets and
rely on cross-subsidisation from other parts of the business.
Chart 4.2.8 shows the Tier 1 capital ratios
of a sample of the 20 largest EU banks. From 2005 to 2007, these banks had a
capital base of about 8 % of RWA. Starting from 2008, the Tier 1 capital ratio
gradually improved through to 2012. In 2012, all of these 20 EU banks had a
reported Tier 1 capital ratio of more than 11 % and more than half of the banks
reached capital ratios of over 13.3 %.  
The EBA's monitoring exercise (with data
from June 2013) shows a similar trend of increasing capital.[70] For the sample of internationally active large banks (the so-called
Group 1 banks),[71] the average common equity Tier 1 (CET1) ratio increased by 0.8
percentage points compared to the previous exercise (with reporting date
end-December 2012). By June 2013, the reported Tier 1 and total capital ratios
were on average 13.4 % and 16 %, respectively, for Group 1 banks. For the
smaller banks in Group 2, the corresponding figures were 13 % and 15.8 %. 
These capital ratios are the current
"as reported" ratios and do not yet reflect the new Basel III
definitions of capital (in the numerator) and increases in risk-weightings (in
the denominator). For example, the Group 1 banks' average Tier 1 ratio would
decline from 13.4 %, under the current rules, to 9.2 % under Basel III.
Similarly, for Group 2 banks, the average Tier 1 ratio would decline from 13 %
to 9.3 %. 
While the majority of banks already meet
the new capital requirements, some banks fall short and need to build more
capital. For Group 1 banks, the total capital shortfalls corresponding to the
regulatory ratios (including capital conservation buffer and the surcharge for
global systemically important banks) amount to EUR 103.3 billion (Tier 1
capital). The CET1 shortfall as of June 2013 is EUR 36.3 billion, down from EUR
70.4 billion in December 2012. For Group 2 banks, the CET1 shortfall compared
to the target level would be approximately EUR 29.1 billion. These shortfalls
are calculated assuming full implementation of Basel III, which in practice
only occurs from 1 January 2019.
Progress has been less marked in relation
to the leverage ratio. Based on EBA's monitoring exercise, chart 4.2.9 shows
that the average Basel III Tier 1 leverage ratio has generally fluctuated
around 3.4 % for Group 2 banks during June 2011 and June 2013. For Group 1
banks, the leverage ratio is lower on average, and while it increased until
June 2012, it remained at or slightly below the 3 % target since then. It
should be pointed out that 66 % of Group 1 banks and 76 % of Group 2 banks
would already meet the Basel III Tier 1 leverage ratio.[72]  
 Chart 4.2.8: Evolution of Tier 1 capital ratios (%) || Chart 4.2.9: Evolution of leverage ratios (%) 
 || 
 Source: SNL Financial, Commission Services calculations. || Source: EBA (2014) 
4.2.2
Improving liquidity buffers and preventing excessive maturity transformation 
While strong capital requirements are
necessary to improve the solvency position of banks and their ability to absorb
losses with capital, they are by themselves not sufficient to enhance the
resilience of banks. Banks also need a strong liquidity base and to adequately
manage their cash flows and liquidity position, in particular to sustain
stressed market conditions.  
The crisis has shown that institutions' did
not hold sufficient liquid means (e.g. cash or other assets that can be quickly
converted into cash with no or little loss of value). Many banks had
inappropriate funding structures. When the crisis hit, they were short of
liquid assets and not able to raise cash as funding markets had dried up. This
would have contributed to the demise of several financial institutions if it
had not been for the state aid interventions and central bank support.
Liquidity stress situations have proved lasting over time. While a number of
Member States already imposed some form of quantitative regulatory standard for
liquidity, others did not, and there was no harmonised regulatory treatment at
EU level.[73] 
There is a strong economic case for
introducing bank liquidity requirements.[74] Banks play a valuable role in the economy in providing liquidity
insurance (see chapter 2) and maturity transformation. The resulting maturity
mismatch between short-term funding (e.g. deposits and wholesale debt funding)
and longer-term investment (e.g. bank loans) is a defining characteristic of
banks. As a result, banks are inherently unstable and vulnerable to confidence
crises (materialized either through depositor runs in retail markets or, in the
context of the recent crisis, short-term creditor or repo runs in wholesale
markets).
This is costly: a fundamentally solvent and
healthy bank can be forced into insolvency in the event of a depositor run on
the bank, which may force the bank to liquidate illiquid assets at a loss
("fire sales"). Similarly, and more relevant in the context of this
crisis, interbank lending can freeze if banks stop trusting each other. Money
market funds and other short-term creditors can lose confidence in individual
banks and the entire banking sector. Thus, the wholesale funding market can dry
up if confidence evaporates or risk aversion in the market increases. Raising
cash at short notice through the sale of assets may be impeded if there are
wider stresses in the market. Indeed, market illiquidity (i.e. inability to
sell an asset at short notice with little price impact) often interacts with
funding illiquidity in times of crisis. This can create a funding shortage as
banks are neither able to borrow funds nor sell assets, except at prohibitive
cost or loss. In times of crisis, these liquidity problems can turn instantly
into a solvency problem.[75]    
To reduce the risk of bank runs, well-known
instruments have been put in place, such as deposit guarantee schemes and
lender of last resort facilities (LoLR or emergency lending assistance, ELA). The
recent government guarantees on newly issued debt and the large-scale LTROs by
the ECB (see Box 3.4.1) play a comparable role. However, such safety nets can
give rise to excessive risk-taking behaviour by the beneficiary banks, and they
risk creating competitive distortions through an artificially lowered funding
cost for beneficiary banks. Averting these moral hazard risks makes a case for
regulating liquidity (and for regulating banks more generally).  
Regulating funding liquidity can help
support market confidence in the ability of a bank to fulfil its short-term
obligations without generating huge distress. The crisis presents clear
evidence pointing out how the collapse of market confidence and trust (and the
bursting of a liquidity “bubble” based on under-priced risks and
self-fulfilling beliefs) was an important reason for the deterioration of
liquidity conditions in wholesale markets. Banks which were excessively funded
in the short-term money market or reliant on securitisation ran out of cash. 
During this financial crisis, many of the
institution which significantly relied on short-term wholesale funding needed
to be bailed out. There is evidence that banks’ reliance on short-term
wholesale funding resulted in increased financial fragility (Demirgüç-Kunt and
Huizinga, 2009 and 2010; Ratnovski and Huang, 2009). Banks with more stable
funding structures continued to lend more relative to other banks during the
global financial crisis (Cornett et al., 2010) and were less likely to fail
(Bologna, 2011). 
Regulation of bank liquidity is necessary
where there is otherwise a risk of banks engaging in excessive maturity
transformation and building up excessive asset-liability mismatches (usually
combined with excessive leverage). By reducing these risks, liquidity
regulation can enhance the resilience and stability of banks.  
The CRD IV package adopted progressive
phasing in of LCR until 2018, i.e. one year earlier than Basel III (see box
4.2.3). Depending on the results of the observation period applied to the NFSR
and reports prepared by the EBA, the Commission will prepare, if appropriate, a
legislative proposal by the end of 2016 to ensure that institutions use stable
sources of funding[76].
 Chart 4.2.10: Reduction in the reliance on wholesale funding 
 Source: ECB 
Since the liquidity requirements are yet to
be phased in, it is too early to observe the impact in the market. However,
market pressures and the expectation of future liquidity requirements already
have induced banks to improve their liquidity position. 
For example, aggregate
balance sheet data for EU banks suggests that banks reduced their reliance on wholesale funding and increased
their use of customer deposits as a funding source over the period 2008 to 2012
(see chart 4.2.10).  
Based on EBA's monitoring exercise, 60 % of
the large banks in the sample ("Group 1 banks") already met the
minimum requirement of a 100 % LCR by June 2013, compared to 69 % of the
smaller Group 2 banks. In total, the LCR shortfall was EUR 262 billion, which
represents about 0.8 % of total assets. Banks are less prepared for the NSFR.
While more than 50 % of the banks in the sample already meet or exceed the
minimum NSFR requirement, the total amount needed to fulfil the minimum
requirement of stable funding is EUR 833 billion.  Since the new requirements
are only gradually introduced, banks that are below the requirements can still
take a number of measures until 2018 to meet the standards, including
lengthening the term of their funding or reducing maturity mismatches. 
Box 4.2.3: Basel III global liquidity
standards
Basel III introduced for the first time
internationally harmonised liquidity standards. It requires banks to manage
their cash flows and liquidity much more intensely than before, to predict the
liquidity flows resulting from creditors' claims better than before, and to be
ready for stressed market conditions by having sufficient "cash"
available, both in the short term and in the longer run. More specifically,
Basel III introduced two new liquidity ratios:
- Liquidity Coverage Ratio (LCR) to
improve short-term resilience of the liquidity profile of financial
institutions. The LCR requires banks to have sufficient high-quality liquid
assets (HQLA) to fund projected cash outflows over a 30-day period. The
standard requires that, absent a situation of financial stress, the value of
the LCR is no lower than 100 % (i.e. the stock of HQLA should at least equal
total net cash outflows), so that the banks have a defence against the
potential onset of liquidity stress; and 
- Net Stable Funding Ratio (NSFR) to
ensure that a bank has significant levels of stable funding to support its
activities over the medium term. NSFR should help limit excessive maturity
transformation and over-reliance on short-term wholesale funding, taking into
account the liquidity profile of a bank's assets and off-balance sheet
commitments, over a one-year period.
4.2.3
Reducing pro-cyclicality and systemic risk
One of the most destabilising elements of
the crisis has been the procyclical amplification of financial shocks
throughout the banking system and wider economy – i.e. banks (and other market
participants) behaved in a procyclical manner, rapidly expanding their balance
sheets and leveraging up in the pre-crisis boom years, but then deleveraging
when the crisis hit and liquidity dried up. When the crisis hit, financial
markets forced banks to deleverage in a manner that amplified downward
pressures on asset prices. The deleveraging process exacerbated the feedback
loop between bank losses, falling bank capital and shrinking credit
availability (see also chapter 6). Bank behaviour fuelled the bubble in the
boom phase and would in any case have worsened the bust when the cycle turned
abruptly if it had not been for the unprecedented state aid and central bank
support.
The pre-crisis regulatory framework
contributed to the procyclicality.[77] Capital rules that are risk-sensitive introduce, by construction, a
degree of cyclicality in minimum capital requirements over time. However, the
main pro-cyclical dynamic of the Basel II capital framework was its failure to
capture key risk exposures for banks in advance of the crisis, such as complex
trading activities, securitisations and exposures to off-balance sheet
vehicles. Banks were able to expand their balance sheets (and off-balance sheet
activities) in the pre-crisis boom years without carrying capital to protect
against these risks. As described above, the CRD IV package will disincentivise
the procyclical behaviour by requiring banks to hold minimum capital for these
risk exposures and, as
described below, by introducing additional capital buffers that swing with the
business cycle.  
Ensuring a minimum leverage ratio can
further reduce procyclical dynamics. If bank capital is only 2 % of the balance
sheet (i.e. leverage amounts to 50), then following a loss of EUR 2 million,
the bank must either recapitalise or liquidate EUR 100 million worth of assets
just to re-establish that 2 % leverage ratio.[78] For the same loss, a bank with a higher starting leverage ratio
level of 3 % (4 %) would "only" need to liquidate EUR 66 million (EUR
50 million) of assets, and so on. Deleveraging puts pressure on asset markets,
inducing prices to fall, with negative repercussions for other market
participants which also have assets of the same class on their books. As shown
with the simple numerical example, the extent of the required deleveraging
following a loss depends on what the bank's capital position is. The higher the
leverage ratio (i.e. the more capital the bank holds) the lower the
deleveraging pressures in response to a shock. 
There is empirical evidence that banks
adjust their balance sheet actively, and do so in a way that leverage is high
during booms and low during busts, in particular for banks engaged in
investment banking activities.[79] That is, leverage itself is procyclical. A minimum leverage ratio will
help ensure that banks' capital position cannot fall below a certain level for
any given balance sheet size, thereby dampening the dynamics described above.[80] 
The new capital adequacy framework contains
a number of other key provisions to reduce procyclicality, including inter
alia:

 the capital conservation buffer – banks are required to conserve capital to build buffers that
     can be used in periods of stress. The buffer is set at 2.5 % of
     risk-weighted assets. Banks
     are allowed to draw on this buffer in periods of stress. However, the
     closer their common equity is to the minimum requirement, the greater the
     constraints they will face on the distribution of earnings (e.g. dividend,
     share buybacks, bonuses); and
 the countercyclical capital buffer – there is an additional discretionary buffer which allows
     national regulators to require up to another 2.5 %
     of capital during periods of high credit growth. In justified cases,
     national authorities may set even higher buffer rates. The buffer will be
     implemented depending on national circumstances with the ultimate goal to
     protect the banking system against excessive credit growth.

As regards the capital conservation buffer,
at the onset of the financial crisis, a number of banks continued to make large
distributions in the form of dividends, share buy backs and generous
compensation payments even though their individual financial condition and the
outlook for the sector were deteriorating. Much of this activity was driven by
a collective action problem, where reductions in distributions were perceived
as sending a signal of weakness. However, these actions made individual banks
and the sector as a whole less resilient. Many banks soon returned to
profitability but did not do enough to rebuild their capital buffers to support
new lending activity. Taken together, this dynamic has increased the
procyclicality of the system.[81]  The new buffer seeks to address this market failure and promote
capital conservation in the banking sector.
As regards the countercyclical capital
buffer, the financial crisis (just like previous banking crises) was preceded
by a period of rapid credit growth in many parts of Europe (see chapter 3 for
data on EU private and public sector debt levels). The losses in the banking
sector and resulting deleveraging pressures exacerbated the downturn in the
economy (as banks reduce their lending), which in turn further destabilised
banks (as borrowers are less able to service their debt and the proportion of
non-performing loans increases). If banks are required to build up additional
capital in periods when credit is growing to excessive levels, this increases
their ability to absorb losses. Moreover, the building up of higher capital
would help moderate excessive credit growth in the first place.
Reducing systemic risk
While procyclicality amplified shocks over
the time dimension, a separate problem is the excessive interconnectedness
among banks (and other financial institutions), which contributes to the
transmission of shocks across the financial system and economy. In line with
international Basel III requirements, the new capital adequacy framework
contains a number of rules to reduce interconnectedness and systemic risk in
the banking system, including:

 higher capital requirements for
     systemically important banks: the CRD IV includes a mandatory systemic
     risk buffer of CET1 capital for banks that are identified by the relevant
     authority as globally systemically important. The identification criteria
     and the allocation into categories of systemic importance are in
     conformity with the G20 agreed criteria (size, cross-border activities and
     interconnectedness). The mandatory surcharge will be between 1 and 3.5 %
     of RWAs and will apply from 1 January 2016 onwards;[82]
 a systemic risk buffer: Member States may
     introduce a systemic risk buffer of CET 1 capital in order to prevent and mitigate
     long-term non-cyclical systemic or macro-prudential risks;[83]
 higher capital requirements for OTC
     derivatives that continue to be cleared bilaterally, so as to incentivise
     central clearing (see section 4.3.2 below);
 higher capital requirements for trading
     and derivative activities, as well as complex securitisations and
     off-balance sheet exposures (e.g. structured investment vehicles);
 higher capital requirements for
     inter-financial sector exposures; and the introduction of liquidity
     requirements that penalise excessive reliance on short term, interbank
     funding to support longer dated assets. 

The proposed structural reforms in the
banking sector are also intended to reduce interconnectedness and systemic risk
(see section 4.2.6). In addition to better regulations, the reforms seek to
improve the supervision of banks by putting greater emphasis on the stability
of the banking system and wider financial system as a whole (as opposed to only
concentrating on the supervision of individual banks). As further discussed in
section 4.6, as part of the new European System of Financial Supervision
(ESFS), the European Systemic Risk Board (ESRB) is now responsible for the
macro-prudential oversight of the financial system within the EU to help
prevent and mitigate systemic risks.[84]
4.2.4
Improving bank governance and risk management 
The financial crisis revealed fundamental
failures in bank governance and risk management systems (as well as significant
failures in the assessment of risks by regulators and supervisors).  The banks
that failed or encountered difficulties and had to be bailed out by governments
were generally lacking an appropriate risk culture[85]. In many cases, there was insufficient oversight by Boards on
executive management. Boards were not adequately involved in strategy and gave
low priority to risk issues as compared to other topics. Banks were allowed
and, in some cases, even encouraged, by their Boards to take excessive risks
that included unprecedented levels of leverage and high-risk business
strategies. More generally, the risk management function in banks was not given
the proper weight in the decision-making process, as part of a wider lack of
a risk culture within banks. Consequently, risk
issues were often not given appropriate consideration in major management
decisions. Supervisors failed to exert proper monitoring and control over banks
and their risk management practices. Furthermore, shareholders did not fulfil
their role of "responsible owners", which should have entailed
actively monitoring companies and using shareholder rights to ensure long-term
value creation for companies and improve their corporate governance and
strategy. This form of market discipline failed. 
The impact of weak risk management and
internal control systems at banks was further aggravated by improperly
structured remuneration policies, including the large annual cash bonuses that
make up a key variable element of remuneration in banks, in particular for investment
banks. These remuneration structures failed to align employees' incentives with
the long-term performance of the bank and instead provided incentives for
excessive risk taking that maximised profits in the short-term. Moreover, while bankers
and traders shared in any profits they generated, losses in the crisis were
predominantly borne by shareholders and taxpayers. 
The
EU regulatory response
As part of the CRD IV package that entered
into force in July 2013, the reforms undertaken by EU institutions have focused
on: (i) risk management, ii) remuneration policies, and (iii) transparency.
Under the new rules, risk management
policies for banks must be established that set out effective internal
processes to identify, manage, monitor and report on the risks the institutions
are or might be exposed to. Also, the risk management function is empowered to
be independent from operational line units and to inform senior management
directly.
Additional
rules apply regarding the choice and composition of board members. Members must
possess sufficient knowledge, skills and experience and allocate sufficient
time to perform their duties. This is particularly important given the
complexity of many large banking groups today, which generates significant
difficulties for non-executive members of management bodies to understand all
dimensions of potential and actual risks taken by the financial institution. In
significant institutions, a committee must be established to search for
candidates and pick and nominate management. To ensure appropriate
responsibility and accountability, the number of directorships held is limited.
Institutions are now required to have diversity policies regarding gender, age
and geographical origin, as well as with respect to the management’s
educational and professional background. These requirements will help limit the
possibility that management becomes captured by “group-think”. The measures are
meant to allow and promote constructive criticism and a necessary level of
scrutiny. Finally, to guarantee independence and avoid conflicts of interest,
the reforms now establish that the chairman of the management body cannot hold
at the same time supervisory and executive (CEO) functions. This will ensure
that dominant executive members of the board can be questioned and challenged
by external and non-executive members.
The reforms seek to improve remuneration
policies by limiting incentives for short-term risk-taking and realigning
employees´ incentives with the long-term interest of the firm. The variable
component of remuneration of so-called “material risk takers” is now to be
based on a multi-year analysis of the performance of the individual, the
respective unit and the bank as a whole. At least 40 % to 60 % of variable
compensation will be deferred within a 3-5 year period and at least 50 % of variable
compensation will be paid in non-cash instruments. Moreover, 100 % of variable
remuneration is now subject to claw-back clauses to enable alignment with
realised (ex-post) risk. Also, at institutions that supervisors consider
significant enough, remuneration policies will be designed by a remuneration
committee at the board level. Furthermore, to tackle excessive risk taking, the
approved reforms also set a maximum ratio between the fixed and variable
components of total remuneration of 1:1, with a possibility for shareholders to
raise it to 1:2.[86] 
Transparency is enhanced by making sure it
extends to the bank’s risk management objectives and policies as well as with
respect to its remuneration standards. In this regard, the reforms now make it
imperative for institutions to disclose in an annual remuneration report how
many employees earn more than EUR 1 million per year. Additionally, CRD IV also
requires public disclosure – on a country-by-country basis – of company names,
people employed, overall turnover, profits made, taxes paid and subsidies
received.
Taken together, the new standards for
internal risk management, remuneration and transparency are expected to reduce
excessive risk-taking behaviours and improve the overall risk culture in banks.

There is already evidence that the risk
governance of banks has significantly improved since the financial crisis. For
example, a thematic review by the Financial Stability Board (2013) of 36
banking groups across the G20, including EU banks, found improvements in some
key areas, including in: 
·        
assessing the collective skills and
qualifications of the board as well as the board’s effectiveness; 
·        
instituting a stand-alone risk committee that is
composed only of independent directors and having a clear definition of
independence; 
·        
establishing a group-wide chief risk officer
(CRO) and risk management function that is independent from revenue-generating
responsibilities and has the stature, authority and independence to challenge
decisions on risk made by management and business lines; and 
·        
integrating the discussions among the risk and
audit committees through joint meetings or cross-membership.
Indeed, the review found that many of the
best risk governance practices at surveyed firms are now more advanced than
national guidance. The FSB interprets that this outcome may have been motivated
by firms’ need to regain market confidence rather than regulatory requirements.
While progress has been significant, the FSB review also identified gaps in the
risk governance frameworks at the surveyed banks and a need for further
progress in some areas. The need for further progress in the area of risk
governance has also been recognised by the industry.[87] 
4.2.5
Establishing crisis management and bank resolution frameworks
Failures of
banks cannot be ruled out, and although the above measures reduce the
probability of bank failure occurring, they explicitly are not providing a
zero-failure regime. Hence, there must be tools for dealing with bank failures
and mitigating their impact.  
The financial crisis has shown that public
authorities generally lacked adequate tools to identify and effectively deal
with unsound or failing financial institutions. Among other reasons, such tools
are needed to prevent insolvency or, when insolvency occurs, to minimize its
impact by preserving the critically important functions of the bank concerned,
and isolating its negative elements. When confronted with failing banks during
the crisis, public authorities faced a trade-off to either preserve financial
stability or protect taxpayers' money. While authorities were able to develop
appropriate tools to ensure the former,[88] they lacked appropriate tools to safeguard the latter and deal with
bank failures without compromising public finances. As noted in chapter 3.4, a
total of EUR 1.5 trillion in state aid was used to bail out and support EU
financial institutions (mainly banks) in the crisis. 
Part of the problem is that standard
liquidation and bankruptcy procedures are not well suited to preserve the
critical functions of banks. Bankruptcy provides legal protection against
creditors regarding the assets of a firm, financial or non-financial. For
instance, it can imply that creditors are prohibited from seizing or selling
collateral, starting or continuing litigation against the debtor or taking
other action to collect what is owed. The objective of bankruptcy is to
maximize the value of the firm to address the claims of creditors as a whole.
In general, bankruptcy law is designed to
grant temporary protection to the insolvent firm from its creditors and to
allow the firm to continue to operate and to preserve and realise maximum
value. Bankruptcy applied to an insolvent bank would hence protect the bank
from its "creditors", but this implies that depositors would lose the
full access to their accounts and that borrowers would lose full access to
their lines of credit. This is likely to give rise to financial panic and bank
runs elsewhere in the financial system, given that liquidity provision and the
general presumption of having guaranteed access to deposits is at the heart of
the bank business model. Also, banks are at the nexus of the payments system. If
bankruptcy and liquidation are initiated, this is likely to be much more
disruptive to the bank's creditors, counterparties and the wider economy than
is the case with a non-financial corporate.[89] Hence, liquidating a bank under normal bankruptcy proceedings is
not an option often used by public authorities. 
Lehman Brothers, the largest bankruptcy in US history at its time, exemplifies the time, cost and wider implications that a financial
institution's bankruptcy can have for the wider economic and financial system.
Strictly speaking, Lehman Brothers was not a bank: it was a bank holding
company that included several banks. Once it filed for bankruptcy on September
2008, it did not emerge from it until March 2012 and as a former shadow of
itself: an estate solely devoted to pay creditors[90].
Given the difficulty of taking banks into
bankruptcy, some governments developed special tools to deal with failing and
failed banks that have systemic significance. These include establishing, for
instance, separate bankruptcy proceedings for banks. They also include
developing what are known as resolution tools, which allow for an orderly
intervention by authorities.
Some of these resolution tools performed
relatively well during the crisis. For instance, unlike EU Member states, the US already had special resolution tools in place: The Federal Deposit Insurance Corporation (FDIC)
in the US had resolution powers. While relatively few banks were allowed to
fail in the EU (less than 40), approximately 500 small and medium-sized banks
where resolved in the US[91]. Moreover, in 2010 the US upgraded its tools with the Dodd-Frank
Act to also be in a position to better deal with the failure of larger banks.
Referring to the failure of Lehman Brothers in particular, the FDIC made the
case that recovery rates with the new tools would have allowed Lehman's general
unsecured creditors to fetch 97 cents on the dollar, instead of the 25 that its
estate is expected to deliver[92].
In the EU the problems were magnified by
the interaction present between increased cross-border operations of banks with
legislative differences across Member States. The absence of common conditions,
powers and processes for bank resolution constituted a barrier to the smooth
operation of the internal market and hindered cooperation between national
authorities when dealing with failing cross-border banking groups. Although
special bank resolution regimes were developed at national level in response to
the crisis, these were divergent and risked not being capable of dealing with
failures of cross-border banks. Thus, EU level intervention was necessary to
avoid the distortions caused by diverging national approaches and thereby
improve the resolution of cross-border banks.
The new EU Bank Recovery and Resolution
Directive (BRRD)
In June 2012, the Commission proposed a
common framework of rules and powers to ensure that authorities are able to
intervene early to restore the viability of a financial institution that faces
financial distress and, where necessary, allow a failing financial institution to
exit the market in an orderly manner while safeguarding its critical functions,
avoiding disruptions to economic activity, minimising recourse to taxpayers and
protecting depositors adequately. 
The Bank Recovery and Resolution Directive
(BRRD) covers deposit-taking banks and large investment firms. Past crises have
demonstrated that banks and investment firms (hereafter both referred to as
‘banks’ and ‘institutions’ interchangeably) represent the kinds of business
models most prone to experience a destabilising loss of confidence in their
ability honour their obligations and to give rise to systemic concerns at the
point of failure. These institutions are also those subject to harmonised
prudential requirements under the Capital Requirements Regulation and
Directive.
BRRD was agreed by the co-legislators in
December 2014. It was subsequently approved by the European Parliament in April
2014 and is expected for a final vote in the Council in May 2014. Publication
is foreseen in June 2014. The BRRD will help to:

 ensure that the supervisors and
     resolution authorities adequately plan and prepare for the distress banks may
     face and, where possible, prevent such distress through ex-ante measures;
 improve supervisors' capability and
     capacity to intervene at an early stage;
 provide authorities with harmonised
     resolution tools and powers to deal, in particular, with cross-border institutions
     in a coordinated manner; and
 place the burden of financing bank resolution
     on private resources, as opposed to taxpayers.

As regards planning, preparation and
prevention, the BRRD requires banks to draw up and regularly update recovery
plans which clearly set out the measures they would take to restore their
financial position in the event of a significant deterioration. Resolution
authorities will have to prepare resolution plans for each institution and
present the actions they might take if a bank meets the conditions for
resolution. Based on the plans, resolution authorities are to identify the
obstacles to resolve an institution, including a bank’s holding company and
subsidiaries. To address the impediments to resolution, they can ask, amongst
other things, an institution to change its legal or operational structures to
ensure it can be resolved with the available tools in a way that does not
compromise its critical functions.
The BRRD further sets out early
intervention powers. These powers are available to a supervisor when an institution
does not meet or is not likely to meet the requirements set out under the CRD
IV package. In this case, authorities can ask banks to implement the measures
set out in its recovery plan (if not already activated), require the management
body of the institution to be removed or replaced, draw up a new plan with
specific timeframes, and require the institution to convene its shareholders or
creditors in case urgent decisions need to be taken, including those with a
material impact on the long-term viability or status of the institution. In
addition, in certain cases, supervisors can appoint temporary administrators to
run the bank for a limited period of time.
With the BRRD, resolution can be triggered
once a bank is failing or likely to fail, there is no reasonable prospect that
an alternative private sector measure, including supervisory action, would
prevent failure of the institution in a timely fashion, and there is a public
interest in bypassing insolvency procedures to meet the resolution objectives
set out above. It also establishes the principle that no creditor should be
worse off in resolution compared to if the institution had been placed in
liquidation. In the event of resolution, the BRRD endows resolution authorities
with the following tools:

 Sale of
     business. Power to transfer shares or other
     instruments of ownership and any assets, rights or liabilities to a
     purchaser on commercial terms;
 Bridge institution. Power to transfer shares or other instruments of ownership
     and any assets, rights or liabilities to a new bridge bank. The latter is
     meant to maintain the critical functions of the institution under
     resolution. Upon the transfer, the institution under resolution can then
     go into normal insolvency proceedings;
 Asset separation. Power to transfer any assets, rights or liabilities of an
     institution under resolution to an asset management vehicle with a view to
     maximising their value through an eventual sale or orderly wind down;
 Bail-in. Power
     to impose losses on shareholders and unsecured creditors, respecting the
     seniority of claims and excluded liabilities. The resolution authority can
     convert debt to equity or reduce the principal of the claims. This is
     further discussed below.

In addition, the BRRD provides for
additional protection of bank depositors in the event of resolution by
establishing a general preference for deposits of natural persons and SMEs,
with even a higher preference to deposits covered by the deposit guarantee
scheme (see below).
As explained earlier, BRRD was approved by
the Parliament in April 2014, following the political agreement reached between
the co-legislators. Member States are to apply all provisions as from January 2015,
apart from the bail-in provisions which must be applied from 1 January 2016 at
the latest. 
Once applied, the new recovery and
resolution framework for the EU will provide the relevant authorities with the
necessary tools to ensure that failing institutions can be wound down in a
predictable and efficient way with minimum recourse to public money. In the
context of the Banking Union, these new rules will be applied within the Single
Resolution Mechanism (SRM), once in place. The SRM is analysed separately in
section 4.6 below. 
Bail-in capacity of EU banks
An effective resolution regime must
minimise the costs of a failing institution to be borne by taxpayers – and as
such breaking the link between the bank risks and the sovereign. It should also
ensure that systemic institutions can be wound down without jeopardising
financial stability. The bail-in tool provided for in the BRRD seeks to achieve
that objective by ensuring that shareholders and creditors of the failing
institution suffer appropriate losses and share the burden arising from the
costs of resolution. In addition to protecting taxpayer funds in the event of
failure, this gives investors in a bank an incentive to monitor the health of
the institution ex ante, which reduces the risk of a failure occurring in the
first place.
According to the BRRD, losses should first
allocated to shareholders either through the cancellation or transfer of shares
or through severe dilution, and to holders of other regulatory capital
instruments. Where those instruments are not sufficient, subordinated debt
should be converted or written down. Senior liabilities should be converted or
written down if the subordinate classes have been converted or written down
entirely. The BRRD foresees a minimum amount of bail-in of 8 % of total
liabilities including own funds before, under exceptional circumstances, the
resolution fund can be used to absorb losses.[93]
The amount of losses that can be forced on
shareholders and creditors depends on the liability structure of EU banks.
Table 4.2.2 provides information on the liability structure of bank balance
sheets for a sample of 45 EU banks, showing the "average" bank as
well as for different stylised bank business models. The table illustrates the
extent to which the bail-in tool could be potentially applied as at the end of
2012. It also illustrates the differences that arise between different bank
business models and the capacity of individual banks' shareholders and
creditors to absorb losses.
Table 4.2.2: Liability structure per type of bank,
expressed as a percentage of total assets (2012YE)
Source: Sample of 45 EU banks data from
Bloomberg, Dealogic, SNL Financial.
The table indicates that different banks
would currently have to bail-in a portion of senior debt if at least 8 % of
total liabilities plus own funds were to be bailed-in before, in exceptional
circumstances, the resolution fund could be used to absorb the losses.
Consistent with this evidence, several analysts foresee that banks will respond
by raising their levels of capital and subordinated debt. The intention is to
ensure that these two sources of funding should be in a position to bear full
absorption capacity. The costs of bail-in on bank funding are discussed in
chapter 6.
While the responsibility for covering bank
losses will fall on private investors in this type of institutions, in some
extreme cases there can be recourse to external resolution funding. The BRRD
requires resolution funds to be financed by the banks themselves, and to be
built up to a level equal to at least 1 % of covered deposits within 10 years.
Recourse to the privately funded resolution fund and, if the former was
exhausted, to alternative funding means would only be needed in the minority of
extreme and duly justified cases.    
Redefining
creditor claims and establishing depositor preference
The liability structure presented in Table
4.2.2 hints at a related but separate issue to the level of bail-inable debt
and total loss absorbing capacity of a bank: namely, the need to establish a clear
hierarchy of claims regarding which creditor gets paid first (or, conversely,
takes on losses first).
In addition to establishing that losses
should first be absorbed by regulatory capital and then subordinated debt, as
per the bail-in requirements, the BRRD further changes the hierarchy of claims
against a failing bank by introducing depositor preference. Chart 4.3.11
summarises the hierarchy of claims in the BRRD. Depositor preference will
strengthen the standing of depositors in the hierarchy of claims, minimise
taxpayers’ losses and reinforce financial stability.  
 Retail depositors are generally protected from losses in resolution and in insolvency through deposit guarantee schemes (DGS) established in all Member States. As noted above, in response to the crisis, the level of guarantee was increased to EUR 100 000 for eligible depositors in a bank. Covered deposits are fully protected from losses up to this limit. Whilst other eligible deposits are potentially available for loss absorbency purposes, deposits by natural persons and SMEs have been given a higher priority ranking over the claims of ordinary unsecured, non-preferred creditors in insolvency proceedings, reducing the likelihood of them having to bear any loss. In addition, national DGS, which will replace covered deposits in loss absorption, will receive super preferential treatment and will thus contribute as the very last. || Chart 4.2.11: BRRD: hierarchy of claims in a bank 
 Note: LAC stands for loss absorption capacity; RF for resolution fund, DGS for Deposit Guarantee Schemes. Source: Commission Services 
Covered deposits are estimated to present
approximately EUR 5.2 trillion in the euro area, or about 16.5 % of the average
bank's balance sheet. While DGS are in the first instance industry-funded, they
are implicitly backed by taxpayer support. Thus, changing the hierarchy of
claims in favour of the DGS is effectively also a measure to reduce risks to
public funds. Depositor preference is therefore justified on the grounds of
protecting both eligible depositors and taxpayers.  That is, it protects
citizens both in their role as depositors and taxpayers.
While seeking to minimise the risk to
taxpayers and avoid a repetition of the large-scale bailouts that were required
in this crisis, the BRRD will allow for extraordinary public support to solvent
banks in the form of a guarantee or precautionary recapitalisation, subject to
specific qualifications[94], to remedy a serious disturbance in the economy and preserve financial
stability. Such support will also have to comply with the Union State aid framework, as explained in Box 4.2.4.[95] 
Box 4.2.4: The BRRD and the State aid rules
The
transposition period of BRRD will end on 31 December 2014, with the exception
of provisions relating to the bail-in tool that shall apply from 1 January 2016
at the latest.
Any
State support for a financial institution before 1 January 2015 will have to
comply with State aid rules and especially with the new Banking Communication
applicable as of 1 August 2013. The two main principles are that (i) any
recapitalisation and impaired asset measures will be authorised only once a
restructuring or liquidation plan has been approved by the Commission and that
(ii) shareholders, hybrid capital and subordinated debt holders have to
contribute to reduce the capital shortfall to the maximum extent before State
aid can be granted.
As
from 1 January 2015, on top of State aid rules, any state support to a
financial institution will have to comply with the BRRD requirements, which
means that no public recapitalisation will be possible outside resolution,
except in strictly defined cases of precautionary recapitalisations (. Under
precautionary recapitalisations, state aid rules will ensure a full burden sharing
of shareholders and subordinated holders. Other non-precautionary public
recapitalisations will be possible within resolution only after burden sharing
under both BRRD and State aid rules.
As
from 1 January 2016 at the latest, any public support, in the form of injection
of funds by the Single Resolution Fund or by national resolution funds will be
possible within resolution after a minimum bail-in equal to 8 % of liabilities,
including own funds. Precautionary recapitalisations will still be possible outside
resolution provided that they comply with the BRRD rules and with the State aid
rules.
4.2.6
Addressing "Too-big-to-fail"
The EU financial system is characterised by
the presence of relatively few large, banking groups, which are active in
commercial banking (deposit taking and lending to individuals and businesses),
traditional investment banking (security underwriting and advisory services),
asset and wealth management services, and capital market and trading activities
such as market-making, brokerage services, securitisation, proprietary trading,
etc. Several of them form financial conglomerates that are also active in
insurance. Prior to the crisis, these large EU banking groups have rapidly
increased in size, scope and complexity. Much of the balance sheet growth volume that has taken
place was driven by intra-financial business, rather than lending to the wider
economy. The largest EU banking groups have total
on-balance-sheet assets exceeding EUR 1 trillion (see section 3.1). Several
large EU banking group balance sheets exceed the GDP of the country where they
are headquartered. 
Large banking groups in particular have
benefited from the significant amounts of explicit aid from governments and
central banks (see Box 3.4.1). 
In addition, the perception of being too
big to fail (TBTF) gives rise to bail out expectations and is reflected in an
artificially low funding cost and hence an implicit subsidy for TBTF
banks. The implicit subsidy is provided by taxpayers and in particular benefits
the TBTF bank shareholders, management and employees, and their customers to
the extent that the subsidy is passed on. Although the quantification is
challenging, the implicit subsidy for TBTF banks is shown to be significant in
absolute size and as a percentage of the annual profitability of banks (see Box
4.2.5). According to several
studies, implicit subsidies are estimated to mainly benefit the largest banks.[96]
Box 4.2.5: The implicit subsidy benefiting Too-Big-To-Fail banks
Market discipline is supposed to lead inefficient
firms to fail and exit the market. However, as has been mentioned above, this
is not always the case in the banking sector. The recent crisis has shown that
policymakers are prone not to declare that a large or otherwise significant
bank has failed, hence, typically referred to as too-big-to-fail
("TBTF"). Anticipated public support gets reflected in lower returns
of bank liabilities held by bondholders and depositors. The lower funding cost
that banks benefit from can stem from non-risk adjusted contributions to
deposit guarantee schemes as well as from the expectation that certain bank
creditors or investors would not face the (full) risk of loss (Fitch (2014)
estimates that support from sovereigns has reduced the cumulative five year
default rate on its fixed income portfolio approximately six-fold, from 6.95 %
failure rate to 1.15 % actual default rate). Thus, while government safety nets
can help prevent systemic crises, they can also have several adverse effects:
(i) impose strains on public finances once called upon, and (ii) lead to
several market distortions.
There has been significant interest by academics and
policymakers to determine the size of the implicit government guarantee and the
implicit subsidy[97]. By definition, implicit subsidies are not
transparent, and therefore not observable or easy to estimate. The precise
estimate of their level depends on the exact methodology used, as well as on
the sample period and countries under consideration. However, empirical
analyses typically confirm that implicit subsidies exist and in most cases are
significant, reaching several billion euros annually and representing a
significant share of countries' GDP (typically more than 0.5 %) and banks'
profits (more than 30 % in some studies). A summary of the methodology and
results is provided in the Commission's impact assessment on bank structural
reform.[98] 
Credit ratings of banks often involve a
"stand-alone rating" and a "support rating". Whereas the
former assesses the bank's creditworthiness by looking at the business model
and net cash flow generation of the business activities as such, the latter in
addition takes into account the extent to which the bank implicitly enjoys
backing from the state when in need (in practise, abstraction is made from
possible parental or cooperative support to isolate the sovereign support).
Prior to the crisis, the 29 most systemically important global banks benefitted
from just over one notch of uplift from the ratings agencies due to
expectations of state support (for example from AA to AA+ or from A+ to AA- for
S&P and Fitch ratings or from Aa3 to Aa2 for Moody’s ratings). Today, those
same banks benefit from around two or three notches of implied support on
average, although results differ across banks, Member States, and time (see
also Charts 1 and 2 below). 
According to a number of researchers and
regulators expectations of state support have risen substantially since the
crisis began (Ueda and di Mauro (2012), Haldane (2010b, 2012)). Some of the
subsidies have already declined in recent years, thanks to the introduction of
effective and credible resolution regimes (e.g. UK), due to a worsening of the
creditworthiness of the sovereign creditor (e.g. Spain), or following concrete
proposals and government endorsement of structural reform initiatives (e.g. UK)[99]. In other Member States they have not or
hardly decreased, or have in fact increased (see also Schich and Kim (2012)). 
Chart 1: Average uplift in notches (difference between support
rating and stand-alone rating) in March 2013
.
Chart 2: Change in average uplift between March 2013
and June 2011 
Source: Moody's and European
Commission calculations      
Implicit subsidies or artificial funding
cost advantages can be estimated in monetary terms by mapping the support
rating and stand-alone rating into a funding cost and by multiplying the
corresponding funding cost differential with the volume of outstanding
rating-sensitive funding sources at a given point in time. The Commission has
thus estimated the size and determinants of the implicit state guarantee and
implicit subsidy enjoyed by a sample of 112 EU banks covering 60-70 % of the
total bank assets in the EU over the period 2011-2013[100]. The implicit subsidy estimated by the
Commission is in the range of EUR 72-95 billion and EUR 59-82 billion in 2011
and 2012, respectively. In relative terms, this amounts to 0.5 % to 0.8 % of
annual EU GDP and between one-third and one-half of the banks' profits.
Similar findings are found elsewhere in
literature. Thus, there is strong evidence suggesting that there is a
significant subsidy. Moreover, the evidence also points out that larger banks
benefit disproportionally from government support. Government support is also
higher for banks headquartered in Member States with high sovereign ratings and
for banks with high levels of wholesale/interconnected activities.
Implicit subsidies have a significant
distortionary impact, as they contribute to excessive balance sheet growth and
risk taking, and give rise to competition distortions between large banks, on
the one hand, and small and medium-sized banks, on the other hand. These
distortions in turn reinforce the initial problem and give rise to TBTF banks
becoming even bigger, complex, interconnected, and systemically important over
time. Moreover, the implicit support results in a relative increase in the size
of the financial sector, which unduly diverts resources from other sectors of
the economy (see box 6.1.1). Reducing the implicit subsidies is therefore a key
objective of the financial regulatory reform agenda.
Looking forward, Fitch (2014) estimates
that the BRRD is likely to further weaken the sovereign support. Extraordinary
support for senior creditors, while still possible under BRRD, is becoming
significantly more uncertain. As a result, Fitch revised its outlook on tens of
European banking groups from stable to negative due to a weakening of sovereign
support assumptions.
TBTF banks often grow - supported especially by cheaper funding compared to other banks -
not necessarily because they are more efficient or provide better services, but
because they enjoy greater implicit subsidies.[101] In addition to imposing a burden on taxpayers, the implicit subsidy
causes different types of distortion, among others:[102]

 competitive distortions – banks that
     benefit from the implicit subsidy have a competitive advantage over those
     that do not. Beneficiary banks can benefit from artificially cheap funding
     to expand their business at the expense of banks that do not enjoy a
     similar advantage. Also, banks in Member States with a sovereign more
     capable of standing behind its banks are at an advantage to equally strong
     banks headquartered in weaker Member States.
 excessive risk-taking – the implicit
     subsidies allow banks to reap upside profits from risky strategies while
     being protected against downside losses. Since investors in banks do not
     need to fully price in risk-taking, bank management is incentivised to
     take more risk than it would if their cost of funding reflected their
     activities (i.e. if market discipline would be effective); and
 excessive balance sheet growth and
     misallocation of resources to the banking sector – guaranteed funding
     allows banks to grow artificially, diverting resources, such as talented
     human capital, from other sectors of the economy than would be the case in
     the absence of the subsidy.  

The measures to strengthen banks' solvency
(the capital and liquidity requirements as part of the CRD IV package) and
measures to strengthen bank resolvability (the BRRD) reduce the probability and
impact of bank failure.[103] As discussed above, under the new capital rules, systemically
important banks face higher capital requirements both in terms of quality and
quantity. The reforms to bank capital requirements will reduce incentives to
take excessive risks. It will also enable banks to absorb more losses before
defaulting. These two effects will reduce the probability of default. The
increased capital requirements on banks’ trading books may also reduce banks’
rapid balance sheet growth. As regards the new resolution tools, these provide
a necessary framework to ensure that banks can be resolved in an orderly
manner. 
However, higher capital and the
availability of resolution tools are not enough to eliminate the TBTF problem,
in particular for the large European banking groups which are universal banks
and typically combine retail/commercial banking activities and
wholesale/investment banking activities in one corporate entity, or in a
combination of interconnected entities. 
Thus, to complement existing reforms,
“structural” measures have been proposed by the European Commission in January
2014 to reduce the probability and impact of failure of TBTF banks. Such
structural measures have global support, as evidenced by recent statements by
G20 leaders and ministers,[104] and are already being adopted in a number of EU Member States.
The Commission proposal on structural
bank reform
The Commission bank structural reform
proposal follows the work of the High-Level Expert Group (HLEG) on bank
structure reform, set up by Commissioner Barnier in November 2011 and chaired
by Erkki Liikanen. In its final report of 2012, the
HLEG recommended amongst others that existing and ongoing reforms need to be
complemented by a structural reform in the banking sector; it recommended the
mandatory separation of proprietary trading and other high-risk trading
activities into a separate legal entity within the banking group for banks
where such activities amounted to a significant share of the its business.[105]
In July 2013, the European Parliament adopted an own initiative report, welcoming
measures at EU level to tackle concerns related to TBTF banks.[106] 
The Commission adopted its proposals on
structural reform in January 2014,[107]
with the following objectives: (1) reduce excessive risk taking within
the banking group; (2) remove material conflicts of interest between the
different parts of the banking group; (3) avoid misallocation of resources and
encourage lending to the economy; (4) contribute to undistorted conditions of
competition for all banks in the internal market; (5) reduce interconnectedness
within the financial sector leading to systemic risk and contagion; and (6)
facilitate orderly resolution and recovery of the banking group. 
The proposal targets a small group of large
and complex banking groups, the European banking groups identified by the Bank
for International Settlements (BIS) as Global Systemically Important Banks (EU
G-SIBs), as well as a number of additional banking groups that engage in significant
trading activity and exceed certain balance sheet metrics.[108] Around 30 banking
groups are expected to fall within the scope of the proposed regulation, accounting
for 65 % of the EU total assets.[109]
The proposal provides for two types of
measures for the banks that fall under the scope of the regulation:
·        
A prohibition of proprietary trading
activities for the group of banks that fall under the scope of the regulation (which would apply as of 2017).[110]
The rationale for the full prohibition of proprietary trading is that such an
activity generates high risks and is by definition not customer-oriented. It
has the ability to produce “tail risk” or systemic risk and is easily scalable
(in comparison to more relationship-based activities such as lending). Proprietary
trading potentially gives rise to large open positions and counterparty risk
(risk that the counterparty to the investment will fail to pay), as well as
interconnectedness between institutions. The potential opaqueness, complexity,
and interconnectivity of proprietary trading represent important impediments to
orderly and swift resolution. Proprietary trading can also be a high-frequency
activity that may result in thousands of daily transactions. As a result,
snapshots of the positions of these activities may have limited predictive
value for future positions and understanding and monitoring the risks is
difficult. Proprietary trading is particularly prone to conflicts of interests
because the bank in its role of proprietary trader no longer is a service
provider to its client, but becomes a potential competitor and hence faces
interests that are no longer aligned with those of its clients. The bank can
make improper use of client-related information to increase its own profits. 

 The potential separation of other trading activities (which would apply as of 2018). Banks engage in a number of
     other trading and investment banking activities including market making,
     investment and sponsorship of complex securitised products and
     over-the-counter derivatives trading. These activities may however expose
     credit institutions to excessive risks if they represent a significant
     part of the bank's business. In such cases where large risky trading
     activities trigger a number of risk alerts (because of their size, complexity,
     opaqueness etc.), a separation of these activities within group entities
     that take eligible deposits might be warranted, unless the bank
     demonstrates to the satisfaction of the supervisors that these activities
     do not pose a threat to the financial stability of the deposit taking
     entity or to the EU financial system as a whole. If the activities remain
     within the banking group, they have to be transferred to an entity that is
     legally separate from the deposit-taking entity. The proposal also grants
     the supervisor powers to require separation of certain trading activities
     when it deems that the activity in question threatens the financial
     stability of the bank in question or of the EU.[111] Banks
     would need to demonstrate that the objectives of the structural reform are
     not put at risk in order to “avoid” separation of their activities into a
     “trading entity”.

The reform is only at proposal stage, so
it is too early to measure its impact. The market response to the proposal
announcement and statements from market participants in the days after the
launching of the proposal suggest that the impact of the proposal may be
perceived as limited, although this may be linked to the fact that the proposal
was long expected and that the final outcome will depend on negotiations in the
period ahead. It is difficult to foresee when the proposal will become law and
whether the proposal will be strengthened or weakened following negotiations
with the new European Parliament and Council in the meantime.[112] Other responses from
market participants refer to the long timeline foreseen and corresponding
uncertainty and costs. The proposal is tabled for discussion and market
participants expressed a willingness to cooperate constructively in the period
ahead.    
The impact assessment[113] that accompanies the
proposal expects significant tangible and non-tangible benefits to arise from
this reform, however difficult their quantification might be. These include but
are not limited to: reduced risk of bank failure, thus a more resilient banking
system, the facilitation of bank resolution and recovery which in times of
stress will translate into lower costs of possible bank failures, easier
monitoring and supervision of banks, reduced moral hazard and conflict of
interest, improved capital and resource allocation for the benefit of the
economy and enhanced competition among market participants. 
On the other hand, the proposal would
reduce the implicit subsidies that the EU TBTF banks enjoy today for some of
their risky trading activities. The proposed measures may lead to higher
funding costs for these trading activities within the banks concerned. The
reduction of implicit public subsidies would contribute to enhancing the
level-playing field in the banking sector because the gap in the funding costs
between the TBTF and smaller banks would narrow. There may also be operational
costs related to the separation of some trading activities in a specific legal
entity. However, banks would have time to deal with this transfer of existing
trading activities as the proposal would be phased in over time.
Overall, the wider societal benefits from
this reform are deemed to significantly outweigh the costs by increasing the
financial stability and resilience of the EU banking and financial system as a
whole. Moreover, this reform focuses on large banks only and hence would not
affect the vast majority of EU banks providing traditional financing activities
to retail customers, SMEs or larger companies. 
4.2.7
Quantitative estimates of macroeconomic benefits of select banking reforms
The different regulatory measures work
together to enhance the stability and resilience in the EU banking sector. The
resulting wider economic benefits can be measured in terms of a reduction in
both the probability and impact of banking failures and the corresponding
reduction in the expected costs resulting from banking crisis. 
Only a few studies have attempted to quantify
these benefits of (a sub-set of) the banking reforms (see also annex 1 for a
review of the literature). All the studies are characterized by significant
model and data uncertainty, and the results can at best be taken as indicative.
The Basel Committee's Long-term Economic
Impact (LEI) report (August 2010) presents estimations of the long-term net
benefits of stronger capital and liquidity standards of the Basel III rules.[114] 
The benefits of the regulatory measures are calculated as the reduction in the
annual probability of a crisis times the costs of crisis, measured as the
cumulative output losses (in present value terms). According to the LEI study, the
cumulative discounted losses associated with banking crises range between 19 %
(in case the crisis has no permanent effects) and 158 % (in case of permanent
effects) on annual pre-crisis GDP levels (see also section 3.4). When there is
a moderate permanent effect of a financial crisis, the cost of crisis is
estimated to equal 63 % of pre-crisis annual output (based on the median of different
studies considered in the LEI report). LEI estimates a fall by 2.7 percentage
points (from 4.6 % to 1.9 %) in the annual probability of a systemic financial
crisis when the ratio of capital requirements increases by 2 percentage points
from 7 % to 9 %. Considering moderate permanent effects of a crisis, the
benefits of the increase in required capital equals to (2.7 % x 63 %) = 1.7 %
of the pre-crisis GDP per year.  When in addition liquidity
regulation is introduced and the NSFR is met at 100 %, the annual expected
benefits add to 1.82 % of pre-crisis GDP. The LEI study also examines the costs
of the requirements (see chapter 6 and annex 1). Considering benefits and
costs, the net benefits are estimated to equal to 1.56 % of pre-crisis annual GDP.
The LEI report's estimates of net benefits of the regulatory measures remain
positive even if the crisis-related output losses are assumed to be more
temporary in nature. Net benefits also remain positive for a broad range of
capital ratios. 
For the UK, the Bank of England (2013) estimated the impact of higher capital requirements coming from the
CRD IV for the period 2010 to 2021. The net benefits (i.e. after accounting for
costs) sum up to an annual £8.25 billion, which is roughly 0.53 % of UK GDP in
2012. Reflecting the model and data uncertainty, the results vary for different
confidence intervals (e.g. for the 95 % confidence interval, the net benefits lie between £-2 billion
and £23 billion).[115]

New quantitative analysis has also been
undertaken for the purpose of this study, as summarised in Box 4.2.6 and
explained in more detail in annex 4 (for benefits) and annex 5 (for costs). The
results are based on simplified models that seek to capture the macroeconomic
impacts of select banking reforms, namely higher capital requirements (as per CRD
IV package) and bail-in and resolution financing arrangements (as per BRRD). 
Box 4.2.6: (Net) benefits of increased capital requirements, bail-in
tools and resolution fund
Annex
4 sets out the details of a quantitative model (SYMBOL) that aims to assess the
macroeconomic benefits of the regulatory reforms in the banking sector. Given
the specification of the model, only certain types of bank reforms can be
included – namely, higher capital requirements under the CRV IV package and the
bail-in and resolution fund provisions of the BRRD. More specifically, the
model simulates the benefits of increasing capital requirements from 8 % to
10.5 % of risk-weighted assets (RWA) (see section 4.2.1), the bail-in tools and
intervention by the resolution fund (see 4.2.5). The other important reforms are
not captured in the model, as they generate benefits along different dimensions
and through mechanisms that are difficult to include in the model.  
The
benefit estimates reported below are all based on banks' 2012 capital position
(allowing for potential buffers that banks hold above the regulatory
requirement) and only count the impact of moving from that position to the new
required level. This may underestimate the benefits, for the reasons set out in
annex 4, so annex 4 also reports higher benefit estimates based on the
assumption of no capital buffers (i.e. where all banks are assumed to start
with capital equal to 8 % of RWA and move to 10.5 % of RWA).  
The simulations show
that the increased capital requirements result in a 22 % reduction in the potential
public finance costs associated with bank failure. Considering also the two
additional tools, i.e. bail-in and resolution fund, the costs of public
finances are reduced by 92 %. This assumes that these tools are effective in
preventing contagion resulting from bank failure. To further avoid losses for
public finances, the BRRD allows for extra tools to be used, including for
example the full bail-in of unsecured debt or the full use of the resolution
fund. These tools are not included in the estimations, because supervisors have
discretion in their use. The model assumes that capital requirements combined
with the resolution tools in BRRD are fully effective and stop contagion in the
system. As discussed in section 4.2.6 above, for the largest banks, structural
reform is needed to complement higher capital requirements and resolution tools
to reduce the risk and cost of bank failure. The impact of the structural reform
proposal cannot directly be included in the same quantitative model, but
depending on the extent to which structural reform is required to resolve the
largest, systemically important banks, about a third of the estimated reduction
in public finance costs as a result of effective resolution may be attributable
to structural reform. [116] 

The macroeconomic
benefits of the reforms are measured in terms of avoided GDP losses. They arise
from the fact that new regulatory requirements reduce the probability of a
systemic crisis in the banking sector. The reduction in the probability of
systemic crisis is then applied to the estimated costs of such crisis, which
are expressed as the net
present value of cumulative output losses and amount to 98.6 % of annual pre-crisis EU GDP. The
results show that the avoided output losses and corresponding benefits of the
reforms amount to 0.51 % of annual pre-crisis EU GDP if only higher capital
requirements are considered and to 1.07 % if all three measures are combined.
Assuming a lower level of the cumulative costs of crisis, namely 50 % of annual
EU GDP (see section 3.4), the benefits of all three measures would amount to 0.59
% of EU GDP per year. Thus, considering also this lower bound, the estimated
benefits are 0.6-1.1 % of annual pre-crisis EU GDP (or about EUR 75-140 trillion
per year, if applied to 2008 EU GDP).  
Macroeconomic costs
(also in terms of GDP) are estimated separately (using the QUEST model) and
presented in Box 6.4.1 and annex 5. The yearly macroeconomic costs are estimated
to be around 0.3 % of annual EU GDP, based on the assumptions set out in annex
5. 
Thus, on balance, the
models suggest that the potential annual net benefits of the three reform
measures may be between 0.3-0.8 % of annual pre-crisis EU GDP per year. This
corresponds to a net benefit of about EUR 37-100 billion per year, based on 2008
EU GDP.
However, given the high
degree of uncertainty, the estimates should be considered more as a tendency,
rather than interpreted as exact numbers. They are sensitive to the choice of
the modelling approach and the assumptions made. Both models, on costs and
benefits, are highly simplistic and focus only on some mechanisms by which
costs and benefits are transmitted to the economy. For example, the SYMBOL
model to simulate benefits captures credit risk of banks only, and the QUEST
model to estimate costs only considers the credit channel and is based on a simplified
balance sheet of the EU banking sector. 
4.3 Stability and resilience
of financial market infrastructures  
This section describes the reforms pursued
to enhance the stability and safety of financial markets and the
infrastructures that support it. Trading, clearing and settlement of financial
transactions form the three fundamental activities in financial markets. Hence,
the EU regulatory agenda has paid a lot of attention to these activities,
including in particular the review of the Markets in Financial Instruments
Directive (MiFID) as the central piece of legislation for securities markets
(section 4.3.1), the new rules for the central clearing of OTC derivatives
(EMIR) (4.3.2) and the regulation of central securities depositories (CSDs)
(4.3.3). These three reforms together form a framework in which systemically
important securities infrastructures (trading venues, central counterparties,
trade repositories and CSDs) are subject to common rules on a European level.
In addition, the section covers the
restrictions that have been put in place to address the risks in relation to
short-selling and credit default swaps (4.3.4). While also relevant for the
stability of financial markets, reforms on securities financing transactions
are covered in section 4.4 as part of wider measures on shadow banking. Also,
the reforms on credit rating agencies, accounting standards, the audit process
and financial benchmarks are discussed separately in section 4.6 as they also
have a key role in enhancing the integrity of markets by increasing the
reliability of ratings and financial information.[117] 
4.3.1 Improving trading in securities markets
The Markets in Financial Instruments
Directive (MiFID) was transposed in November 2007 as the central piece of
legislation for securities markets. It governs the operation of traditional
stock exchanges and alternative trading venues as well as the provision of
investment services in financial instruments by banks and investment firms.
While MiFID increased competition between trading venues and brought more
choice and lower prices for investors, some shortcomings were exposed (e.g. in
relation to market fragmentation, the high degree of dark trading). Furthermore,
the financial crisis clearly called for a stricter framework for non-equities
markets, and in particular derivatives, including commodity derivatives. This
was confirmed by the commitments by the G20 leaders at the 2009 Pittsburgh
summit.[118]

 Chart 4.3.1: Impact of the crisis on EEA equity trading 
   
 Source: CEPS (2011). 
In the years
following the application of MiFID capital markets in Europe have changed in
many ways.[119]
However, as the implementation of MiFID coincided with the financial crisis
(which significantly affected financial markets as illustrated by the sharp
decline in equity turnover and volumes in chart 4.3.1) and with rapid
innovation in financial services, its effects are virtually impossible to
assess in isolation.[120] 

Stronger
competition between trading venues and investment firms, both on trading costs
and execution services, together with technological innovation dramatically
changed the structure of financial markets across Europe, particularly equity
markets. Many new trading venues emerged, trading costs declined and the speed
of trading drastically increased. This development has been particularly
pronounced in cash equity markets.
At the same time, however, capital markets
have become fragmented and more opaque, which can be observed by the
proliferation of dark trading venues, dark pools and broker dealer crossing
networks. 
Dark trading is trading that is not subject
to pre-trade transparency requirements[121]
either because it is not covered by the definitions of trading venues or because
waivers from pre-trade transparency requirements apply. Dark trading allows
market participants to carry out trades without exposing their orders to the
public ahead of the execution ('pre-trade transparency'). Three different forms
of dark trading need to be distinguished. 'Dark pools' are trading venues that
fall within the categories of regulated markets or MTFs but for which waivers
to pre-trade disclosure apply (e.g. for large in scale trades). Broker crossing
systems are systems used by investment firms to match client orders internally.
Typically such systems use algorithms to slice larger parent orders into
smaller 'child' orders before they are sent for matching. Some systems try to
match only client orders while others also provide matching between client
orders and house orders (with the permission of clients). If client orders are
not matched internally they are then routed on to a trading venue for
execution. Crossing systems are not covered by the existing definitions of
trading venues of MiFID and hence not subject to pre-trade disclosure. While
the role of broker crossing systems remained still small in the overall market,
these systems grew very quickly between 2008 and 2010 and nearly tripled from
an average of 0.7 % of total EEA trading in 2008 to an average of 1.5 % in the
first quarter of 2010.[122]
Finally, trading that takes place over the counter (OTC) is not subject to
pre-trade disclosure and therefore also falls within the category of dark
trading.
 Chart 4.3.2: Proportion of dark trading on broker crossing systems and dark MTFs as a percentage of European executable activity 
   
 Source:  TABB Group (2013), "Dark Matters: Time for facts". 
In 2011, dark trading accounted for 45 % of
EEA trading, of which pools and broker crossing networks accounted for
approximately 7 % and OTC trading for around 38 %. Dark trading (including both
broker crossing networks and dark pools) is expected to continue growing if it
is not subject to requirements on transparency and investor protection comparable
to those for regulated markets. Chart 4.3.2 shows that the proportion of dark
activity including Broker crossing systems and dark MTFs (but excluding dark
trading on regulated markets and OTC trading) has been increasing since the
second half of 2012. In particular, trading activity in dark MTFs has been
rising from 3.16 % in August 2012 to 5.05 % in October 2013.[123]
These developments have resulted in an
uneven playing field between markets and market participants, as they are
subject to different rules, conditions and costs whilst carrying out similar
activities. Also, there is insufficient transparency for market participants to
make optimal investment decisions, for the price formation mechanism to work
effectively and for regulators to detect potential market concerns and threats
to financial stability and to react to those. 
Concerning market fragmentation, despite
providing comparable services to regulated markets, multilateral trading
facilities (MTFs) were subject to a less stringent regulatory and supervisory
regime since they are not fully covered by the market abuse rules. In addition,
crossing systems and derivative trading platforms have emerged that carry out
similar activities to MTFs without being subject to the same regulatory
requirements. As most of these requirements relate to transparency and investor
protection, the lack of a level playing field may hinder the safety of
financial markets as well as their efficiency. Also, the share of trading on
MTFs increased to 18 % of total turnover by February 2011[124].
Another concern has been the growth
of algorithmic trading and High Frequency trading (HFT) which has drastically
increased the speed of trading. Data availability in this area is limited, but
recent estimates by the European Securities and Markets Authority (ESMA)
suggest that HFT traders make up 22 % of the total value traded for a sample of
European equities in May 2013. In terms of orders, HFT activity was higher,
with most orders placed by HFT traders (60 % of all orders). While HFT offers
many opportunities, it is important to control systemic risks that might arise
from this technological innovation. Events in recent years, e.g. the
"Flash crash" of 6 May 2010 or the loss of USD 420m by Knight Capital
in August 2012 have revealed that algorithmic trading can be destabilising and
amplify extreme market movements. At the same time, there is still significant
debate on the impact of HFT on market quality, including liquidity and price
discovery, and on volatility (see box 4.3.1).
The transparency regime in the
MiFID for market participants in both the equities and non-equities markets has
turned out to be insufficient. The increased use of dark pools, not subject to
the transparency regime under MiFID, raises regulatory concerns as it may
ultimately affect the quality of the price discovery mechanism on the original markets.
For example, insufficient pre-trade transparency in markets can hinder the
price formation process. Market participants as well as supervisors have
expressed concerns about time delays in the publication of trade reports in the
equities markets. For non-equity markets, transparency requirements were not
covered by the MiFID, but only regulated at national level and not always
harmonised or sufficient. These issues, if not addressed, can undermine market
safety and efficiency as well as investor protection. During the financial
crisis, existing transaction reporting requirements failed to provide competent
authorities with a full view of the market because their scope is too narrow
and because they are too divergent.
The MiFID
review (MiFID II)
In response to
the crisis and as a result of new risks emerging, the Commission presented in
October 2011 proposals to revise MiFID, consisting of a Directive and a
Regulation (MiFIR).  This package – commonly referred to as MiFID II – was approved
by the European Parliament in April 2014, following the January 2014 political
agreement with the Council. After entry into force in summer 2014, significant
implementation work will continue in the course of the next two years, since
many technical details need to be elaborated. It is expected that MiFID II will
be applied from end 2016. To ensure a smooth transition into the new
regime, longer transition periods are envisaged for some areas.
The central
objective of the MiFID II is to make financial markets more resilient,
transparent and efficient. Another main objective of MiFID II is to ensure
investor protection, which is separately discussed in section 4.7.4. 
MiFID II
recognises the need for the different business models, while ensuring a high
level of market integrity and a level playing field among trading venues (e.g.
open and non-discriminatory access rules). While MiFID II has many different
elements, focus here is on the elements that can be directly linked to the
financial crisis and are relevant to the financial stability objective of the
reform agenda. [125]

MiFID II aims
to enhance the robustness and efficiency of securities trading and trading
venues. MiFID II introduces a category of organised trading facility (OFT)
as a third category of multilateral trading venue. This will ensure that
organised trade execution systems that have so far not fallen under the
existing MiFID trading venues (e.g. broker crossing networks) are subject to
the same transparency and organisational requirements as those that already
were covered by MiFID (i.e. regulated markets and MTFs). The different types of
trading venues will be clearly distinguished based on their characteristics. The
aim is to ensure a level playing field and avoid fragmentation without imposing
a one-size-fits-all regulation. 
In
addition, MiFID II aims at controlling the risks stemming from algorithmic
trading and HFT by various measures, ranging from requiring algorithmic traders
to be properly regulated, to liquidity provision requirements and the testing
of high frequency trading programs (see box 4.3.1).
The
financial crisis disproved the widespread view that professional investors know
what is best for themselves and the market as a whole as has been seen on
numerous occasions (e.g. lack of due diligence in the area of securitisation;
blind faith in judgements of rating agencies). MiFID II addresses this
misplaced assumption by enhancing the regulatory framework not only for equity
markets but also for non-equity markets, which are traditionally dominated by
wholesale market participants and dealer markets. As further discussed in
section 4.3.2, MiFID II also introduces mandatory trading of clearing-eligible
and liquid derivatives on multilateral trading venues, including commodity
derivatives. It thereby complements derivative markets reforms (see below) and
delivers on an important G20 commitment.  
MiFID
II contains important measures to enhance transparency. Transparency is
central to ensure appropriate risk monitoring by market regulators and market
participants. The key rationale for transparency is to provide investors with
fair access to information about current trading opportunities, to facilitate
an efficient price formation process and assist firms to provide best execution
to clients. Increased transparency also addresses potentially negative adverse
effects of market fragmentation and liquidity and support market participants
in correctly valuing their portfolios. MiFID II will improve transparency in
three ways: 
1)
Introduction of a consolidated tape of post-trade data (i.e. continuous,
real-time data on the trading volume and price of securities on all trading
venues);
2)
Strengthening existing trade transparency requirements for equity markets and
introducing a trade transparency regime for non-equity markets; and
3)
Strengthening transaction reporting to supervisory authorities. 
Trade
transparency requirements are necessary to balance the interests of individual
investors and the collective interest of having transparent and
well-functioning markets. While individual investors are interested in
receiving as much information about markets and prices as possible they are not
inclined to disclose information about their trades so as to not lose their
informational advantage. Trade transparency requirements hence help to remove
information asymmetries. 
Whilst
increased transparency does not imply a one-size-fits-all regime to the
non-equity markets, differences in market structure do not justify exempting
non-equity markets completely from trade transparency requirements. The
financial crisis has clearly brought to light the opacity of many non-equities
markets, in particular the markets for derivatives and bonds, which hinders
supervisory authorities and market participants to appropriately monitor
markets and which is conducive to an environment with low competitive pressure
and high trading costs. It is important to address these shortcomings while
taking different market structures (e.g. lower liquidity, higher trading sizes)
into account. This will be accomplished by allowing for waivers from
transparency in specific circumstances to avoid detrimental impacts on market
liquidity (see chapter 6).
The
strengthening of the existing trade transparency regime for equities and the
introduction of a trade transparency regime for non-equities markets together
with the introduction of a trading obligation for derivatives and for shares
and the setup of an appropriate framework for consolidated trade data are
expected to enhance the price formation process and help to overcome market
fragmentation. MiFID II also contains specific measures to enhance the
transparency and oversight in commodity derivatives markets, but these are
separately discussed in section 4.6.2.
Overall,
this new transparency regime is expected to enhance price discovery in both
equity and non-equity markets and provide the necessary level of transparency
for investors to make optimal decisions and for regulators to detect potential
stability issues and to provide adequate responses. 
Box 4.3.1:
High-frequency trading and the MiFID II requirements
There is a lack of
consensus among academics, practitioners and regulators on both the definition
of high-frequency trading (HFT) and its effects on the working of securities
markets,[126] notably its impact on real liquidity,
price volatility, market abuse possibilities and market efficiency (including
price discovery). At the same time, HFT accounts for a significant part of
trading activity in a large number of exchanges. Current estimates on the
proportion of HFT in the EU markets range between 30-60 %. 
The existing theoretical
and empirical literature on HFT is vast and growing rapidly.[127] However it is inconclusive as regards the
beneficial effects or otherwise of HFT. Moreover, it mostly centred in US
markets, making it difficult to extrapolate results to the EU market. Some early
US studies were supportive and emphasised the benefits of HFT. This research
suggested that HFT was a natural evolution due to advances in technology,
quantitative finance and the securities markets. Thus, HFT was seen as
contributing to greater liquidity; lower volatility; lower transaction costs;
and improved speed and accuracy of the price discovery process. In sum, high-frequency
traders can be seen as market makers providing liquidity to the market,
lowering volatility and narrowing bid-offer spreads, thereby making trading and
investing cheaper for other market participants.
Notwithstanding these
alleged benefits, concerns emerged after several flash crashes and
turbulence attributed to the presence of HFT (see also section 4.3.1).[128]  Other empirical literature assessing
these market episodes[129] and relying on more recent available data,
has concluded that HFT can also decrease liquidity, increase volatility and
adversely impact market confidence.
First, there are natural limits to the alleged
benefits of HFT. There may exist unhealthy competition among high-frequency
traders to acquire the capability to trade at ever higher speeds by investing
in broadband cables, microwave technology etc. This leads to a speed or arms
race, to profit from “low latency arbitrage”[130]. High-frequency traders invest in speed to
trade one fraction of a second faster than other traders. As a result the
fastest High-frequency trader may be able to know, with near certainty, where
the market will be a fraction of a second ahead of everybody else, profiting at
nearly zero risk. The problem is that, beyond a certain threshold, this speed
race becomes essentially a zero sum game, with a severe potential negative
impact on efficiency of the markets.
A second concern is that the increase in market
quality attributable to HFT is only transitory and it comes at the expense of
institutional liquidity providers whose presence ensures the adequate valuation
of tradable securities in the long-term. High-frequency traders can effectively
take profits from rather than provide liquidity to long-term investors,
particularly at times when liquidity is already low and/or the market is under
stress. Thus, HFT may push institutional investors out into dark
pools where HFT activity does not take place. There is evidence that
institutional investors, at least in some instances, have chosen to execute
their orders through systems that do not involve any pre-trade transparency. By
using voice trading systems or dark pools they ensure that their orders cannot
be picked up by high-frequency traders. While this may be in the investors’
individual interest, it is not in the interests of the market as a whole,
because dark trading harms the market price formation mechanism. If, as feared,
this speed race among HFT ends up shifting market quality participants away
from transparent exchange markets, this could discourage long-term
investment through exchange markets.
Technology is a key driver of innovation and growth,
but it also raises risks in the marketplace. As a consequence, regulators are
confronted with a challenge to maintain the integrity of markets, whilst
at the same time not suffocating advances in their development. It is in this
context that regulatory measures have been taken at the EU level, notably as
part of MiFID II review to mitigate and control the risk and concerns
associated with HFT. Effective implementation of these measures across Europe
shall ensure that HFT lives up to its promise of improving market quality
without endangering or distorting the adequate functioning of securities
markets either in normal times or in times of market stress. The targeted requirements and measures to
address the specific concerns referred to above include:
1) Obligation to
provide continuous liquidity: Flash crashes may be caused or accentuated by
HFT trading systems shutting down whenever there is an unforeseen movement in
the market. This has the effect of withdrawing liquidity from the market, potentially
accentuating any fall. To address this problem, HFT market makers are required
to provide liquidity into markets continuously and could be sanctioned for any
failure to provide such liquidity. 
2) Minimum tick sizes:
Minimum tick sizes limit the minimum fractions for quotes or orders and are
adopted to reduce the incentives for HFT. HFT strategies frequently exploit
minor differences in prices (which is only possibly where the tick size is
small) to step ahead of more long-term investors who are less likely to make
trading decisions based on small price differences. Imposing minimum tick sizes
may therefore reduce HFT trading opportunities, whilst favouring long-term
investors. This will be further calibrated by ESMA in delegated and
implementing acts. 
3) Minimum order to
trade ratio: HFT trading strategies frequently involve the issuing of
numerous orders to test the market, which are then rapidly withdrawn. To
address this concern, a minimum ratio of unexecuted orders to executed trades
is imposed on market participants. This, too, will be calibrated by ESMA in delegated
and implementing acts.
4) Restrictions on
distortive fee structures: The fee structures of trading venues may
encourage distortive HFT practices. Hence, restrictions are imposed to ensure
that co-location services are offered on a non-discriminatory basis and do not
create incentives for disorderly trading.
5) A requirement on
algorithm testing: This ensures that the people using such algorithms
understand them both for their own risk management purposes and also to reduce
risk in the system as a whole.
4.3.2 Improving derivatives
markets and advancing central clearing
As already shown in chapter 3, derivatives
markets grew significantly in the years leading up to the crisis. This growth
concentrated on OTC derivatives markets, as opposed to derivatives traded on
exchanges. The size of derivatives markets, as measured by the gross notional
value of derivatives outstanding, exceeded USD 700 trillion by 2008, but has
fallen somewhat since (Table 4.3.1).[131] 
Between 1998 and 2008, the market size for OTC derivatives grew by a factor of
10. The growth in the global derivatives market far outpaced that of the global
economy: the notional value of OTC derivatives outstanding exceeded global GDP
in 1998 by a factor of 3, but in 2008 the market had grown to exceed global GDP
by more than 12 times. 
Table
4.3.1: Size of derivatives markets 
   || 1998 || 2008 || 2012 
 Global size of OTC derivative markets (gross notional value in USD trillion) || 70 || 700 || 633 
 Global size of exchange-traded derivative markets (gross notional value in USD trillion) || 14.3 || 82.8 || 59.5 
 World GDP (in USD trillion) || 30.2 || 61.4 || 71.9 
 Ratio of derivative markets size to global GDP || 2.8 || 12.7 || 9.6 
Source: Commission
Services based on BIS (gross notional derivatives) and World Bank (GDP).
Size and rapid growth is not necessarily a
problem. However, the financial crisis exposed significant weaknesses in the
structure of derivatives markets, in particular OTC derivatives. While markets
in certain OTC derivatives asset classes continued to function well, the crisis
highlighted the significant contagion potential due to the interconnectedness
of OTC derivatives market participants and to the limited transparency of
counterparty relationships, as further set out below. Owing to the perception
that OTC derivatives are reserved for professional investors and hence did not
require tight regulatory intervention, OTC derivatives had generally been
subject to light-handed regulation prior to the crisis, which contributed to
their rapid growth. 
At least three main problems in OTC
derivatives were highlighted by the crisis: 
The first problem relates to the lack of
transparency of OTC derivatives and exposures. The bilateral nature of this
market makes it rather opaque to parties outside a particular transaction. For
regulators and supervisors, this means that they did not have complete information
about the size of different segments of the markets and the breakdown of
positions of the regulated entities. As a result, they were not able to monitor
activities in the market and to detect the potential risks building up. The
lack of transparency made detection of systemic risks generally more difficult
and exacerbated the asymmetry of information faced by regulators, thus creating
significant scope for moral hazard. The lack of transparency proved problematic
during the financial crisis, when supervisors realised that they were no able
to assess the precise exposures of firms to derivatives markets. This prevented
them from being able to accurately assess the consequences of a default of a
market participant and of the potential knock-on effects on other market
participants, thus giving authorities no alternative but to bail-out the
distressed participant.
The lack of transparency also affects market participants, who know
their own exposures to their counterparties but not what the exposure of any of
their counterparties is to other market participants. During the financial
crisis, the lack of transparency on positions generated mistrust among market
participants and contributed to the drying up of liquidity in the market. 
The second problem relates to the insufficient
management of counterparty risk and lack of collateralisation. OTC
derivatives contracts involve significant counterparty risk, i.e. the risk that
a counterparty may not honour its obligations under the contract when they
become due.[132]
Volatility in the credit risk of market participants can lead to excess
correlations between certain types of OTC derivatives contracts during times of
crisis, amplifying the effects of market participants' credit risk re-pricing
and leading to heightened price volatility in the entire system.[133]
A high degree of market concentration in the OTC derivatives dealer network
amplifies the effect of individual counterparty risk to a system-wide level.[134]
The effect of one of these major dealers facing financial distress or defaulting
altogether then ripples throughout the system, as happened in the case of the
Lehman bankruptcy. Moreover, the absence of regular margin calls exacerbated
pro-cyclicality: market participants reacted to the deterioration of their
counterparties’ credit risk by imposing on them substantial additional margin
calls, triggering liquidity strain on these counterparties and the market as a
whole.
A major problem with derivatives was that
they provided the perception of eliminating the underlying risks, while in
reality they only redistributed them—the overall volume of risks remained
unchanged in the system. 
The crisis revealed that the level of
counterparty credit risk related to OTC derivatives was far higher than
previously thought. OTC derivatives were typically collateralised bilaterally
as opposed to being cleared by a central counterparty (CCP). While bilateral
collateral agreements were concluded to mitigate counterparty credit risk, the
level of collateral provided was inadequate and too low compared to the level
of counterparty credit risk.[135]
Put differently, the amount of leverage in the market was higher than should
have been the case given the amount of collateral. 
Bilateral collateralisation requires
management of numerous clearing relationships with the individual
counterparties, necessitating investments in systems and manpower. Such a
complex web of bilateral networks makes it extremely challenging, if not
impossible for an institution to gauge its aggregate credit risk exposure, also
taking into account that the institution does not have visibility of the
bilateral exposures of its counterparties that may create indirect exposures to
the institution itself. 
The third main problem relates to the lack
of standardisation and insufficient management of operational risk. Many
OTC derivatives contracts were non-standardised and highly complex. Such
contracts require significant manual intervention at several stages at the
processing, which becomes particularly problematic once the transaction volumes
of a type of contract start to increase rapidly. Indeed, in the past, the rapid
expansion of volumes in the OTC derivatives market has invariably led to
significant processing backlogs of unconfirmed trades.[136] Low levels
of standardisation of contracts and low automation of processes increases
operational risk, i.e. the risk of loss resulting from inadequate or failed
internal processes, people and systems. This may in turn lead to increased
legal risk, limit transparency and even lead to an increase of counterparty
credit risk. For example, the failure to confirm a transaction because of lack
of automation may jeopardise its enforceability or the ability to net it
against other transactions. Furthermore, to the extent that it allows errors in
recording transactions to go undetected, an unconfirmed transaction may cause
market or counterparty credit risks to be incorrectly measured and, most
seriously, to be underestimated. This risk is further increased when portfolio
reconciliation and dispute resolution procedures are insufficient. The low
levels of standardisation also limit the level of adoption of centralised
market solutions (i.e. trade repositories and CCPs).
An additional issue that concerns
standardisation (or lack thereof) is its impact on liquidity. In general, the
more bespoke the product, the less liquid it is (and hence the more difficult
it is to sell or replace it, even more so in distressed market conditions). 
EU derivative markets reform
Consistent with the international agreement
at G20 level[137],
the EU took action on different fronts to reduce systemic risk and increase the
safety and efficiency of the OTC derivatives market, principally through the
European Markets and Infrastructure Regulation (EMIR) which entered into force
in August 2012: 
·     Central counterparty clearing: EMIR
requires eligible (standardised) derivative contracts to be cleared through
CCPs. It also promotes financial stability by establishing stringent
organisational, business conduct and prudential requirements for these CCPs. 
·     On-exchange trading: standardised OTC
derivatives contracts are required to be traded on exchanges and electronic
trading platforms. As discussed in section 4.3.1 above, this obligation will
enter into force through MiFID II, which governs the operation of trading
venues. 
·     Increased risk management, collateralisation and capital
requirements for non-centrally cleared trades: If a
contract is not standardised and eligible for CCP clearing, enhanced risk
management techniques must be applied to reduce bilateral counterparty credit
risk. EMIR requires financial (and certain non-financial)[138] counterparties to
measure, monitor and mitigate risks, e.g. by improving operational processes
(electronic confirmation of contracts), conducting regular portfolio reconciliation
between counterparties,[139]
and engaging in portfolio compression for large numbers of contracts with the
same counterparty. [140]
In addition, EMIR requires non-centrally cleared trades to be appropriately
collateralised through the posting of initial and variation margins on a
bilateral basis. Separately, under the new capital adequacy framework for banks
(CRD IV package), capital requirements are higher for non-centrally cleared
derivatives. These measures together will also provide incentives to move to
central clearing and trading of derivatives. 
·     Improved transparency: EMIR ensures that
data on all European derivatives transactions is reported to recognised trade
repositories and is accessible to supervisory authorities, enabling them to monitor
effectively the risk and exposures of the major market players and intervene
when necessary to avoid the build-up of excessive concentration of risk that
could lead to systemic failures. Combined with on-exchange trading and central
clearing, this will significantly reduce the current opacity of the OTC
derivatives market.
These measures are
complementary and in combination will facilitate the early detection of risks
building up in the financial system, reduce the counterparty credit risk
related to OTC derivatives, and overall result in more stable OTC derivatives
market. 
Chart 4.3.3 shows a
stylised comparison between the bilateral and CCP clearing models. In addition
to helping mitigate systemic risk, CCP clearing is associated with benefits
pertaining directly to financial institutions, including improved counterparty
credit risk management, multilateral netting opportunities, lower uncertainty
about counterparty exposures and greater transparency of market activity.[141]

 Chart 4.3.3 Stylised presentation of bilateral and CCP clearing || 
 || 
 Source: Commission Services 
Besides lowering
collateral requirements, multilateral netting reduces the settlement risk on
delivery date. CCP clearing is the most effective way of reducing counterparty
credit risk and is broadly feasible in all market segments. Although CCP
clearing can cover large parts of OTC derivatives, it cannot apply to all OTC
derivatives. It is, therefore, also important to improve product and market
standardisation, strengthen bilateral collateral management and to ensure
central storage of contract details.
According to Pirrong
(2011)[142],
CCPs can contribute to the stability of the financial system by reducing price
volatility and the incidence of extreme price moves that can occur when a large
derivatives trading firm defaults.[143]
CCP rules facilitate the porting of customer positions held in accounts at a
troubled CCP member to financially sound member firms. This reduces the
likelihood that a defaulter's clients suffer losses and that customer margin
will be encumbered by the bankruptcy process. It also facilitates the ability
of customers to trade unhindered in the event of default of their clearing
firm. By allocating default losses more efficiently, CCPs can mitigate the
potential for cascading defaults. 
Central clearing
should also enable regulatory capital savings, increase operational efficiency
and solve disruptive information asymmetries for market participants. The use
of specific processes, such as portfolio compression, should reduce counterparty
credit risk and operational risk. Although contract standardisation could lead
to less flexibility for certain market participants, it would be mitigated, if
not offset, by the benefits of such standardisation (e.g. easier adoption of
automated processes, ability to centrally clear).
The obligation to
report all derivatives contracts to a trade repository is expected to allow for
full transparency of the derivatives market. This will enhance the
effectiveness of supervision and also increase market efficiency. The reported
data will be used by micro and macro prudential regulators, central banks and
supervisory authorities. The huge amount of information will of course also
provide challenges for the authorities, since the data needs to be processed to
identify areas where risks are growing. 
Separately, there has also been growing
concern that the trading of derivatives creates instability in the underlying
asset markets and the wider financial system. This concern applies in
particular in relation to commodity derivatives and the related financialisation
of commodities markets. The term "financialisation" stands for
the increased presence of financial investors in commodities markets that are
traditionally dominated by commercial investors, and the related concern that
the presence of financial investors may contribute to excessive physical
commodity price increases and volatility, e.g. for food or energy to the
detriment of consumers.[144]
MiFID II will tackle these concerns by: 1) reinforcing cooperation between
regulators of physical and commodity derivatives markets, given their
increasing interconnection;[145]
2) introducing position reporting requirements to tackle insufficient
transparency in both financial and physical commodities markets; and 3) extending
the scope of MiFID to commodities’ traders to provide supervisors and trading
venues with intervention powers to prevent disorderly markets and detrimental
developments.[146]
In particular, MiFID II introduces position limits for trading in commodity derivatives.
These measures will increase the transparency and market integrity of commodity
derivatives markets and allow regulators and supervisors to better assess the
price formation and price volatility of these markets and their interaction
with primary markets.[147]

Evidence of
improvements in the market
EMIR is already in
force, but some of its key obligations will only take effect going forward. Nonetheless,
operational risk mitigation techniques and reporting to trade repositories are
already effective. Progress towards centralised clearing is underway. CCPs had
to apply for reauthorisation or recognition by September 2013, but the clearing
obligation itself will only apply later in 2014, after CCPs have been
reauthorized under EMIR (to ensure that they meet the strict risk management
standards set down by EMIR) and technical standards on which classes of
derivatives should be subject to clearing have been proposed by the European
Securities and Markets Authority and adopted by the Commission.  
Some improvements
can already be observed in the market. These reflect, at least in part, changes
in the market in anticipation of the future requirements, although it is
difficult to isolate the impact of the rules from other factors influencing the
market. 
The outstanding
notional amounts of OTC derivatives globally increased in the first half of
2013 to reach USD 693 trillion at the end of June 2013 (chart 4.3.4).[148]
The gross market value of OTC derivatives (i.e. their replacement cost at
current market prices) declined to USD 20 trillion in the first half of 2013
(chart 4.3.5), whilst the gross credit exposures (i.e. the gross market values
after bilateral netting but before collateral) stood at USD 3.9 trillion.
 Chart 4.3.4 Outstanding notional amount of OTC versus exchange-traded derivatives (USD trillion) || Chart 4.3.5 Gross market values of OTC derivatives (USD trillion) 
 || 
 Source: BIS 
A shift to central clearing increases the
outstanding notional amounts due to novation,[149] which in part
explains the increase in the notional amounts observed in 2013. 
The percentage of centrally cleared OTC
derivatives has increased steadily (chart 4.3.6). It is expected that
ultimately some 70 % of the OTC derivatives market would be centrally cleared.[150]
It has been estimated that the volume of cleared OTC transactions (notional
amounts without adjustment for double counting) at the end of 2012 totalled USD
346.4 trillion, of which USD 341.4 trillion was attributable to interest rate
derivatives and USD 5 trillion to CDS.[151]

EMIR mandates portfolio compression (whereby
offsetting trades are identified and eliminated) when there are a large number
of trades with the same counterparty, so as to minimise related operational
risk. Portfolio compression is already increasingly being used in the market,
so the EMIR provision is setting minimum standards that match good market
practice.    
Chart 4.3.7 shows the increase in portfolio
compression activity over time. Portfolio compression reduced the notional
amounts of OTC derivatives by USD 48.7 trillion in 2012.[152]
Approximately USD 35.9 trillion worth of the compressed interest rate
derivatives transactions was centrally cleared. 
CDS are now particularly prone to efficient
compression, as a large proportion of contracts were standardised during 2009
and 2010. Overall, USD 143.7 trillion of interest rate derivatives and USD 70.6
trillion of CDS have been eliminated via portfolio compression since the end of
2007.
 Chart 4.3.6 Central clearing of OTC derivatives (% of outstanding notional amounts) || Chart 4.3.7 Portfolio compression of OTC derivatives (% of outstanding notional amounts) || 
 || || 
 Source: BIS, ISDA 
In the CDS market,
CCPs were party to some 23 % of the notional amounts outstanding at the end of
June 2013, based on BIS data (chart 4.3.8). Although the DTCC Global Trade
Repository data slightly differs from BIS statistics, it equally confirms
steady progress with the share of centrally cleared OTC derivatives (chart 4.3.9).
CCPs are party to some 60 % of the notional amounts of all OTC interest rate
derivatives outstanding (i.e. swaps and forward rate agreements – FRAs). The
rapid rise in the central clearing of FRAs is particularly notable, since it
only started in 2010. 
 Chart 4.3.8 Central clearing of credit default swaps (% of notional amounts outstanding) || Chart 4.3.9 Central clearing of OTC interest rate derivatives (% of notional amounts outstanding) 
 || 
 Source: BIS || Source: DTCC and TriOptima 
The industry has
also been collateralising a significant and increasing proportion of
bilaterally cleared OTC derivatives trades, reducing counterparty credit risk
ahead of the new margining rules.[153]
Estimates suggest that the estimated collateral in circulation in the
bilaterally cleared OTC derivatives market rose by 1 % in 2012.[154]

 Figure 4.3.10 Collateralisation of bilaterally cleared OTC derivatives transactions (% of gross credit exposure of all OTC derivatives) 
 Source: BIS, ISDA 
In light of the
ongoing shift towards central clearing and portfolio compression, the
collateralisation level of bilaterally cleared OTC derivatives is clearly on
the rise, reaching about half of gross credit exposure of all OTC derivatives.
At the end of 2012, 69 % of bilaterally cleared OTC derivatives trades were
subject to collateral agreements,[155]
with the number rising to 75 % for large firms. Chart 4.3.9 shows the increase
in collateralisation if expressed in percent of gross credit exposure.
The above changes in the market demonstrate
that market practice has changed significantly since the financial crisis
struck.  The market seems to go for increased central clearing and more
collateralisation as a response to the crisis as well as the new regulation and
upcoming requirements.  
The Macroeconomic Assessment Group on
derivatives (MAG) of the BIS published a study in 2013 to assess the expected
overall benefits (and costs) of derivatives reform at global level. Although
subject to uncertainties due to modelling assumptions and data scarcity, the
MAG derivatives study concludes that the main benefit
of the reforms arises from reducing counterparty exposures, both through
netting as central clearing becomes more widespread and through more
comprehensive collateralisation. The Group estimates that in the central
scenario this effectively brings the annual probability of a financial crisis
propagated by OTC derivatives almost down to zero.[156] With the present
value of a typical crisis estimated to cost 60 % of one year’s GDP,[157] the estimations
suggest that the reforms help avoid losses equal to 0.16 % of GDP per year. The
MAG study balances the benefits against the costs to derivatives users of
holding more capital and collateral (see chapter 6), concluding that the net
benefit of the reforms is roughly 0.12 % of GDP per year. While these estimates
are based on derivatives reforms at global level, they suggest gross (net)
benefits of about EUR 21 billion (EUR 16 billion) per year if applied to 2013 EU
GDP.
4.3.3 Enhancing the securities settlement process
Settlement is an important process, which
ensures the exchange of securities against cash following a securities
transaction (for instance an acquisition or a sale of securities). Central
securities depositories (CSDs) operate the infrastructures (so-called
securities settlement systems) that enable the settlement of virtually all
securities transactions. CSDs also ensure the initial recording and the central
maintenance of securities accounts: they record how many securities have been
issued, by whom, and changes in the holding of those securities. CSDs therefore
assume the critical role of guaranteeing a safe and efficient transfer of
securities. Because they provide these services, CSDs are systemically
important institutions for the financial markets.
CSDs in the EU settled approximately EUR 887
trillion worth of transactions in 2012 and were holding almost EUR 43 trillion
of securities.  There are over 30 CSDs in the EU, generally one in each
country, and two 'international' CSDs (Clearstream Banking Luxembourg and
Euroclear Bank). In terms of relative shares, the latter concentrate around 65
% of transactions measured in terms of value between them – up from 55 % in
2006.[158]
Despite their systemic importance, there were
no common prudential, organisational and conduct of business standards for CSDs
at EU level. In addition to the lack of common regulatory framework, there were
also no common rules for the settlement process. The access and competition
between different national CSDs are quite limited. These important barriers to
cross-border settlement had a negative impact on the efficiency and on the
risks associated with cross-border transactions. 
While generally safe and efficient within
national borders, CSDs combine and communicate less safely across borders,
which means that an investor faces higher risks and costs when making a
cross-border investment. For example, the number of settlement fails is higher
for cross-border transactions than for domestic transactions (the settlement
failure rate for cross-border transactions reaches up to 10 % in some markets),[159] and cross-border
settlement costs are up to four times higher than domestic settlement costs. At
the same time, cross-border transactions (ranging from usual purchases/sales of
securities to collateral transfers) continue to increase in Europe and CSDs
become increasingly interconnected. These trends are expected to accelerate
with the advent of Target2 Securities (T2S) – a Eurosystem project on
borderless common securities settlement platform in Europe, which is scheduled
to start in June 2015.[160]

The CSD Regulation
In response to these problems, the
Commission proposed a regulation on improving securities settlement in the EU
and on CSDs in March 2012 and the last plenary of the current European
Parliament in April 2014 approved the political agreement reached between the
Union co-legislators. The Regulation is expected to deliver benefits by:
·        
increasing the safety of settlements, in
particular for cross-border transactions, by ensuring that buyers and sellers
receive their securities and money on time and without risks; 
·        
increasing the efficiency of settlements, in
particular for cross-border transactions, by reducing cross-border barriers for
the operations of national CSDs; and to
·        
increasing the safety of CSDs by applying high
regulatory requirements in line with international standards.
In order to achieve the first main benefit,
the Regulation introduces a number of key provisions: the dematerialisation of
securities;[161]
the harmonisation and shortening of settlement periods to a maximum of two
days;[162]
and penalties for failure to deliver securities on the agreed settlement date.
These provisions can be expected to reduce settlement failures and enhance
settlement discipline, thereby enhancing safety of the settlement process.
Regarding the second type of benefit, the
efficiency of the settlement process will be enhanced by reducing the scope for
national monopolies, reducing cross-border barriers and opening access to the
settlement systems: CSDs will be granted a 'passport' to provide their services
in other Member States; users will be able to choose between all CSDs in
Europe; and CSDs in the EU will have access to any other CSDs or other market
infrastructures such as trading venues or Central Counterparties (CCPs),
whichever Member State they are based in (see also section 4.7 on the
efficiency objective of the reforms).
Regarding the third benefit, CSDs will have
to comply with strict organisational, conduct of business and prudential
requirements to ensure their viability and the protection of their users. They
will also have to be authorised and supervised by their national competent
authorities, with ESMA playing a coordination role. Thus, for the first time at
European level, there will be a common authorisation, supervision and
regulatory framework for CSDs.
The Regulation is not yet in force, so it
is too early to observe any impacts in the markets. The analysis in the Commission’s
impact assessment shows that there will be important benefits in terms of
efficiency, over and above the safety of the settlement process (see section
4.8). Overall, the measures should therefore facilitate issuers’ ability to
raise capital in the markets and investors’ ability to place their funds more
safely and cost effectively.
4.3.4 Reducing the financial stability
risks and enhancing the transparency of short-selling and credit default swaps 
Short-selling is a transaction that
involves the sale of a security, which the seller does not own, with the
intention of buying it back at a later point in time (at a lower price).
‘Naked’ short-selling is a transaction whereby the seller has not borrowed the
securities, or ensured they can be borrowed before settlement prior to their
sale. In normal market conditions, short-selling enhances market liquidity and
contributes to efficient pricing by contributing to faster transmission of
information into market prices, thereby mitigating overvaluation. However,
short selling and in particular ‘naked’ short-selling can also be used to
manipulate market prices downwards, at the risk of a short squeeze leading to
settlement failures. Thus, short-selling has the potential to increase the
magnitude of market disruptions by reinforcing a downward price spiral in
distressed markets and amplifying systemic risks. 
Related concerns apply to sovereign credit
default swaps. Sovereign CDS can be used to secure a position economically
equivalent to a short position in the underlying sovereign bonds. The buyer of
a naked sovereign CDS benefits from the deterioration of the credit risk of the
sovereign issuer in a very similar manner as the short-seller of the bonds
derives from this same deterioration in the bond price.  While sovereign CDS
provide the key economic benefit of allowing investors to hedge the default
risk of the (sovereign or corporate) debt, speculation in CDS could put
pressure on the underlying sovereign bond spreads. Similar to short-selling,
there are concerns that this could impair funding conditions for the issuer of
the sovereign debt and potentially provoke a vicious spiral, whereby rising
funding costs translate into an ever increasing probability of default.
Concerns about (naked) short-selling and the
buying of naked sovereign CDS have come to the forefront during the financial
crisis and subsequently in the context of the euro area sovereign debt crisis.
EU Member States reacted very differently to these concerns. A variety of
measures were adopted using different powers by some Member States, while
others did not take any action. There was no legislative framework at European
level to deal with the concerns in a coherent way. The fragmented approach to
these issues risked limiting the effectiveness of the measures imposed, leading
to regulatory arbitrage (which basically means shopping around for the least
onerous regime) and creating additional costs and difficulties for investors. 
The new
short-selling and CDS regulation
In response, the Commission proposed a Regulation
on short-selling and certain aspects of CDS in 2010 that entered into force in
November 2012. Whilst acknowledging that short-selling has economic benefits
and contributes to the efficiency of EU markets (notably, in terms of increasing
market liquidity, more efficient price discovery and helping to mitigate
overpricing of securities), the Regulation seeks to address four main risks:
·        
Transparency deficiencies: the lack of transparency in relation to short selling prevents
regulators from being able to detect at an early stage the development of short
positions which may cause risks to financial stability or market integrity. It
also provides the opportunities to engage in aggressive short-selling that may
have detrimental effects, but go undetected.
·        
The risk of negative price spirals: as noted above, there are risks of short-selling (or short
positions through CDS transactions) amplifying price falls in distressed
markets, and that this could lead to systemic risks.
·        
The risks of settlement failure associated
with naked short selling: when a financial
instrument is sold short without first borrowing the instrument, entering into
an agreement to borrow it, or locating the instrument so that it is reserved
for borrowing prior to settlement (i.e. naked short selling), there is a risk
of settlement failure. Some regulators consider that this could endanger the
stability of the financial system, as in principle a naked short seller can
sell an unlimited number of shares in a very short space of time.
·        
The risks to the stability of sovereign debt
markets posed by naked sovereign CDS positions. 
Correspondingly, the expected benefits of
the Regulation come from:

 Enhanced transparency: significant net short positions in EU shares and government
     debt need to be notified to regulators; 
 Additional powers to regulators in
     exceptional situations within a coordinated EU framework: in exceptional situations, regulators are given the powers to
     impose temporary measures, such as to require further transparency or to
     restrict short selling and credit default swap transactions. ESMA is given
     a central role in coordinating action in exceptional situations and
     ensuring that powers are only exercised where necessary;
 Reducing the risks inherent in naked
     short-selling: certain restrictions are
     imposed on naked short selling of EU shares in order to reduce the risk of
     settlement failures and increased price volatility. In particular, in
     order to enter a short sale, an investor must have borrowed the
     instruments concerned, entered into an agreement to borrow them, or have
     an arrangement with a third party who has located and reserved them so
     that that they are delivered by the settlement date (the so-called “locate
     rule”). These requirements are adapted in relation to sovereign debt; and
 Reducing the risks posed by naked
     sovereign CDS: a ban is introduced on entering
     into a naked sovereign CDS (that is a sovereign CDS acquired by the buyer
     not to hedge against a) the risk of default of the sovereign issuer where
     the buyer has a long position in the sovereign debt of that issuer, or b) the
     risk of a decline of the value of the sovereign debt where the buyer of
     the CDS holds assets or is subject to liabilities the value of which is
     correlated with the value of the sovereign debt. A competent authority may
     temporarily suspend the ban where it believes, based on objective elements,
     that its sovereign debt market is not functioning properly.

A number of exemptions apply, e.g. for
market-making activities and primary market operations, in order to minimise
potential adverse consequences for market liquidity and price discovery (see
chapter 6).
In December 2013, the Commission published
a report with an initial review of the functioning and effectiveness of the
short-selling Regulation since it entered into force in November 2012,[163]taking
into account technical advice from ESMA.[164]
The results show that the Regulation improved the transparency of
short-selling. There is also evidence of a general improvement in settlement
discipline in shares. ESMA considers that the introduction of the restrictions
on naked short-selling had a noticeable impact in reducing the incidence of
settlement failures in share transactions.[165]
However, it cautions that the analysis should be interpreted with due care
given the short time span, the empirical limits and the difficulty in
identifying the specific effects of the Regulation. 
The same applies to the wider economic
effects of the Regulation, where the results are more mixed. For example, two
Member States (Italy and Portugal) are reported to have applied the powers to
temporarily restrict short-selling, but according to feedback from market
participants, the bans created confusion and uncertainty and led to immediate
impacts on liquidity and price efficiency. More generally, the empirical
evidence available indicates that the Regulation has had some beneficial
effects on volatility, mixed effects on liquidity and a slight decrease in
price discovery. Overall, there is however no compelling evidence of a
substantial negative impact (see chapter 6). 
As concluded in the Commission’s review
report of December 2013, it is too early, based on available evidence, to draw
firm conclusions on the operation of the SSR framework which would warrant a
revision of the legislation at this stage. The Commission will, therefore,
continue monitoring the application of the short-selling Regulation. Based on
more empirical data and evidence, and once sufficient regulatory experience has
been accumulated, a new evaluation could be concluded by 2016.
4.4 Stability of shadow
banking  
Definition, size and drivers of shadow
banking growth 
The Financial Stability Board (FSB) defines
shadow banking broadly as “credit intermediation that involves entities and
activities fully or partially outside the regular banking system” or in short “non-bank
credit intermediation”.[166] 
Shadow banking is an important alternative
financial intermediation channel, next to regulated banks, and yields similar
benefits for society. Chart 4.4.1 presents a simplified illustration of such
non-bank credit intermediation in contrast to the traditional bank
intermediation channel (see section 2.3). In practice, shadow banking entities
raise funding with deposit-like characteristics, perform maturity or liquidity
transformation, allow credit risk transfer or use direct or indirect leverage.
Shadow banking is comprised of a chain of interconnected financial
intermediaries that conduct either all three or any one of the classic banking
functions - maturity, credit, and liquidity transformation-, but without access
to explicit public safety nets, such as deposit guarantee schemes and central
bank emergency liquidity assistance. 
Although there are significant data gaps to
date (see box 4.4.1), attempts so far suggest that shadow banking is significant
in size and grew rapidly in the run-up to the crisis (see also chart
3.1.5). The FSB estimates that worldwide aggregated financial assets of “other
financial intermediaries”[167] reached 71.2 trillion USD at the end of 2012, which is equivalent to
24 % of total financial system assets (or 117 % of the corresponding aggregate
GDP).[168] The “EU” non-bank financial intermediation accounts for 31 trillion
USD (i.e. 22 trillion USD for the euro area and 9 trillion USD for the UK),
whereas the US non-bank financial intermediation amounts to 26 trillion USD.
Recent ESRB (2014) estimates of EU shadow banking assets are broadly in line.[169]
Chart 4.4.1: Simplified
illustration of credit intermediation via the shadow banking system
Notes: This chart is a highly stylised illustration
only, which does not give a full picture of the shadow banking system or of the
relative importance of its component parts. See separate list of abbreviations
and further explanations below.
Source: European Commission
Box 4.4.1: Measuring the size of shadow banking 
Measuring the relative size of shadow banks
and shadow banking is challenging in general due to the heterogeneity of entities
and activities, the fact that shadow banking is not always easy to distinguish
from traditional banking, and its scalability and quickly evolving nature. 
Measuring the size of shadow banking is
nevertheless important given the fact that (i) the size of the shadow banking
sector in the EU (more precisely euro area and UK combined) is reported to be
greater than in the US and (ii) the sharp decline in US shadow banking since
the financial crisis is more than compensated by increasing volumes in UK, euro
area, and other jurisdictions (FSB, 2012; FSB, 2013a). ESRB (2014) reports that
the EU shadow banking sector is estimated to have grown in total assets by 67 %
in the 7 years between December 2005 and December 2012 (whereas EU banks
according to ECB MFI statistics have grown by only 34 % or roughly half that
much over that same time period).
Attempts to “fill the gap” are made by ESMA
(2013), Bouveret (2011), Bakk-Simon et al. (2012), FSB (2012; 2013a), and ESRB
(2014). Current efforts necessarily compile and combine several databases that
have not been designed for these purposes and which are managed by central
banks, industry associations, and commercial data providers. FSB (2013b)
provides a summary of the data available to regulators on securities financing
transactions (SFTs), showing the lack of frequent and granular data on EU
securities financing markets. Similarly, ESRB (2013) concludes that the
information available to EU regulatory authorities is not sufficient for the
purpose of monitoring the systemic risks that may arise from SFTs. Existing
industry data or data collected in other publicly available surveys displays
weaknesses in relation to the level of granularity, coverage of instruments and
of institutions and their geographic coverage across Member States. This makes
it particularly difficult to compare and use the data from different surveys
for prudential purposes. To date, the economic and financial statistics
collected for the EU (and euro area) are not detailed enough nor have sufficient
coverage to allow for a full understanding of shadow banking related policy
concerns, such as the leverage and maturity transformation achieved by the
shadow banking sector and the possible channels for systemic contagion towards
the regulated banking sector. Relevant time series statistics are of particular
importance when evaluating possible regulatory measures at the European level. 
Work is currently being undertaken by the
European Central Bank (ECB), European Systemic Risk Board (ESRB) and European
Supervisory Authorities (EBA, EIOPA, ESMA) to fill EU shadow banking data gaps.
In January 2014, the European Commission published a proposal for a Regulation
requiring the reporting of SFTs to trade repositories in the EU (see also main
text). This will allow central banks and supervisors to monitor closely the
build-up of system risks related to SFTs. These initiatives will shed light on
shadow banking activities, in particular with a view to add granularity in (i)
the breakdown within non-bank financial institutions so as to better identify
leverage and maturity transformation concerns, (ii) the counterpart information
to monitor relationships between regulated banks and shadow banks, and (iii)
the residual maturity breakdowns of exposures (current statistics often focus
on original maturity only).
Policy concerns related to shadow
banking
Shadow banking intermediation has important
benefits for financing the economy and can help foster economic growth.
However, shadow banking may, because of its size, give rise to systemic risk,
which has already been highlighted above. 
A second factor that raises systemic risk concerns is the high level
of interconnectedness between the shadow banking system and the regulated
sector, particularly the regulated banking system. Several shadow banking
activities are shown to be operated from within systemically important banks or
in a chain in which systemically important banks play an important role. The
shadow banking system is “much less shadowy than we thought” (Cetorelli and
Peristiani, 2012). In the EU, shadow banks provide up to 7 % of banks’
liabilities, and banks hold up to 10 % of their assets issued by the shadow
banking system (ESRB, 2014). Given that the EU financial system is
bank-intermediated, compared to the much more market-intermediated US financial
system, the EU faces a greater urgency to map and understand the role of large
EU banks in shadow banking activities. Shadow banking is a phenomenon that also
defies geographic boundaries and there are important cross-border and even
trans-Atlantic links between regulated banking and shadow banking. It turns out
that the large EU banking groups have become intimately linked and connected to
the US financial system in the run-up to the crisis, notably through the US
shadow banking sector. At the peak of the crisis, the large EU banking groups were
significantly: (i) relying on funding provided by US MMFs; (ii) acting as
sponsor for USD asset-backed commercial paper (ABCP) vehicles; (iii) borrowing
through repo transactions with US collateral; and (iv) investing in US
mortgage-backed securities (MBS) and asset-backed securities (ABS) (Bouveret,
2011).
Third, regulatory
arbitrage may drive
shadow banking sector growth and in turn raise concerns for the stability and
leverage of the system as a whole. Regulatory arbitrage certainly explains part
of the growth of shadow banking in the US and Europe.[170] In the pre-crisis
period, banks could reduce regulatory capital charges by the use of allegedly
bankruptcy remote special purpose vehicles (so-called conduits and structured
investment vehicles) that relied on implicit (thus not requiring capital
charges) and explicit credit and liquidity support from banks or by simply
holding securitised assets on their own balance sheet which received better
credit ratings than the original non-securitised assets. Regulatory arbitrage
has exploited loopholes and has led to a sharp build-up of risk and leverage
along the way. 
The exploitation of regulatory gaps and
regulatory arbitrage possibilities contributed to the build-up of risk and
leverage in the system. Maturity and liquidity mismatches increased sharply
outside the regulatory perimeter (through SIVs, broker-dealers). Excessive
leverage arose in the financial system. When wholesale funding dried up
throughout the system, an unprecedented systemic crisis has been triggered
which to date requires significant and exceptional government and central bank
intervention. The underestimation of correlation enabled financial institutions
to hold insufficient amounts of liquidity and capital and to sell cheap
insurance against negative shocks. 
Fourth, given the absence of explicit
public safety nets, shadow banking is vulnerable to increased
interconnectedness and bank-like runs, as recently evidenced by the money
market fund (MMF) segment. The crisis of 2008 itself can be seen as a market run
on the repurchase agreement segment. Thus, the procyclical nature of funding
liquidity provided by shadow banking entities can be disruptive, if not controlled
and curtailed.[171]
For example, rehypothecation of collateral to support multiple deals (in
particular, securities lending and repurchase agreements) helped fuel the
financial bubble through increased liquidity as well as the build-up of hidden
leverage and interconnectedness in the system. 
Fifth, shadow banking regulation is
required to curtail moral hazard coming from implicit public safety nets. Given
their de facto similarity to regulated banks, numerous shadow banking
activities and entities have enjoyed the ex post coverage of public safety nets
(see below for experience of MMFs). Safety nets serve useful purposes ex post,
but create incentives for excessive risk-taking and significant competition and
other distortions ex ante. As is the case in the bank structural reform debate
(see section 4.3), the question arises why and to what extent shadow banking
activities necessarily need to enjoy (implicit) taxpayer support. It may need
to be ensured that public safety nets only cover (i) activities essential to
the economy and (ii) liquidity risk (not solvency risk), so as to curtail moral
hazard and aggressive and inappropriate growth of the activities under
consideration. If performed by entities more alienated from commercial banks
(which benefit from public safety nets), shadow banking activities may not
create systemic risks to the same extent. 
Policy concerns are not solely driven by
systemic risk concerns. Regulation can and should help in fostering the
recovery of sustainable, safe and high-quality securitisation markets with a
view to unlocking funding sources for the economy (see chapter 7).  
EU policy measures in the area of shadow
banking
Shadow banking is
a phenomenon that defies institutional and geographic boundaries. The EU regulatory response to the crisis in general and shadow
banking in particular has therefore been internationally coordinated through
the G20 and the FSB. At the end of 2011, the FSB initiated five work streams
aimed at identifying the key risks of the shadow banking system. These work
streams focus on the following policy concerns: 

 limiting spill-overs between shadow banking entities and
     regulated banks; 
 reducing the vulnerability of money market funds
     to runs; 
 identifying and controlling the systemic risks
     from new and unregulated shadow banking entities; 
 assessing and aligning incentives associated
     with securitisation activities; and 
 dampening the
     risks and procyclicality associated with securities financing
     transactions, i.e. securities lending and repo).

The Commission has been active in
addressing the policy concerns raised by the G20 and FSB. The shadow banking
regulatory agenda of the Commission has been set out in a Communication adopted
in September 2013, which also provides a comprehensive overview of the policy
measures taken to date and the work plan going forward[172]. The below sections
focus on specific areas where a new regulatory framework has either been
adopted (AIFMD) or proposed (money market funds, securities financing
transactions). Work in the area of shadow banking is on-going.
Alternative Investment Fund Managers
Directive (AIFMD)
Early on in the crisis concerns arose as to
the use of leverage and counterparty exposures by hedge funds. For this reason,
the Commission proposed in April 2009 a directive on Alternative Investment
Fund Managers (AIFMD), including managers of hedge funds.[173]
Non-harmonised funds or so-called
Alternative Investment Funds (AIFs) contain different investment funds. AIFs
invest in a wide variety of asset types and employ very different investment
strategies. Inter alia, hedge funds, private equity funds, infrastructure
funds, commodity funds, real estate funds or other special funds can all be
classified as AIFs. The AIF sector is estimated to represent around EUR 2.5
trillion in assets. From a prudential and shadow banking perspective, the hedge
funds are the most relevant entities to be analysed.
Macroprudential and microprudential
problems
AIFs amplified the boom and the
subsequent bust. Certain types of AIF managers have exhibited a strong
appetite for credit derivatives and ABS and thus have contributed to the rapid
growth of these markets. AIF managers, in particular those managing large,
leveraged hedge funds, may also have contributed to the pre-crisis asset price
inflation in many markets. The same actors may also have contributed to the
speed and scale of the market correction witnessed in the early stages of the
crisis. On average, AIFs lost significant value during 2008 and assets managed
by EU-domiciled managers contracted by 11.5 %. In addition to adverse market
conditions, many managers were faced with increased redemption demands from
investors and with tighter lending conditions from banks. Leveraged funds were
forced to unwind positions (hedge fund leverage, for example, has declined from
around 3 to 1.5). Faced with such pressures, in particular hedge funds were
often forced to sell assets into declining markets, thereby realising losses
and adding further pressure on declining asset prices. This pro-cyclical behaviour
may have undermined financial stability and contributed to a deepening of the
crisis.
AIFs had inadequate liquidity and
capital (i.e. shock absorbers). Excessive reliance
on counterparties and trend-following at the expense of sound risk management and
due diligence were observed by many market participants, including managers of
alternative funds. The combination of increasing redemption requests and
illiquid asset markets resulted in major funding liquidity risks for several
AIFs. Many AIFs experienced net outflows of funds. Others unable to exit
illiquid investments had to activate gate provisions in order to limit
withdrawals and some offered lower fees in exchange for longer lock-in periods.
The counterparty risks faced by hedge fund managers were demonstrated by the
near-failure of Bear Stearns and the bankruptcy of Lehman Brothers that
highlighted the importance of monitoring the security of the cash and security
balances held with prime brokers.
Adopted measure
The AIFMD aims to put in place a comprehensive
and effective regulatory and supervisory framework for managers of alternative
investment funds in the EU. Concretely, the AIFMD makes all AIF managers
subject to appropriate authorisation and registration requirements, allows
monitoring of macro and microprudential risks, and introduces several investor
protection tools. Another objective is to develop a single market in the area
of AIFs.
The
AIFMD was published in the EU Official Journal in July 2011[174] and Member States were
obliged to transpose it by July 2013. A number of key conditions have to be met
to be authorised as an AIF: it must hold sufficient capital and have
appropriate arrangements in place for risk management, valuation, the
safe-keeping of assets, audit and the management of conflict of interests. 
In order to provide competent authorities and investors with the
necessary information that is needed to monitor the macro- and microprudential
risks, AIFs are subject to detailed reporting requirements on their activity,
including their positions, their risks and their counterparties. A specific set
of rules has been established for the AIFMs that manage leveraged AIFs,
typically the hedge funds. Those funds are subject to more stringent reporting
requirements and competent authorities may decide to limit the use of leverage
should they assess that it may pose a risk to the financial system.
Expected benefits
Due diligence will be facilitated on an
ongoing basis. Each AIF manager will be required to set a limit on the leverage
it uses and will be obliged to comply with these limits on an ongoing basis.
AIF managers will also be required to inform competent authorities about their
use of leverage, so that the authorities can assess whether the use of leverage
by the AIFM contributes to the build-up of systemic risk in the financial
system. This information will be shared with the European Systemic Risk Board.
The AIFMD will also create powers for competent authorities to intervene to
impose limits on leverage when deemed necessary in order to ensure the
stability and integrity of the financial system. ESMA will advise competent
authorities in this regard and will coordinate their actions, in order to
ensure a consistent approach. As a result, the procyclicality of the financial
system is expected to be dampened by the AIFMD. In addition, investor
protection will improve, mainly through the increased transparency of AIFs and
markets.[175]

Money Market Funds (MMFs) Regulation
In Europe, MMFs are an important source of
short-term financing for financial institutions, corporates and governments.
Around 22 % of short-term debt securities issued either by governments or by
the corporate sector are held by MMFs. MMFs hold 38 % of short-term debt issued
by the EU banking sector. MMFs in Europe manage assets of around EUR 1 trillion.
The EU market is equally split between Variable Net Asset Value (VNAV) MMFs and
Constant Net Asset Value (CNAV) MMFs. While VNAV MMFs behave like any mutual
fund with a NAV or share that fluctuates in line with the value of the
investment assets held in the portfolio, CNAV MMFs maintain a constant share
price (e.g. 1 EUR or 1 USD per share), irrespective of fluctuations in the
value of the MMF's investment assets.  
Problems
MMFs give rise
to contagion and are vulnerable to runs. The inherent liquidity
mismatch between the maturity of MMF assets and the commitment to provide daily
redemptions may prevent an MMF from meeting all redemption requests during
stressed market conditions. A liquidity mismatch can cause redemption bottlenecks
for both CNAV and VNAV MMFs. During the crisis, several EU based MMFs had to
suspend redemptions due to their inability to sell illiquid assets (mostly
securitised products like ABCP). If one MMF stops redeeming investors,
investors in all other MMF tended to "rush to the exit" by
withdrawing their money as well. As a consequence, banks and corporate issuers
lose an essential channel to distribute their short-term debt. 
CNAV MMFs are
structured as an investment fund where each share invested can be redeemed at a
stable price (unlike other investment funds). Events in 2007/08 and again in
2011 have shown that stable redemption prices cannot be maintained during
stressed market conditions. In these situations, the MMF has to either decrease
its NAV or share price or the sponsor has to provide financial assistance to
“prop up” a stable redemption price. The first situation (decrease in value) is
often referred to a "breaking the buck" (breaking the dollar or
breaking the euro) because the fund must decrease its NAV from 1 EUR per share
to reflect current market value of its shares. “Breaking the buck” is an event
that can trigger massive outflows, in particular when coupled with a
general deterioration in the credit quality of one or more MMF issuers. The
second situation is less transparent because the injection of sponsor support
avoids that the MMF is obliged to formally "break the buck". Instead,
the MMF sponsor (often a bank) needs to make up the difference between the
stable redemption price and the real value of the NAV out of its own means.
Because banks did not build capital reserves directly linked to their exposure
to the risk of MMFs decreasing in value (regulatory arbitrage), sponsor
support often reached proportions that exceeded the sponsor’s available
reserves.
Proposed measure
The MMF proposal aims to prevent the risk
of contagion to the economy (the issuers of short-term debt) and to the
sponsors (usually banks).[176]
The MMFs should have adequate liquidity to face investor’s redemption requests
and their structure should be transformed such that the stability promise can
withstand adverse market conditions.
In September 2013, the Commission adopted a
regulation proposal that intends to make the MMFs managed and marketed in the
EU safer. Liquidity and stability aspects are at the core of the Commission
proposal. The proposal is now with the co-legislators which may introduce
amendments in the course of negotiations. Under the current proposal, the rules
are expected to enter into force in 2015.
Liquidity shock absorbers are put in place. During the crisis numerous MMFs had to suspend
redemptions or even close the fund. To respond to that problem, MMFs should
always have "natural" liquidity at hand in order to provide orderly
redemptions. This is achieved in the Commission proposal by introducing daily
and weekly minimum thresholds of maturing assets (at least 10 % daily and 20 %
weekly). The second aspect is to ensure that the portfolio is of appropriate
duration and sufficient quality. This is ensured in the proposal by introducing
new diversification standards (5 % cap on individual issuers in CNAV MMFs),
including new maturity and credit requirements for those MMFs that invest in
ABS, in particular ABCP. The third point is on the investor side. Under the
current proposal, managers will be obliged to “know their customers” better (in
terms of redemption cycles and amounts). This is in order to better anticipate
the redemptions patterns of their investors.
The proposal also puts in place solvency
shock absorbers. Stable redemptions are often impossible without the
support of the sponsor. To remedy this unhealthy dependence on 'discretionary'
sponsor support the Commission proposal introduces an obligation that all CNAV
MMF gradually establish a capital buffer amounting to 3 % of the MMF's NAV.
This buffer will serve to absorb differences between the stable NAV per share
and the real NAV per share. 
Expected benefits
The proposed MMF regulation is expected to
render the European MMFs more secure in adverse market conditions, mitigating
systemic risk concerns. The regulation is expected to give retail investors a
fairer treatment (compared to institutional investors). By increasing the MMF
safeguards, more retail investors will be attracted to these markets. With
regard to SMEs, their protection will be enhanced when acting as investors.
SMEs, like corporates of larger size, may use MMFs to place their excess cash
for short periods. Reducing the probability to face limits or suspensions of
redemptions will prevent SMEs from suffering cash shortfalls.[177]
Regulation on the reporting and transparency
of Securities Financing Transactions (SFTs) 
Securities financing transactions (SFTs)
are considered to be any transaction that uses assets belonging to the counterparty
to obtain funding from or to lend them out to another entity. In practice, this
includes lending or borrowing of securities and commodities repurchase (repo)
or reverse repurchase transactions, or buy-sell back or sell-buy back
transactions. SFTs are used by almost all actors in the financial system, be
they banks, securities dealers, insurance companies, pension funds or
investment funds.  According to ESMA (2014), EU repo markets account for
some 70 % of the EU shadow banking sector’s liabilities, which, in turn, equal
19 % of the EU banking sector liabilities. At the end of 2013, the total size
of these markets had shrunk to EUR 5.5 trillion, compared with over EUR 6
trillion in June 2013.[178]
Global estimates on securities lending transactions are EUR 1.4 trillion.[179]
According to ESMA (2014), the total value of EU securities on loan averaged USD
560 billion in the second half of 2013. EU government bonds at USD 336 billion
represented the main type of assets on loan at end-2013, whilst equities averaged
USD 160 billion and (EUR and GBP) corporate bonds USD 57 billion. The main
purpose of SFTs is therefore to obtain additional cash or to achieve additional
flexibility in carrying out a particular investment strategy. 
Problems
SFTs have the propensity to increase the
build-up of leverage in the financial system as well as to create contagion
channels between different financial sectors. The recent financial crisis
showed that securities financing markets are vulnerable to bank-like runs and
fire sales of the underlying collateral, especially when the value of the
assets is decreasing. Moreover, the assumption that securities financing is
always robust even in stressed market conditions proved to be flawed, as
interconnections among markets and market participants led to contagion. 
EU regulatory authorities lack the
necessary data to better monitor the use of SFTs and the risks and the
vulnerabilities for the stability of the financial system that they imply. At
the same time, investors are not properly informed whether and to what extent
the investment fund, in which they have invested or plan to invest, has
encumbered or intends to encumber investment assets by means of engaging in
SFTs and other equivalent financing structures that would create additional
risks for the investors. Finally, insufficient contractual transparency makes
clients uncertain about the extent to which their assets can be rehypothecated,
or about the risks posed by rehypothecation.[180]

Proposed measure
Different measures on the transparency
of shadow banking activities have been proposed in
January 2014.[181]
Under the current proposal, the transparency measures
would enter into force in 2016.
To ensure that regulators have
access to the information, the proposal requires that all SFTs are reported to
a trade repository, or, if that is not possible, directly to the European
Securities and Markets Authority (ESMA). In order to ensure that investors have
sufficient information over the use of SFTs, the proposal requires periodical
reports and fund's pre-investment documents such as the prospectus to include
detailed information on the use of those SFTs by fund managers. To ensure that
investors are informed over rehypothecation activity, the proposal includes
specific transparency requirements which have to be met by the parties
involved, including written agreement and prior client consent.
Expected benefits
Transparency in the area of SFT
is important as it provides the information necessary to develop effective and
efficient policy tools to prevent systemic risks. The reporting of SFTs to
trade repositories will allow supervisors to better identify links between
banks and shadow banking entities. It will also shed more light on the funding
operations of shadow banking entities. Supervisors and regulators will then be
able to monitor the market and, if necessary, design better-targeted and timely
actions to address any risks to financial stability that emerge. Transparency
in the use of SFTs by investment funds is vital. At present, there is very
little information available on the use of these transactions by funds, in
particular with regard to securities lending and total return swaps. The
Regulation will therefore not only benefit investors, but also enable
regulators to access valuable information. This, in turn, will allow them to
assess the risk linked to the use of these instruments and propose further
measures if necessary. Finally, the harmonised rules with respect to
rehypothecation will limit potential financial stability risks and remove
uncertainty about the extent to which financial instruments have been
rehypothecated.[182]
4.5 Stability and resilience of the insurance sector 
The insurance industry was significantly
affected by the crisis (and in some cases as more
than mere innocent bystander). In particular, since the origins of the crisis
lay in credit markets, those firms offering various forms of credit insurance
were significantly affected, as were the insurers as investors in credit
products. Furthermore, across the sector, equity market movements presented
significant challenges to insurance companies. EU insurance companies
themselves experienced a sharp drop in their share prices following the onset
of the crisis, although the trend has reversed since (chart 4.5.1). The financial
positions of insurers have suffered from the low interest rate environment
following the onset of the crisis and from the slow economic recovery and weak
growth outlook. Moreover, due to their sovereign debt exposures, the sovereign
debt problems created financial and operating problems for domestic insurers in
some parts of the euro area, as clearly evidenced in the recapitalisation needs
of a number of insurers following the 2012 Greek sovereign debt restructuring.
At the more general level, the crisis demonstrated the need for effective risk
management and governance for insurance companies just as much as for banks. 
 Chart 4.5.1: Share prices of European insurers (index, 02/01/2003 = 100) || Chart 4.5.2: Total assets of 10 large EU insurers vs banks (EUR billion) 
   || 
 Notes: Shows Stoxx 600 Insurance Europe index and corresponding index for banks. Source: Bloomberg || Note: Sample includes 10 insurers (Axa, Allianz, Generali, Legal & General, Aviva, Prudential, Aegon, CNP Assurances, ING Verzekeringen, Crédit Agricole Assurance) versus 10 banks (HSBC, Deutsche Bank, BNP Paribas, Barclays, Crédit Agricole, RBS, Santander, SocGen, Lloyds, Groupe BPCE). Source: SNL Financial 
The risks and business profile of insurance
are different from banking in at least two main respects. First, the business
model is different: whereas banks (and shadow banks) are typically involved in
the maturity transformation of short-term liquid liabilities into longer-term
assets, insurers typically do not take such maturity transformation risks.
Thus, insurers are less exposed to liquidity risks and "runs".[183] Second, the failure
of insurance firms is far less likely to create systemic risks than that of a
bank (and not just because the largest insurers are generally smaller than the
largest banks, see chart 4.5.2). This means that financial stability risks are
less relevant in insurance than in banking. Many of the risks are independent
and uncorrelated (e.g. natural disasters, life expectancy).
Nonetheless, from a prudential regulation
point of view, banks and insurers have at least one important thing in common
which distinguishes them from other financial services providers, namely that
they bring the funds which customers deposit or invest directly onto their
balance sheets and therefore expose customers directly to the financial risk
inherent in those balance sheets. 
Also, insurer failure[184] can directly disrupt
the provision of critical financial services. For example, long-term savings
contracts provided by life insurers that are often an individual's primary
pension provision are critical financial services that can often be substituted
only at an unacceptable cost. 
Insurer failure may also result in
financial instability if the failure propagates stress to other financial
firms.[185]
For example, interconnections within the insurance sector can be generated
through reinsurance, whereby insurers pass on some of the risks they have taken
on to other insurers. While reinsurance helps individual insurers manage their
insurance risk, it also results in additional counterparty risk exposures.
Hence, failure of a major reinsurer (although not observed in practice) could
affect the solvency of the insurers from which it faced claims. 
Insurers are also interconnected with other
parts of the financial system, either because of their participation in
financial markets or because insurers form part of wider financial groups. In
most European countries, insurance companies are the largest institutional
investors and have the potential to disrupt financial markets. Owing to the
rising size of insurers’ investment portfolios, any significant risk
reallocation within the insurance industry has the potential to impact asset
price dynamics. 
The collapse of AIG – a major global
insurance group – in 2008 was triggered by its activities in derivative and
securities lending markets. It was not AIG's insurance underwriting activity
which caused the failure, but the auxiliary financial market activities it undertook
on the back of its core insurance business. The US government rescued AIG
partly because of the likely impact that a disorderly failure would have had on
other market participants. In the EU, a number of insurers – and financial
groups with an insurance arm - also received state aid during the crisis.[186] 
Overall, the economic case for
regulation to achieve stability and resilience of the insurance sector is
justified, inter alia, by two key sources of market failures: 

 First, there is asymmetric information
     (as is the case in banking and other financial services provided).
     Policyholders need to be confident that commitments made by insurers will
     be honoured, but they do not have sufficient information to assess this.
     They do not have the expertise to appraise insurers' financial statements
     and make an informed assessment of an insurer's solvency. There is also
     limited market oversight and discipline. There is scope for moral hazard
     behaviour given that insurers receive premiums upfront, but it can take
     time before any payments are due. This leaves scope for insurers to take
     action that conflicts with policyholders' interest and financial
     stability. The incentive problems are reinforced if insurers believe that
     government bailout in the event of failure is likely.  
 Second, there are negative externalities
     in that the potential impact of a failed insurer could raise financial
     stability concerns and cause other adverse spillover effects to the
     economy, albeit much less so than a failed bank, as set out above. 

The insurance sector has of course long
been subject to solvency standards to mitigate the risk and impact of insurance
failure. However, it has also long been recognised that the prudential
framework for insurance needs a fundamental overhaul: the regime is not risk
sensitive; it has not ensured the removal of all restrictions preventing the
proper functioning of the single market; it does not properly deal with group
supervision; and it has been superseded by industry, international and
cross-sectoral developments. This led to the Solvency II Directive proposal
presented in July 2007 and amended in February 2008[187]. 
The new prudential framework for
insurers (Solvency II)
The overriding objective of Solvency II is
to bring about a fundamental change to the solvency and risk management
standards for the European insurance industry and to thereby increase the
resilience and stability of the insurance sector, resulting also in improved
policyholder protection. More specifically, Solvency II will deliver, inter
alia:

 a risk-based capital framework—Solvency II replaces 14 existing Directives on insurance
     supervision. It will implement an economic and risk-based supervisory
     framework. Insurers will have to hold sufficient financial resources to
     cover the risks inherent in their business and to absorb unexpected
     losses.[188]
     The adoption of this framework should encourage firms to better understand
     the risks they run, and thus increase the resilience of both firms and the
     industry as a whole.
 a market-consistent approach—Solvency II aims to embed a market-consistent approach to the
     regulation of insurance across the EU. Market-consistent valuations for
     both assets and liabilities of insurers' balance sheets will give both
     markets and supervisors much greater clarity of a firm's financial
     position, including the firm's capacity to meet its obligations;
 improved transparency—Solvency II requires consistent data disclosures by firms
     across Europe. This should facilitate better peer analysis on a pan-EU
     basis and generally raise the level of understanding by investors,
     supervisors and policyholders. Increased public disclosure will also
     enhance market discipline.
 improved supervision and intervention
     tools—Solvency II creates a codified ladder of
     intervention across the EU which will help group supervisors to act
     quickly and effectively in times of firm-specific or systemic stress.

Moreover, different regulatory regimes across
the EU often place different financial requirements on very similar products,
favouring some firms and disadvantaging others. By moving to a harmonised
risk-based approach, Solvency II should align regulatory requirements with the
underlying economics and risks of individual products. This will provide a
level-playing field across the EU. Supervisors will be able to get a
better, more consistent, view of European groups. Also, harmonisation and
greater transparency may lead to increased competition. Moreover, firms which
operate across the EU will have lower costs of regulatory compliance.
The new regime emphasises that capital is
not the only (or the best) backstop against failures, and stresses the
importance of risk identification, measurement and proactive management.
Indeed, one key benefit that the Solvency II process has already generated
is improved risk management. The launch of the Solvency II project in 2000
induced some firms (and supervisory authorities) to embrace the new provisions
early.[189]
Insurers (especially the large ones) started introducing stress scenarios and
internal models for risk-based capital allocation, as well as increasing the
profile of risk management and strengthening compliance teams to gear up early
for Solvency II. Also, some firms' business models have already changed for the
better. Insurers which started constructing (and in some cases applying)
internal capital models before the crisis indicated that this has helped them
through the crisis.[190] 
More generally, the process of internal model development brings benefits
through improved understanding of the sources and magnitude of risks facing the
companies.[191]

The introduction of internal models has
however raised a number of concerns, in particular given the recent experience
where sophisticated internal capital models, e.g. in banking, have not been
reliable. Wide-spread adoption of internal models may also result in a loss of
transparency and comparability between insurers. This has led some to call for
companies that have an internal model approved by the regulator to also report
a solvency ratio calculated using the standard formula of pre-determined risk
weights.  
Solvency II with risk-based capital and
market-consistent valuation was vigorously supported by the industry in the
pre-crisis boom years. While still supportive of
the overall framework, the crisis has shifted the debate on the expected
impacts of Solvency II. In particular, the low interest rate environment that
followed the crisis presents a major challenge for insurance companies. As a
consequence of the market-consistent valuation approach of Solvency II, the
post-crisis present value of liabilities is higher than it would have been had
the pre-crisis (higher) interest rates prevailed. This, in turn, demands higher
reserves. The effect is significant given the typically long-term nature of
insurance liabilities. 
Given that we are in the aftermath of a
considerable crisis, under a risk-based capital framework like Solvency II, one
would necessarily expect prudential requirements for firms to be higher now
than in the pre-crisis period. One would also expect the risk management of
companies to address the volatility in asset prices and interest rates, since
this can effectively deteriorate insurers' solvency in times of crisis.
However, there is a valid concern that market-consistent valuation may induce excessive
"artificial" volatility in the solvency ratios of insurers with
matched long-term liabilities (see chapter 6 for some of the potential adverse
consequences). This has led to significant modifications to Solvency II
following the crisis experience, through a package of measures known as the
long-term guarantee package.[192]
The measures include adjustments to the discount rates for calculating
insurance liabilities (the so-called "volatility adjustment" and the
"matching adjustment"), aimed at reducing the impact of volatility in
asset prices and credit spreads. This aims to stabilise insurers' capital base
and avoid pro-cyclical investment behaviour of insurers. 
In order to ensure appropriate supervision
of the whole insurance sector, the same principles apply to all insurers.
However, by introducing simplified requirements for small undertakings
proportionate to the nature, scale and complexity of the risks to which the
undertaking is exposed, Solvency II seeks to avoids unduly burdening small,
uncomplicated firms if they are dealing with equally uncomplicated risks.[193]  
Overall, the
aim of Solvency II is not to increase capital levels of insurance companies
across the board. Indeed, quantitative impact studies conducted by EIOPA
demonstrated that the significant majority of insurers are not expected to
raise capital because of Solvency II. Rather, the aim is to align solvency
requirements more appropriately with the underlying economic risks. As a
result, some insurance products may attract a higher capital charge and hence
may become more expensive to provide, but this is because they reflect higher
economic risks (e.g. life insurance products with guarantee). Concerns about
artificial volatility in solvency ratios are being mitigated by the long-term
guarantee package, which will facilitate transition to Solvency II in the
current market environment. Once applicable in 2016,[194] the risk-based and
market-consistent framework can be expected to deliver a more resilient and
stable insurance sector. The actual impact can only be assessed thereafter.
4.6 Financial integration and the Single Market
The single market has brought significant
benefits to EU Member States. It has contributed to solid economic growth and
has supported employment. Estimates suggest that, from 1992 to 2008, the single
market has generated an extra 2.77 million jobs in the EU and an additional
2.13 % in GDP. [195]

Integration in the markets for financial
services is a key element of the single market. Among other benefits, financial
integration has contributed to the convergence and decline in financing costs
for corporations and households and the opening up of investment and
diversification opportunities across Europe.[196]   
Financial integration and the deepening of the
single market in EU financial services is therefore a key objective which
governs all reform measures at European level. As outlined in chapter 3, the
financial crisis revealed significant shortcomings in the institutional
framework supporting the single market and, given monetary union, in particular
within the euro area. This created tensions between financial integration and
stability. 
The financial reform agenda seeks to
address these shortcomings and jointly restore financial integration and
stability. As further set out below, this includes in particular the move
towards a single rulebook for EU financial services (section 4.6.1),
establishment of the European System of Financial Supervision (section 4.6.2)
and the proposal to create a Banking Union with a single rulebook, a Single
Supervisory Mechanism (SSM) and a Single Resolution Mechanism (SRM) (section
4.6.3).  Additional measures taken as part of the Single Market Acts I and II
to promote access to finance are also briefly presented (section 4.7.4).  
4.6.1 Towards a true single rulebook 
The financial crisis revealed a significant
lack of harmonised rules, leaving excessive room for divergences in national
rules and a fragmented supervisory framework lacking consistency and
coordination among supervisors, both across borders and across financial
sectors. The lack of harmonisation resulted in a regulatory patchwork and huge
legal uncertainty for financial institutions and investors, allowed for the
exploitation of regulatory loopholes, distorted competition and created barriers
for financial actors and investors to operate across the single market.
Moreover, the financial crisis has shown the disruptive effects of national
divergent approaches and ring-fencing measures which are incompatible with an
integrated market. 
In response to the crisis, a number of
countries took unilateral action and imposed regulatory reforms aimed at
reducing financial stability risks at national level. Examples include actions
to suspend or ban short-selling, implementation of special frameworks for bank
resolution, reforms to restrict the structure of banks, and so on. The national
rules were divergent and risked not only being ineffective, given the
integration of markets, but also creating arbitrage opportunities and related
distortions.  Thus, a main benefit of EU level action comes from achieving a
coordinated, harmonised response to the crisis across the EU (and better
coordination of the crisis response at global level between the EU and its
international partners). 
The need for coordinated action also
applies to policy measures that are not directly crisis-related. For example,
the current prudential framework for insurance companies is based on minimum
standards that can be supplemented by additional rules at national level. Most
Member States operate an 'EU-minimum plus' regime whereby insurers are subject
to more stringent requirements than those set out in the current insurance
directives. There are also continuing significant differences in the way in
which supervision is conducted, which further undermines the creation of a
level playing field and the integration of the EU insurance market. It also
increases costs for cross-border insurers and hinders competition within the
EU. Solvency II, once it enters into force in 2016 (see section 4.5 above),
will change this and lead to a convergence of prudential standards.  
More generally, a well-functioning internal
market for financial services presupposes stringent, efficient and harmonised
rules for all operators, coupled with an effective supervisory framework,
strong, dissuasive sanctions and clear enforcement mechanisms. In order to
establish a unified regulatory framework for the EU financial sector, the
European Union has engaged in the process of establishing a truly single
rulebook providing for a single set of harmonised rules for the financial
sector throughout the EU. The single rulebook does not only contribute to an
integrated market by ensuring a uniform regulatory framework and its uniform
application, but also closes regulatory loopholes and thus contributes to a
more stable financial system. In addition, it will contribute to a more
efficient and transparent financial system, since market participants only have
to apply with one set of rules instead of 28 different sets of rules. It will
thereby reduce compliance costs for cross-border activities and increase legal
certainty. Moreover, the single rulebook will ensure higher quality of
available and comparable information across the EU for supervisors, market
participants, investors and consumers. Improved transparency will contribute to
effective supervision but also to market and investor confidence.
The creation of the ESFS, and in
particular, the three European supervisory authorities (EBA, ESMA and EIOPA) is
instrumental for further developing the single rulebook.
4.6.2 The establishment of the ESFS 
Building on the recommendations of the De
Larosière report[197],
the Commission presented in October 2009 proposals to strengthen financial
supervision, which were adopted by co-legislators in November 2010. The
European System of Financial Supervision (ESFS) consists of three
micro-prudential European Supervisory Authorities (ESAs), namely the European
Banking Authority (EBA), the European Insurance and Occupational Pensions Authority
(EIOPA), and the European Securities and Markets Authority (ESMA), working
within a network of national competent authorities (NCAs) and the European
Systemic Risk Board (ESRB) as the macro-prudential body. The ESFS has been
operational as from January 2011.
The ESFS reinforces the stability and
effectiveness of the financial system throughout the EU. The ESAs take
important regulatory, supervisory, financial stability and consumer protection
roles. The ESRB provides early warnings of system-wide risks that may be
building up and, where necessary, issue recommendations for action to deal with
these risks. Close cooperation between the micro- and macro-prudential levels
is essential to achieve valuable synergies, to mutually reinforce the impact on
financial stability and to benefit from a fully integrated supervisory
framework. The regulations establishing the ESFS provide for regular reviews of
the system. The first comprehensive review has been carried out during 2013.
The report will be adopted soon. 
While the new system has been operational
for just three years (and the parallel establishment of the Banking Union needs
to be taken into account), the ESA are widely perceived as having performed
well and to have contributed to re-establishing confidence in the financial
system. They are seen as having played a particularly important role in
preparing draft technical standards, fostering supervisory convergence and
culture through their participation in colleges, identifying and assessing
systemic risks. EBA also had an important role in the stress tests and the
recapitalization exercise of European banks in 2012/13. 
The establishment of the Banking Union (see
below) and notably of the Single Supervisory Mechanism (SSM) as a key component
will impact the functioning of the ESFS, but does not call into question its
existence and necessity. The ESAs, and in particular the EBA, will continue to
be responsible for contributing to the single rulebook applicable to the EU 28
and ensuring supervisory convergence. Close cooperation between the EBA and the
ECB will be crucial to avoid duplications and ensure a smooth functioning of
the Banking Union within the wider single market for banking services. 
The review process, as well as the own
initiative report of the European Parliament[198]
and the FSAP report by the IMF[199],
identified some shortcomings of the ESAs, in particular regarding the
governance and the limited action in the area of contributing to supervisory
consistency and on consumer protection 
The ESRB has managed to establish itself as
a key component of the European supervisory framework. It provided a unique
forum for discussion on financial stability issues throughout the crisis and
contributed to raising awareness among policymakers on the macro-prudential
dimension of financial policies and regulations. There are, however, a number
of areas for improvement in terms of external organisation, internal governance
and output, in order to enhance the efficiency of macro-prudential oversight at
EU level. As the areas for potential improvements relate mainly to governance
issues, legislative action seems appropriate.
When establishing the ESFS particular
attention has been given to the interaction between the ESRB and the ESAs.
Close interaction is ensured by cross-membership among the three
micro-prudential authorities and the ESRB via the Joint Committee of the ESAs.
The cooperation between the micro- and the macro-prudential elements has
overall worked satisfactorily with minor arrears for improvement being identified
in the course of the ESFS review. 
4.6.3 The Banking Union – towards more
sustainable financial integration  
Boosted by the single currency and benign
market conditions in the run-up to the crisis, the EU banking sector grew and
became more and more integrated. Banks developed significant cross-border
activities, and some outgrew their national markets. As set out in section 3.3,
debt markets and in particular interbank markets had become most integrated,
while cross-border flows in foreign direct investment and equity portfolio
investment more limited. With capital flows in the boom years largely taking
the form of interbank lending and debt, this exposed recipient countries in the
euro area periphery to significant rollover risk. Financial integration was not
backed by an appropriate institutional framework and therefore carried
financial stability risks, especially in the 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-bust cycles observed in several Member States.
Many cross-border capital flows turned out to be excessive and ultimately
unsustainable.
 Chart 4.6.1: Total assets of foreign branches and subsidiaries of euro area banks across euro area countries (in % of total assets of euro area banks) 
   
 Notes: The chart displays the median for the share of cross-border assets and the overall dispersion (interquartile range) across countries Source: ECB Financial Integration Report (2013). 
The financial crisis abruptly stopped the
integration of banking markets, capital flows stopped or reversed, resulting in
significant economic and financial disruption. For example, chart 4.6.1 shows
that cross-border activities of euro area banks across the euro area increased
strongly and steadily between 1999 and 2008 but have been decreasing since
2008. The chart also shows significant differences in the share of cross-border
assets between euro area countries.
Financial fragmentation threatened the
integrity of the single currency and the internal market. It increased the
divergence of interest rates for firms and households across the euro area and
hampered monetary policy transmission. While interest rates are high in the
euro area periphery, fragmentation has led to very low interest rates and
potential distortion of asset prices in the centre.[200] 
Chart 4.6.2 and 4.6.3 show the significant
financial fragmentation in terms of the availability and costs of market
funding for banks, in terms of both their country of residence and the strength
of their balance sheets (see also section 3.3). In the course of the sovereign
debt crisis, debt issuance fell markedly across euro area banks. This process
was most pronounced for banks of smaller size established in
"stressed" countries.[201]
By contrast, debt issuance by banks, in particular large banks, in non-stressed
countries was more resilient and these banks had to pay much lower spreads on
their newly issued unsecured debts than their counterparts in stressed
countries.  
 Chart 4.6.2: Debt issuance by large and complex banking groups (LCBGs) and other banks in non-stressed countries versus that in stressed countries || Chart 4.6.3: Spreads on senior unsecured debt for banks in non-stressed countries versus those in stressed countries 
 || 
 Notes: Excludes retained deals. Debt issuance measured by indices (june 2011 = 100), based on 12-month moving sums. “Stressed countries” refer to Cyprus, Greece, Ireland, Italy, Portugal, Slovenia and Spain. Source: ECB || Note: Shows spread over benchmarks in basis points. Based on euro-denominated fixed rate deals with an issue size of at least EUR 250 million. Excludes retained deals and government-guaranteed debt. In the first half of 2011, only LCBGs from non-stressed countries issued debt that met the above-mentioned criteria. Source: ECB 
The financial crisis clearly revealed the
incomplete nature of integration in the euro area and the strong link between
banks and the Member States in which they are established resulting in a
harmful interplay between the fragilities of the sovereigns and vulnerabilities
of banks. Bail-outs of failing banks imposed a heavy burden on the public debt
of some Member States. As set out in section 3.3, negative feedback loops
between strained national financial budgets and banks jeopardized not only
national financial stability in the EU, but also called into question the
sustainability of the euro area. The crisis demonstrated that a system largely
based on the supervision of banks at national level and lacking a comprehensive
cross-border resolution framework, is incompatible with an integrated and
stable banking sector and a single currency.
On 23 May 2012, the European Council gave a
mandate to its President, in collaboration with the Presidents of the
Commission, the Eurogroup and the European Central Bank, to present a vision
for the future of a more deep and integrated Economic and Monetary Union. On
the eve of the European Council meeting of 28-29 June 2012, the Commission President
laid out the main thrust of the proposal for a Banking Union to restore
confidence in banks and the financial sector, the euro area and the EU as a
whole.[202]
This approach was affirmed by both the European Council[203] and the Parliament[204].
Towards a
Banking Union 
The Banking Union is a vital part of a deep
and genuine Economic and Monetary Union (EMU). It is instrumental for the EU
and, in particular, for the euro area, where banking plays a central role in financing
the economy. Its overarching objectives are to strengthen financial integration
and complete EMU, restore confidence in the financial sector while minimizing
costs to taxpayers, increase financial stability, and thereby contribute to
economic recovery. The Banking Union aims to achieve these objectives by:

 Ensuring that high and common standards
     of prudential supervision and resolution of credit institutions are
     consistently and impartially applied across all banks. The Banking Union
     will enable both supervisory and resolution decisions to be taken with the
     interests of the EU as a whole. This will contribute to create a level
     playing field in the provision of banking services and address the issue
     of "banking nationalism"[205], i.e. the tendency
     of national supervisors to protect financial institutions in their
     territory or promote national champions or attractive financial centres.
     The Banking Union will deliver an institutional setup that allows the
     benefits from further financial integration to be realised in a more
     stable and sustainable way. It will furthermore stop the trend of market
     fragmentation which risks undermining the single market for financial
     services.
 Generating a higher quality of financial
     integration and tackling the current mismatch between financial market
     integration and the fragmented nature of banking policy in Europe.
     Developments in the last years have provided instances of a 'financial
     trilemma'[206],i.e.
     the impossibility to have an integrated financial system, financial
     stability and national responsibilities. The Banking Union is a tool to
     deal with these problems by replacing national for supranational
     responsibility in a European solution which ensures that all Member States
     are appropriately involved in decision making processes.
 Helping ensure the smooth transmission of
     monetary policy, easing current bottlenecks and frictions which threaten
     to derail the appropriate monetary policy set by the ECB. Banks are the
     main transmission channel of monetary policy to the economy. Enhanced
     integration as a result of the currency union has shown the importance of
     establishing a single European regime for banking supervision and
     resolution. Restoring monetary policy transmission should help contribute
     to ease funding conditions of banks and the economy, in particular SMEs in
     vulnerable Member States.

The single market and the Banking Union are
mutually reinforcing processes. The Banking Union rests upon the single
rulebook applicable to all 28 Member States of the EU, in particular the CRD IV
package and the BRRD (described above in section 4.2). It thereby preserves the
unity and integrity of the single market. Furthermore, the EBA will develop a
single supervisory handbook complementing the single rulebook.
As illustrated in chart 4.6.4, the Banking
Union consists of two main pillars: Banking supervision, i.e. the Single
Supervisory Mechanism (SSM); and bank resolution, i.e. the Single Resolution
Mechanism (SRM), consisting of a central decision-making body (the Single
Resolution Board) and a Single Resolution Fund (SRF). These two central pillars
complement each other.
The Banking Union is constructed as a hub
and spokes system with a strong central level (the ECB for the SSM and the Single
Resolution Board for the SRM) and a decentralised level (i.e. national
supervisory and resolution authorities) involved in decision making and in the
preparation and implementation of decisions at the central level.
The SSM and the SRM have the same material
scope and are mandatory for Member States of the euro area, but they will also
be open to the participation of any other Member States that may want to join. All
banks in participating Member States (i.e. alone for the Euro area about 6000
banks with EUR 34 trillion of assets) will be covered. That is, the SSM will
ultimately be responsible for the supervision of all banks in participating
Member States, and potentially all banks will be subject to the resolution
powers of the SRM. This is not only necessary to increase confidence in the
stability of the banking sector but also to maintain a level playing field.
However, in order to ensure practicable and efficient solutions and make best
use of national expertise in this area, there will be an appropriate
distribution of tasks between the centre and national supervisory and/or
resolution authorities.
 Chart 4.6.4: Illustration of key elements of Banking Union 
 Source: Commission Services 
Reinforced supervision within the SSM
will restore confidence in the health of banks. The SSM implies the transfer to
the ECB of specific, key supervisory tasks for banks established in the euro
area Member States and in participating Member States. While the ECB will
retain ultimate responsibility for all banks within participating Member States,
tasks will be distributed between the central level (ECB) and the decentralised
level (national authorities) to ensure practicable and efficient supervision.
This structure will provide strong and consistent supervision across the euro
area, making best use of local and specific know-how to ensure that national
and local conditions relevant for financial stability are taken into account. 
A single supervisor removes some of the
dividing lines between jurisdictions that create compliance costs.[207]
For example, there will no longer be a distinction between home and host
supervisors for cross-border banks within participating Member States. Instead,
there will be a single supervisory model and eventually a single supervisory
culture, rather than one per country. Also, cross-border groups will be able to
report at the consolidated level. Furthermore, with a European supervisor,
borders will not matter. Issues such as protecting national champions or
supervisory ring-fencing of liquidity will no longer be relevant. Therefore,
another benefit of the SSM will be the lack of "hidden barriers" to
cross-border activity linked to national preferences. This means that banks
will be in a better position to achieve the economies of scale that were
promised by the single financial market - and that they also need to be
competitive at the global level.
The SRM will align the decision-making
of bank resolution to the European level and help to ensure the timely,
efficient and impartial resolution of failing banks
minimizing externalities and coordination problems as well as possible tensions
between European supervision and national resolution. In a context where
supervision is moved to the European level, it is essential that the
responsibility for dealing with bank resolution is moved to the same level. 
Repeated bailouts of banks have created a situation of deep unfairness,
increased public debt and imposed a heavy burden on taxpayers. The BRRD will
help EU countries intervene to manage banks in difficulty to ensure that taxpayers
won't have to end up bailing out banks repeatedly again and the SRM will apply
the rulebook set out in the BRRD. On top of improving the challenges faced in
securing adequate cross-border cooperation, the SRM can reduce national
"home" biases that may appear in, and possibly impede, a resolution
event. The SRM will ensure a swift and effective decision-making process
at centralised level. 
The SRM will be accompanied by a SRF funded
via levies from the banking sector to protect the taxpayer from having to
bail-out banks in times of crisis. Since all banks will profit from enhanced
financial stability, the fund should be built up by contributions of all banks
while taking their risk profile into account and hence respect the principle of
proportionality. The SRF will have significant advantages as compared to a
network of national resolution funds: 

 Firstly, in terms of effectiveness by
     pooling resources, providing a bigger 'firepower' and having a greater
     ability to tap markets in the unlikely scenario that it is necessary.
 Secondly, and importantly, the fund can
     provide an appropriate and effective common backstop of financing for tail
     risk events, whereby there is either insufficient private resources to
     absorb the banks' losses, or it is deemed inappropriate for them to do so
     (following the rules and pecking order set out in the BRRD).  This, in
     turn, can fully break the link between the bank and its national
     sovereign. 
 Thirdly, and finally, by aligning the
     supervisory and fiscal incentives of the different stakeholders at the
     supranational and Member State level (i.e. SSM, SRM, national authorities)
     to ensure an efficient and effective resolution of cross-border banking
     groups.

The Regulation establishing the SSM entered
into force in November 2013. The SSM, with the ECB at its centre, will be
operational by November 2014. The proposal for a Regulation establishing the
SRM was presented by the Commission in July 2013. A political agreement on the
SRM Regulation was reached in March 2014 and it was approved at the last plenary of the current European
Parliament in April 2014. The SRM will start resolution planning as from
January 2015 and will have resolution powers as from January 2016. The SRF will
be built-up progressively over a transitional period of eight years. During the
transitional period, the contributions will be allocated to different
compartments corresponding to each participating Member State (national
compartments). These compartments will be subject to a progressive merger so
that they will cease to exist at the end of the transitional period.
4.6.4 Additional measures aimed at boosting growth 
The Single Market Act (SMA) I (April 2011) [208] and the SMA II (October 2012) [209] announced a set of key actions to further deepen the internal market
and help boost economic growth. Focusing only on actions in the area of
financial services, three innovative fund frameworks were proposed: European
Venture Capital Funds (EuVECA); European Social Entrepreneurship Funds (EuSEFs)
and European Long Term Investment Funds (ELTIFs).
For many companies in the EU, access to
finance has become markedly more difficult with the financial crisis (see also
chapter 6). Financing conditions remain tight especially for start-ups and SMEs
and in countries whose economies have been hit most severely by the crisis. A
drop in venture capital fundraising following the crisis is significantly
limiting the funding available for innovative companies. The EU's 21 million
SMEs represent a major asset for sustainable growth and job creation.
Difficulty in accessing finance is one of the main obstacles that prevent SMEs
from launching new products, strengthening their infrastructure and taking on
more employees. This situation is equally true of well-established SMEs and
those that are innovating and rapidly expanding. To help alleviate those
problems the Commission proposed to create European Venture Capital Funds
(EuVECA). The Regulation (adopted in April 2013[210]) will make it easier
for venture capital funds to invest freely across the Union without obstacles
or additional requirements. Its objective is to ensure that SMEs wanting
to use venture capital can call upon funds with the necessary expertise for the
sector and the capacity to offer capital at an attractive price.
The internal market is based on a
"highly competitive social market economy", which reflects the trend
towards inclusive, fair and environmentally sustainable growth. New business
models are being used, in which these societal concerns are taking precedence
over the exclusive objective of financial profit. This trend must be reflected
in the single market. A level playing field must be ensured. Initiatives, which
introduce more fairness in the economy and contribute to the fight against
social exclusion, should be supported. The tremendous financial lever of the
European asset-management industry (around EUR 9 trillion of assets under
management) should be used to promote the development of businesses which have
chosen – above and beyond the legitimate quest for financial gain – to pursue
objectives of general interest or relating to social, ethical or environmental
development. These objectives have guided the Commission in proposing European
Social Entrepreneurship Funds (EuSEF). The Regulation (also adopted in April
2013[211])
sets up a European framework facilitating the development of social investment
funds, which aims to scale up the impact of national initiatives by opening single
market opportunities to social enterprises.
Alongside SMEs and the social economy, other
parts of the economy are vital for restoring growth. This is for example the
case of long-term investments such as in the infrastructure sector. The large
amounts of capital needed to realise infrastructure projects require the
largest possible pool of investors that can only be reached at the level of the
EU. The possibility to raise capital throughout the EU to be invested in
long-term projects is key for facilitating the financing of such long-term
projects. Allowing fund managers to fully benefit from the single market
opportunities in order to boost investments was therefore one of the core
objectives of the European Long-term investment Funds (ELTIFs) proposal.
This proposal (July 2013[212])
introduces a new investment fund framework designed for investors who want to
put money into companies and projects for the long term. It aims at opening new
sources of financing to long term projects and private companies.   
4.7 Integrity of financial markets and consumer and investor
confidence
In addition to enhancing the stability of
the financial system, the financial reform agenda comprises a number of
measures to enhance the integrity of financial markets. This includes the
measures to counter market abuse (section 4.7.1) as well as a broad set of
provisions to enhance the protection and confidence of (retail) consumers and
investors in financial markets (section 4.7.2).  The reforms also include
important measures to address shortcomings in the credit rating process (4.7.3)
and the measures to enhance the reliability of financial information (section
4.7.4 covers accounting standards and 4.7.5 audit market reforms).  
Furthermore, in February 2013 the
Commission adopted a proposal for a Directive to update the legislative
framework for the prevention of the use of the financial system for the purpose
of money laundering and terrorist financing.[213]
The overarching objective for the revision of the
anti-money laundering (AML) framework is to protect the financial system and
the single market from abuse by criminals seeking to launder illicit proceeds,
or from terrorists seeking to fund terrorist activities or groups.  These measures contribute to protecting the soundness, proper
functioning and integrity of the financial system, but are not further
discussed in this report.  
4.7.1 Countering market abuse 
Regulatory reform was needed to counter
abuse more effectively, which include insider dealing and market manipulation. Insider
dealing consists of a person trading in financial instruments when in
possession of price-sensitive inside information in relation to those
instruments. Market manipulation occurs when a person artificially manipulates
the prices of financial instruments through practices such as the spreading of
false information or rumours and conducting trades in related instruments.
Recent developments in financial markets
have significantly increased the possibility to manipulate these markets, for
example on new trading platforms or using automated trading and high-frequency
trading technologies. At the same time, national authorities often lack
effective sanctioning powers, and in some EU countries, criminal sanctions are
not even available for certain insider dealing and market manipulation
offences.  
Based on the total market turnover of
equity markets, total market abuse has been estimated at EUR 13 billion per
year.[214]
In addition to these costs, market abuse undermines market integrity and
investor confidence, with further potential repercussions for financial
stability. 
For example, if the misuse of inside
information is not sanctioned, investors will lose confidence in the market and
they will be willing to pay less for financial instruments. Companies with the
reputation of insiders misusing their information will see their share prices
fall and their cost of raising capital increase. Investor confidence in these
companies will also drop. Considering that confidence losses quickly spill
over, investors may withdraw from the wider market, driving up the cost of
capital for other companies, which ultimately damage the prosperity of the
economy.[215]

Since the start of the crisis, several
high-profile cases of manipulation of financial benchmarks involving many of
the largest EU banks resulted in record fines of several billion euros for
these wrong-doings. Perhaps the most prominent example is that of the
manipulation of interbank rate benchmarks (LIBOR and EURIBOR), which serve as
reference rates for enormous volumes of contracts, including consumer loans and
home mortgages. For example, an estimated EUR 500 trillion worth contracts are
referenced to LIBOR and EURIBOR globally, including about 40 % of household
loans in the euro area which are based on variable rates (see Box 4.7.1). Since
June 2012, when the investigations started, a number of banks have been found
liable for rate-rigging and settled for record amounts of fines. Moreover,
criminal charges are being brought against the relevant traders.[216] There are also
ongoing investigations by the European Commission into the potential
manipulation of commodity price assessments for oil and biofuels used to
reference the prices of spot contracts and to clear derivative contracts in the
markets for these commodities.[217]
Another case of potential manipulation became apparent in summer 2013, this
time involving the alleged manipulation of foreign exchange (FX) rates, and
already led to a series of staff being placed on leave or suspended at many of
the global banks that dominate the FX market. There are also recent allegations
of manipulation of the London gold fix, which according to an academic research
paper could have been manipulated during the last decade.[218]
New EU measures to counter market abuse
The Commission proposed a new regulation on
market abuse and a directive on criminal sanctions for market abuse in October
2011 (MAR/CSMAD[219]).
The objective is to ensure that regulation keeps pace with market developments,
to strengthen the fight against market abuse across commodity and related
derivative markets, and to reinforce the investigative and sanctioning powers
of regulators. Following the uncovering of the manipulation of LIBOR, EURIBOR
and other financial benchmarks, the Commission modified these proposals to make
the manipulation of benchmarks a prohibited and criminal activity under the
market abuse regime in July 2012[220].
A political agreement on both these proposals was reached by the European
Parliament and the Council in December 2013. The files were approved by the
European Parliament in September 2013 and February 2014, and formally adopted
by the Council in April 2014.
In response to the cases of benchmark
manipulation, the Commission further adopted a proposal for a regulation on
benchmarks which aims to enhance the robustness and reliability of financial
benchmarks, facilitate the prevention and detection of their manipulation and
improve their supervision[221].
This proposal reflects the standards for benchmark setting agreed at
international level by the IOSCO members and endorsed by the FSB and the G20.[222]
In addition, commodity markets have become
increasingly global and interconnected with derivative markets, leading to new
possibilities for cross-border and cross-market abuse. The scope of the
existing market abuse regulation has therefore been extended to market abuse
occurring across both commodity and related derivative markets. It clarifies
that such market abuse is prohibited, and reinforces cooperation between
financial and commodity regulators.
Taken together, the reform measures will strengthen the fight against abusive market practices and reinforce
sanctioning powers against offenders. This will enhance the integrity in
financial markets and contribute to greater consumer and investor confidence. 
Box 4.7.1: Investigations against market manipulations
Manipulation of LIBOR, Euribor and Tibor (Tokyo
interbank offered rate)
Since June 2012,
investigations into the manipulation of major unsecured interbank reference
rate benchmarks (IBORs) such as LIBOR, Euribor and Tibor, have been ongoing
worldwide. Large financial institutions including Barclays, UBS, RBS, ICAP and
Rabobank have been found liable for attempted manipulation of IBORs by the UK,
US and Dutch financial authorities and agreed to pay fines totalling around USD
3.7 billion in the settlements so far.[223]
The Directorate General for Competition of the European Commission in December
2013 imposed a fine of EUR 1.7 billion on eight financial institutions for
participation in illegal cartels
in relation to LIBOR and
Euribor.[224]

LIBOR, Euribor and Tibor
reference returns and payments for enormous volumes of derivative contracts,
commercial and personal consumer loans, home mortgages and other transactions
(approximately USD 360 trillion financial instruments are priced by reference
to LIBOR and up to USD 190 trillion to Euribor).[225] Civil claims against
banks involved in the manipulation of these benchmarks are also expected.[226] Certain contributing
banks have left the setting panels for these reference rates because continued
participation exposes them to reputational and regulatory risk, as well as to
large fines.
These investigations
into the manipulation of IBORs have evidenced the existence of conflicts of
interest which combined with the use of discretion and inappropriate governance
and controls in the setting of these rates made possible their manipulation.
The lack of transparency over the setting process, including of their
methodology and input data, and the poor corporate ethics of some contributors
were also key factors in their manipulation. For example, it appears that the
main motivations behind the attempts to manipulate the benchmark rates were
either to avoid signalling to markets credit issues of the relevant financial
institution (by contributing unsecured interbank lending rates lower than the
actual ones during financial stress periods) or to profit from trades on
derivatives referenced to these benchmarks (by manipulating the reference rates
prior to settlement). This was facilitated by the lack of governance and
controls in place at the relevant banks to manage these conflicts of interest.
Also, the benchmark setting process allowed manipulation because of the
discretion it gave the contributing banks and the lack of transparency. 
Inappropriate
governance, controls and transparency over the benchmark setting process by the
benchmarks’ administrators are determinant factors, as evidenced by the
recommendations of the ‘ESMA-EBA report on the administration and management of
Euribor’[227]
and the ‘Wheatley Review of LIBOR’[228].
FX investigations 
At least six authorities
worldwide, the European Commission, Switzerland’s markets regulator Finma and
the country’s competition authority Weko, the UK’s Financial Services
Authority, the Department of Justice in the US and the Hong Kong Monetary
Authority,  are investigating whether traders in some of the world’s biggest
banks colluded to manipulate benchmark rates in the USD 4 trillion daily
foreign exchange market. The investigations are examining areas such as the
WM/Reuters FX rates following allegations that banks allegedly attempted to
manipulate benchmarks and trade ahead of customers. In view of these serious
concerns, the FSB set up a Foreign Exchange Benchmark Group on 14 February
which will undertake a review of FX benchmarks and will analyse market
practices in relation to their use and the functioning of the FX market[229]. 
It appears that FX
traders colluded with counterparts to front-run client orders and manipulated
the WM/Reuters rates by pushing through trades before and during the 60-second
windows when the benchmarks are set. This practice seems to have occurred
almost daily over a long period of time[230]. 
As in the IBOR case, the existence of conflicts of interest (potential for
large gains by front running client orders and manipulating the WM/Reuters FX
rates) and the inappropriate governance and controls to manage those at
contributor level, combined with the exercise of discretion by traders on which
orders to place during the benchmarks setting window, may have had a key role
in their manipulation. 
Price assessments for
oil and biofuel
There are also ongoing
investigations by the European Commission into the potential manipulation of
commodity price assessments for oil and biofuels used to reference the prices
of spot contracts and to clear derivative contracts in the markets for these
commodities.[231]
There are concerns that the companies may have colluded in reporting distorted
prices to a price reporting agency to manipulate the published prices for oil
and biofuel products. Again, potential conflicts of interest at contributor
level are key. The companies reporting prices to PRAs are also the users of
their price assessments and they could, for example, profit on trading
derivatives for a product (e.g. oil) by colluding to manipulate its price
assessment. Thus, the administrators of these benchmarks and their contributors
should have effective governance and controls in place to minimise and manage
conflicts of interest and to detect potential manipulation attempts.
London gold fix
The potential
manipulation of the London gold fix was exposed by the media already in 2013
and the allegations gained strength in February 2014, following an academic
research paper by Professor Rosa Abrantes-Metz, University’s Stern School of
Business and Albert Metz, managing director at Moody’s Investors Service, which
has not been published yet.
[232]  According to this research paper,
“unusual trading patterns around 3 p.m. in London, when the so-called afternoon
fix is set on a private conference call between five banks of the biggest gold
dealing banks, are a sign of collusive behaviour”. The paper also concludes
“the structure of the benchmark is certainly conducive to collusion and
manipulation, and the empirical data are consistent with price artificiality”.
The German regulator BAFin launched an investigation into gold-price
manipulation already in 2013 and, at the time of writing, the UK Financial
Conduct Authority was examining how gold prices were set.[233]
4.7.2 Protecting consumers and retail investors 
Failures in adequate financial consumer protection can be
considered to be both triggers and magnifiers of the financial crisis:[234]
practices, such as abusive loan origination, mis-selling, conflicts of interest,
inadequate complaints handling, transfer of foreign currency risk, and exploiting
the vague and complex terms and conditions of contracts all have increased the
level of indebtedness of households.  
Many households accumulated risks that they were not aware
of or did not understand in the run up to the crisis. When the crisis unfolded
these factors could only amplify the consequences. The financial crisis has had
massive direct and indirect implications for EU households (see chapter 3),
including in their role as taxpayers involved in bail-out processes but as well
via its impact on growth, employment, earnings, disposable income, public
finances, the provision of public services, both expected public and private
pensions, savings rations and financial and non-financial wealth. 
In countries where there were real estate bubbles before
the crisis and where greater quantities of debt were built up in the run up to
the crisis, many households ended up with negative equity. Also, in some Member
States, particular consumer credit problems were created by the availability of
erstwhile ‘cheap’ foreign currency loans. Due to exchange rate effects, many
consumers ended up in a debt spiral with significant personal consequences. 
Increased levels of household indebtedness are a particular
policy concern.[235] EU-SILC survey data shows that, in
2011 and across the EU area as a whole, one in almost nine households (11.4 %)
were in arrears with payments on rent/mortgage, utility bills or
hire-purchase/loan agreements. These averages conceal a wide variation in the
levels and nature of the financial difficulties being faced by households in
individual countries. 
Concerns do not just apply in relation to consumer debt,
but also in relation to other financial products. The financial crisis has
shown that the consequences of taking unexpected risks and facing consequent
losses can be devastating for consumers, also because investments in financial
products often form the backbone of a consumer's life savings.
A study trying to assess the EU-wide scale of mis-selling
concluded that around 60 % of sales in a mystery shopping exercise across all
EU markets might be deemed 'unsuitable'.[236] The study identified problems
linked to non-compliance with existing point of sale rules and also noticed
that a significant proportion of advice focused on products that are less
regulated at the point of sale, indicating a possible form of regulatory
arbitrage. The study found further problems with the disclosures concerning the
products recommended to clients. 
A national markets survey by the Joint
Committee of the European Supervisory Authorities highlighted numerous
problems arising from the selling of complex products with potentially
volatile outcomes to retail consumers.[237]
In addition to earlier large-scale mis-selling episodes such as the mis-selling
of Payment Protection Insurance (PPI) in the UK, with remediation costs
amounting to some EUR 15 billion, Table 4.7.1 below lists cases of actual or
suspected mis-selling to retail customers across a wide range of countries.
Table 4.7.1 Retail mis-selling of
financial products across the EU
Source: KPMG
(2014) based on Joint Committee of the European Supervisory Authorities (2013).
In
addition, some banks may have mis-sold interest rate swaps to SMEs and
municipalities in the UK, Germany and Italy. Box 4.7.2 provides some further evidence of cases of
mis-selling and irresponsible lending in select EU Member States.
There are multiple causes for these
failings,[238]
including: organisational culture; revenue push at clients’ expense;
ineffective governance and controls; poorly designed processes; inadequate
training; and underinvestment in IT systems. These failings have resulted in
large costs for many financial institutions, including: fines; redress costs
and settlement payments; investment in staff, systems and other resources; and
reputational damage (see also chapter 6). 
Box 4.7.2: Examples of mis-counselling, mis-selling
and irresponsible lending and borrowing
The UK has experienced
large scale mis-selling of Payment Protection Insurance products by some of the
country’s largest banks. The resultant regulatory action has led to a
substantial compensation scheme amounting to more than £13 billion (as of January
2014).[239]
In the UK, non-income
verified (NIV) mortgages, designed initially to meet the needs of the
self-employed, propagated well beyond this initial target group. By the time
the mortgage market reached its height in 2006-2007, 45 % of all mortgages were
advanced on a NIV basis[240].
According to the discussion paper of the FSA, no other country assessed by them
for comparative purposes featured a similarly significant NIV market segment,
with the exception of the USA and Ireland, both of which have experienced a
boom in mortgage credit and house prices followed by a severe reduction in
both. 
According to Bloomberg[241]
in Spain the mis-selling of higher-yielding securities to customers used to
low-risk bank deposits affected as many as 686,296 retail investors holding
about EUR 22.5 billion of preferred shares sold by banks as of May 2011,
according to Spain’s stock market regulator CNMV. Preferred shareholders,
unlike depositors, are not insured against losses, which materialized with the
MoU requisite of burden sharing measures from hybrid capital holders and
subordinated debt holders for banks receiving public capital.
Forex loans are related to
a variety of macro risks: increased probability of credit booms, elevated
credit and funding risks, impediments to monetary policy and enhanced potential
for cross-border spill overs[242].
In addition, it implies a transfer of currency risk from banks to its
consumers. In 2012, in Bulgaria, Hungary, Latvia, Lithuania and Romania 60 % or
above of loans to non-financial corporations were extended in, or indexed to,
foreign currencies.
Miscounseling scandals
in Germany on certain financial products (e.g. 'open-ended real estate funds'
and 'PRIIPS') have been estimated to result in EUR 30 billion of losses per
year for consumers.[243]
In the area of insurance, losses in relation to life and pension insurance
products sold in Germany have been quantified to amount to EUR 160 billion
during the last decade[244]. 
Denmark has experienced
cases of large scale mis-selling to inexperienced and risk-averse retail
investors of highly complex structured products, and of units in funds based on
hedging strategies. Belgium as well as Finland have identified issues with the
increasing complexity of products, such as structured products in Belgium or
product wrapping in Finland, which prevents consumers from comparing features,
prices and charges and, thus, from making well-informed investment decisions.[245]
Consumers of financial services suffer from severe
informational problems. Most consumers find financial products complex. Many
financial decisions require making inter-temporal trade-offs and also require
assessing risk and uncertainty. Decisions are further complicated by the fact
that it is difficult to learn about financial products, also because some of
the financial decisions are made infrequently (e.g. taking out a mortgage to
buy a house). This makes the general case for policymakers to intervene to
protect consumers. 
Reform measures to enhance consumer and retail investor
protection[246]
The most efficient consumer protection
comes from the prevention of occurrence of excesses, similar to those, which
had been experienced in the run up of the last crisis. Thus, the new EU regulatory
framework developed in response to the crisis focusses on enhancing the
stability of the financial system, e.g. through measures on solvency, liquidity
and risk-management practices, resolution and crisis management, and on improved
transparency in financial markets, and thus has comparatively few
consumer-specific regulations. Put differently, many of
the rules discussed in the previous sections to improve stability in the system
also inherently benefit consumers (e.g. higher solvency rules and better risk
management procedures reduce the risk of losses to the customers of financial
services). So do the rules countering market abuse and enhancing the
reliability of financial benchmarks.  
However, important legislation
that specifically targets improved (retail) consumer and investor protection
have also been proposed or already adopted and will enter into force progressively. In addition, the existing
general framework protecting consumers unfair commercial practices acts as a
safety for consumers purchasing financial services. The Unfair Commercial
Practices Directive (2005/29/EC) prohibits misleading and aggressive practices
when marketing financial products. The recent Communication and Report on the application
of the Directive concluded that there was a need to step up its enforcement in
certain sectors, including in particular financial services.[247]
Moreover, as part of the establishment of the ESAs,
prominence was given to consumer protection: the three ESAs are also tasked
with enhancing consumer protection in the EU. 
Since most of the sector-specific
legislation is not yet in force, it is too early to observe any benefits in the
market. However, the potential benefits in the form of reduced consumer harm
from mis-selling and other misconduct are large. The measures, discussed in
more detail below, are expected to contribute to improved market outcomes for
consumers, leading to wider benefits in terms of increased consumer confidence.

The Commission is an active contributor to the different
international workstreams. Work in the field of consumer protection is based on
the principles endorsed by the G20, although the Commission's approach is more
targeted and prescriptive.
The importance and the relevance of adequate consumer
protection have been recognised by the G20: Finance Ministers and Central Bank
Governors called in February 2011 the OECD, the FSB and other relevant
international organisations to develop common principles on consumer protection
in the field of financial services. The adopted principles relate to: legal,
regulatory and supervisory framework; role of oversight bodies; equitable and
fair treatment of consumers; disclosure and transparency; financial education
and awareness; responsible business conduct of financial services providers and
authorised agents; protection of consumer assets against fraud and misuse;
protection of consumer data and privacy; complaints handling and redress; and
competition.
A new international
organisation of financial consumer protection supervisory authorities was also
established in November 2013. The new organisation (to be known as FinCoNet)
replaces the informal network of supervisory authorities which has existed for
a number of years and builds on the work already started by that network.
FinCoNet will focus on banking and credit consumer protection issues and
intends to collaborate with other international bodies and contribute to
advancing the G20’s financial consumer protection agenda.
More responsible lending: The Mortgage Credit Directive
The Directive on credit
agreements relating to residential property (also known as Mortgage Credit
Directive – MCD), which was published on 28 February[248], seeks to
enhance responsible mortgage lending. Member States will have until March 2016
to transpose the Directive into national law.
Problems in the
market
Two thirds of bank
loans in the EU are mortgage loans. Yet, as the recent crisis has shown,
property markets are prone to booms and busts. The financial crisis was partly
triggered by lax property lending practices in the US. Some EU Member States
experienced housing booms and busts, with consequences for the countries’
financial solvability. An important problem identified in the impact assessment
was inadequate creditworthiness assessments.[249] To prevent a repetition, it is of
utmost importance to ensure that responsible lending practices are applied
consistently across the EU. Consumers have, for instance, been found to
overestimate their income or underestimate their commitments in up to 70 % of
mortgage applications. 
The impact assessment
also identified a series of problems linked to the provision of information to
consumers. It demonstrated that the information consumers receive in the
context of a credit agreement negotiation is often considered ‘insufficient,
untimely, complex, non-comparable and unclear’, that advertising and marketing
are often non-comparable, unbalanced, incomplete and unclear and that
inappropriate advice may have been given to consumers,  while the purchase of a
property (often financed by mortgage credits) is likely to be the most
important financial decision a consumer takes during his or her lifetime.[250] 
Summary of the MCD
measures  
To ensure responsible
lending practices, the Directive establishes for the first time EU-wide
creditworthiness assessment standards for the granting of mortgage credits.
Creditors will have to conduct a thorough assessment of the ability for the
consumer to repay the loan before granting any credit. Such assessment will
need to be documented and based on relevant sources. In addition, the creditor will
only make the credit available to the consumer where the results of the
creditworthiness assessment indicates that the obligations resulting from the
credit agreement are likely to be met in the manner required under that
agreement. 
Regarding information
to consumers, the Directive enhances transparency of offers as creditors will
be obliged to inform consumers via a European standardised information sheet (ESIS)
of all relevant characteristics of the credit on offer  at pre-contractual
stage, including inherent credit risks, e.g. those attached to variable
interest rates or foreign currency loans. Consumers will be able to compare
offers and shop around for the most suitable offer on the market. Specific
provisions on advertising, adequate explanations and standards for advisory
services are also introduced by the Directive to ensure proper information to
the consumer. In addition, staff dealing with clients will need to possess
appropriate knowledge and competences and creditors and credit intermediaries
will have to respect conduct of business rules e.g. on remuneration. 
The measures in the MCD
are also a first step towards the creation of a genuine single European
mortgage market. Credit intermediaries that comply with the minimum standards
will benefit from the passport and can thus easily branch out into other Member
States. Access to credit register data across borders is also facilitated for
all creditors. Such measures are likely to increase the availability of
cross-border credit products and will lead to heightened competition, which
benefit consumers. 
Enhanced deposit
guarantee: Review of the DGS Directive 
A Deposit Guarantee Scheme (DGS) acts as a safety net for
bank account holders in case of bank failures. If a bank is closed down or is
unable to repay depositors due to a deteriorated financial situation,
depositors are entitled to compensation by the scheme up to a certain coverage
level. A 1994 Directive[251]
ensured that all EU Member States have Deposit Guarantee Schemes in place and
imposed a minimum coverage level of EUR 20 000 per depositor and per bank.
However, when the 2008 crisis started the existing EU
system of Deposit Guarantee Schemes revealed itself to be fragmented. Member
States applied different coverage levels which limited the benefits of the
internal market for banks and depositors and could aggravate the situation in
times of stress. Moreover, schemes were heterogeneously financed and proved to
be underfunded. In order to restore confidence in the financial sector, in
March 2009 the EU quickly reacted by amending the 1994 Directive to increase
the minimum coverage level from EUR 20 000 to EUR 100 000. 
In order to complete the work, on 12 July 2010 the
Commission proposed a more comprehensive recast of the 1994 Directive[252]. The
proposal was approved at the April 2014 European Parliament plenary session,
following the political agreement between the co-legislators in December 2013.  
Problems with current arrangements
No bank, whether sound or ailing, holds enough liquid funds
to redeem all or a significant share of its deposits on the spot. This is why
banks are susceptible to the risk of bank runs if depositors believe that their
deposits are not safe and try to withdraw them all at the same time, which can
seriously affect the whole economy. If, despite the high level of prudential
regulation and supervision, a bank has to be closed, the relevant DGS
reimburses depositors up to a certain ceiling (the coverage level). Currently
there are around 40 DGSs in the EU, but these are characterised by a number of
problems that reduce the effective extent of depositor protection[253]: 

 The
     scope of protection differs between countries (e.g. in terms of covered
     products and eligibility).  
 There
     can be delays in payout procedures, which could undermine the essential
     purpose of the DGS: depositors might run on banks before the DGS is
     triggered rather than wait for it to make the pay-outs if the statutory
     delay is too long.
 Funding
     is often inadequate: a DGS needs adequate financing in order to be
     credible and effective in its function. As noted above, the crisis fully
     revealed the lack of adequacy both in the prominent case of Iceland and in
     the failure by Member States to allocate additional resources to their
     DGSs even when mandating unlimited coverage. 
 There
     are differences in the involvement of the DGS in bank resolution
     operations where, instead of liquidating a bank and paying out depositors,
     there is an orderly winding up and continuous access is ensured, for
     example by transferring deposits to a bridge bank or a private purchaser
     (see also section 4.2.5).
 There
     is no European framework for cross-border cooperation: currently, the DGS
     Directive foresees that depositors at branches of EU banks are covered by
     the home-country DGS. This can prove cumbersome for depositors of branches
     of a bank from another EU Member State.

Summary of the measures
The amendments to the DGS Directive encompass a number of
key consumer protection measures: 

 The
     coverage level is fixed at EUR 100 000, as already introduced in 2009. Also,
     the scope of protection is harmonised.  
 The
     pay-out deadline is to be reduced gradually from the current 20 working
     days to seven working days in 2024, without depositors having to submit an
     application. 
 Financing
     of the DGS is enhanced, by introducing risk-based ex-ante contributions
     from banks, with ex-post contributions in case of shortfall. Voluntary
     mutual lending between DGSs is introduced, together with the possibility
     of alternative funding arrangements. 
 Additional
     measures are taken to improve the cross-border operations of the DGS and
     facilitate access to deposit guarantee in the case of depositors holding
     deposits in branches of banks from other EU Member States.  

Together, these measures are expected to better protect
depositors’ wealth and strengthen their confidence in banks. This in turn also
helps reduce the risk of bank runs and thereby enhances stability in the banking
sector (i.e. it complements the measures discussed in section 4.2).
Enhanced retail investor compensation: Review of the
Investor Compensation Directive
Investor Compensation Schemes (ICS) are currently
established in all EU Member States under the 1997 Directive on ICS[254]. The
schemes are designed to protect investors where firms or employees have
committed fraud or made operational mistakes which cause client assets to be
lost and the firm is unable to pay compensation. They are financed by
investment firms, but the method of financing is left to Member States'
discretion. The schemes must cover at least EUR 20 000 per investor and
pay-outs must be made within three months of the establishment of the
eligibility and amount of the claim.
Problems with current arrangements
Notwithstanding this framework, a number of frauds in
Member States have resulted in important losses to small investors.[255] In
particular, the compensation minimum threshold of EUR 20 000 was never adjusted
to reflect the increased exposure of European investors to financial
instruments; furthermore, there have been some cases in which the ICS had
insufficient funds to pay claims, or pay-out delays proved too long; finally,
the treatment of investors needed to limit distortions with respect to
deposits, which are covered up to EUR 100 000 under the DGS Directive. 
Summary of the measures
In July 2010, the Commission adopted a proposal amending
the existing ICS Directive[256]
to:

 Update
     the level of coverage from the EUR 20 000 minimum to a harmonised level of
     EUR 50 000; 
 Extend
     the scope of protection to losses due to the behaviour of third party
     custodians which hold assets and funds on behalf of investment firms, and
     to depositaries and sub-custodians of unit holders in collective
     investment schemes;
 Reduce
     pay-out delays by requiring that ICS pay partial compensation based on an
     initial (provisional) assessment of the claim if the pay-out delay exceeds
     9 months; and
 Enhance
     scheme financing by mandating ex-ante funding and introducing a limited last-resort
     mechanism whereby national schemes can borrow from schemes in other Member
     States under strict conditions.

Taken together, these measures are expected to enhance the
level of retail investor protection afforded by ICS and thereby strengthen consumer
confidence in financial markets. 
Better retail investor protection: Revision of the Markets
in Financial Instruments Directive (MiFID II)
Enhancing consumer protection in investment services is one of the
main objectives of the current MiFID (see also section 4.3.1).[257] Hence, it includes
specific requirements to increase levels of protection for retail clients,
mainly related to: preventing and managing conflicts of interests; safeguarding
client assets and client reporting; acting in the best interest of the client
and providing fair and clear information; and carrying out suitability or
appropriateness tests. This is in addition to other requirements under MiFID
such as those for authorisation and effective supervision, transparency and
competition which also have a positive impact on consumer protection. However,
those requirements have been reinforced and enhanced under MiFID II to address
certain issues in investment services which are not sufficiently or effectively
addressed by the current MiFID.  
Problems in the market
The financial crisis
has shown that the consequences of taking unexpected risks and facing
consequent losses can be devastating for consumers, as often investments form
the backbone of a consumer's life savings. Weak governance and controls
combined with the existence of conflicts of interest and inappropriate
incentives in the investment services sector have been exposed by recent cases
of mis-counselling and mis-selling of financial products (see table 4.7.1),
which have greatly undermined confidence in financial markets.
Besides,
insufficient product transparency and asymmetries of information for financial
products often lead to ordinary investors having great difficulties in
comprehending and using the information provided, as disclosures given are
often overly complex, obscure, lengthy and difficult to use. Given an EU retail
investment market with a value of up to EUR 10 trillion, buying wrong or
unsuitable products can quickly become a major problem. 
The evidence above
shows that the consumer protection regime under MiFID did not effectively
prevent cases of mis-selling, mis-counselling and insufficient product
transparency. 
The following
problems have been identified:[258]

·      
Uneven coverage of service providers and
uncertainty around execution-only services: currently investment firms
providing certain services only at national level may be exempted from the
requirements under MiFID provided that they are subject to national rules. Issuance
of financial instruments is not covered by MiFID. Also, financial products
classified as non-complex under MiFID are allowed to be sold without undergoing
any assessment of the appropriateness of the given product.
·     
Lack of clarity and of strict requirements on
the provision of investment advice: under MiFID, intermediaries providing
investment advice are not expressly required to explain the basis on which they
provide advice (e.g. the range of products they consider and assess). Thus,
there is a lack of clarity concerning the kind of service provided, and
requirements are often not adapted to the provision of that specific service by
the intermediary, including those on governance and management of conflicts of
interest. One study indicates that, at present, investment advice is unsuitable
roughly half of the time.[259]
·     
Not clearly articulated framework for
inducements: the MiFID rules for incentives from third parties require
inducements to be disclosed and to be designed to enhance the quality of the
service to the client. However, these requirements have not always proven to be
very clear or well-articulated for investors, and their application has created
some practical difficulties and concerns.[260]
·     
Inadequate requirements on advice to non-retail
clients: in MiFID, the level of investor protection decreases from retail
clients to professional and eligible counterparties, the underlying principle
being that larger entities have access to more information and benefit from
higher expertise. The financial crisis showed that in practice a number of non-retail
investors, notably local authorities, municipalities and corporate clients,
suffered losses due to being mis-sold complex financial instruments the risks
of which they did not fully understand. 
These issues may
lead to the current MiFID framework for investor protection not being effective
in preventing consumers being mis-counselled or mis-sold financial products
which are not appropriate for them, or making sub-optimal investment choices
based on insufficient information with the consequences as explained above. 
Summary of the measures
In addition to the
measures already discussed in section 4.3.1 to strengthen financial markets and
infrastructures, the revised MiFID package (MiFID II[261]) contains a number of
specific measures to enhance consumer and investor protection. In particular,
MiFID II introduces better organisational requirements in order to enhance
governance and controls in relation to consumer protection, such as an
increased role of management bodies in this area, enhanced client asset protection
and standards for product governance so that product manufacturers design and
document products in a way that better reflects investor needs.
The new regime also
provides for strengthened conduct rules for investment firms to prevent and
manage conflicts of interest, such as an extended scope for the appropriateness
tests and reinforced information to clients. Independent advice is clearly
distinguished from non-independent advice, and limitations are imposed on the
receipt of commissions (inducements) to align incentives. 
The specific problems,
as described above, have been addressed as follows:

 The scope of MiFID
     II has been broadened in order to include financial products, services and
     entities which are currently not covered (e.g. structured deposits), and
     the conditions for services where investors receive less protection from
     firms have been limited.
 Stricter
     requirements for portfolio management, investment advice and the offer of
     complex financial products such as structured products have been set and
     managers' responsibility has been introduced for all investment firms.
     Besides, advisers declaring themselves as independent will need to match
     the client's profile and interests against a broad array of products
     available in the market. Independent advisers and portfolio managers will
     be prohibited from making or receiving third-party payments or other
     monetary benefits.
 A stringent
     framework for inducements has been set up. In order to prevent potential
     conflicts of interest, independent advisors and portfolio managers will be
     prohibited from making or receiving third-party payments or other monetary
     gains.

Information to
different categories of clients has been enhanced, particularly when complex
products are involved. MiFID II also introduces harmonised powers and
conditions for ESMA (and to EBA for structured products) to prohibit or
restrict the marketing and distribution of certain financial instruments in
well-defined circumstances. MiFID II has been agreed by the co-legislators and was
approved by the European Parliament in April 2014. Once it comes in to
application in 2016, it is expected that it will enhance consumer and investor
protection in financial services and contribute to restoring consumer
confidence in financial markets.
Improved distribution and advice on insurance products:
Revision of the Insurance Mediation Directive (IMD II)
Whereas MiFID regulates the selling process in the case of
investment services and products, the Insurance Mediation Directive[262] (IMD)
aims to enhance distribution and advice in the insurance market, covering all
insurance product from general insurance products to those containing
investment elements. In July 2012, the Commission proposed a revision of the
IMD (IMD II[263]).

Problems in the market
Consumers often are not aware of the risks associated with
purchasing insurance. In fact, surveys show that more than 70 % of insurance
products are sold without appropriate advice, while accurate professional
advice is crucial in the insurance sector.[264] 
Due to the fact that current EU legislation does not deal
in detail with the sale of insurance products, the rules regulating it differ
substantially across the Member States. The rules also currently apply only to
insurance intermediaries, leaving out of the scope insurance undertakings that
sell directly to customers. 
Summary of measures
The current IMD is a minimum harmonisation directive and
the practical application of its provisions varies a lot between Member States.
Some Member States already apply consumer protection standards that go much
further than the requirements in the IMD. The proposed IMD II seeks to raise
minimum standards of consumer protection all over Europe. 
IMD II also aims at setting similar standards for the sales
of insurance products through insurance intermediaries and those sold by
insurance undertakings or other market players so as to ensure that similar
selling rules apply to everyone that sells insurance products: from insurance
agents, brokers and insurance companies to car rentals and travel agents.
Moreover, it aims to set more common standards between insurance intermediaries
and insurance companies selling life insurance policies with investment
elements and intermediaries selling investment products.
IMD II has strong links to consumer protection provisions
in other financial services legislation, such as MiFID II (see above),[265]
the Mortgage Credit Directive (see above) and the Proposal for a Regulation on
Key Information Documents (KIDs)[266]
for investment products (see below). IMD II aims at being coherent with those
provisions as much as possible. 
In summary, the revised IMD contains provisions to ensure
that:

 sales
     standards apply equally to direct sellers (insurance companies) as well as
     insurance intermediaries (agents, brokers);
 sales
     of insurance complementary to the supply of other services are regulated;[267]
 the
     risk of conflicts of interest are addressed more effectively, including
     disclosure of remuneration by intermediaries; 
 sales
     standards for advised and non-advised sales are strengthened;
 enhanced
     requirements apply to life insurance products with investment elements,
     covering sales standards, conflicts of interest and rules on remuneration;
 a
     delegated act to be adopted by the Commission is to specify the steps that
     insurance intermediaries and insurance companies should take in order to
     prevent conflicts of interest between themselves and their customers (see
     MiFID II[268]);
 professional
     qualifications of insurance intermediaries are adequate and their
     knowledge is regularly updated;
 procedures
     for the out-of-court settlement of disputes are strengthened and
     streamlined to the Directive on Alternative Dispute Resolution[269];
 special
     information requirements apply where insurance undertakings adopt the
     practice of tying or bundling products together;
 effective,
     proportionate and dissuasive administrative sanctions and measures by
     competent authorities in respect of breaches are applied; and
 supervision
     of cross-border insurance business is improved.

Although not yet adopted by the co-legislators, it is
expected that IMD II, once in force, will enhance consumer protection in the
insurance sector by creating common and higher standards for insurance
intermediaries and reducing the risks of mis-selling of insurance products. 
Better information for retail investors: Proposal for a
Regulation on Key Information Documents (KIDs) for investment products
The legislative proposal for a regulation on key
information documents (KIDs) for investment products was proposed by the
Commission in July 2012[270]
and was approved at the last plenary of the current Parliament in April 2014,
following the political agreement between the EU co-legislators. It forms part
of a legislative package aiming to boost consumer confidence by ensuring
well-regulated markets in packaged retail and insurance-based investment
products (PRIIPs). The PRIIPs initiative is wider than the KIDs regulation and
also includes the measures in MiFID and IMD which cover distribution and advice
(‘selling processes’) in relation to investment and insurance products. The
KIDs regulation focuses on product transparency. 
Problems in the market
There is a great variety of investment
products being targeted at retail customers, combining different legal forms
often with similar underlying investment propositions. Yet in general terms all
of these products seek to address a relatively simple investor need: capital
accumulation (in other words, taking on risk so as to have the potential for
beating the risk-free rate of return, as may be represented by a pure deposit
account). 
The complexity of many of the proposed
financial products makes these difficult to understand and to compare in
particular to retail investors. They are often less financially literate than
many professional investors and have few opportunities to learn from experience
in retail investment markets as they typically do not engage repeatedly in
investment activities, but do so only in relation to certain specific and
widely-spaced life events (inheriting money, or investing towards a specific
future liability or goal, such as buying a house, retirement or family
planning). 
The quality of the information provided is
also often very low. Disclosures can be difficult to compare, overly long, and
over-loaded with legal disclaimers. The basic features of products may be
difficult to see, and their risks obscured under difficult to understand
detail. Costs are often opaque, so that the real-world performance that might
be realistically expected becomes hard to discern.
This is in part a regulatory failure:
European and national regulation on product disclosures already applies to most
products, yet Union and national law has often developed on a largely sectoral
basis, at different speeds and with different outcomes in mind and to different
levels of harmonisation. Such a regulatory patchwork can increase
administrative costs and potentially encourage regulatory arbitrage,
incentivising choices of product structures to take advantage of less onerous
requirements.
Lack of good quality information
facilitating retail investor understanding and easy comparison of financial
products leads to investor detriment through mis-sales, to an unlevel playing
field between industry sectors, and to the erection of barriers to the further
development of the internal market.
Summary of the measure
The regulation will improve the quality of
information that is provided to consumers when considering investments. The
new, innovative disclosure document – the Key Information Document (KID) -
specifically aims at helping retail investors. The proposal is focused on
'packaged' products – notably all retail investment funds, insurance-based
investments (such as unit-linked life and 'with profit' insurance contracts
used for savings and investment purposes in many markets), and all retail
structured products.
The KID covers the main features of
investment products in plain language that is easy to understand to
non-professionals. Notably, the information on risks and costs shall be
straight-forward, though without over-simplifying complex products. The KID
should make clear to every consumer whether or not they could lose money with a
certain product. 
The KID must be short, to the point and
follow a common standard as regards structure, content, and presentation. In
this way, consumers will be able to use the document to compare different
investment products and ultimately choose the product that best suits their
needs. The standardisation of information should also aid consumer education
efforts.
Given that this document is to be used for
any kind of packaged product non-withstanding the legal wrapping, retail
investors will be able to compare products that give them exposure to the same
markets via different wrappers and thereby appreciate the different benefits
these encompass. For instance an investor wishing to participate in stock
markets will be able to more easily compare the advantages and disadvantages of
doing so via a UCITS fund, a structured product or insurance-based investment
product. 
The legislation will ensure that every
manufacturer of investment products (e.g. investment fund managers, insurers,
banks) will have to produce such a document for each of their investment
product. Further the proposal makes sure that the KID is provided to the retail
investor in timely manner, so that the investor can make use of it – along with
other pre-contractual information documents – to make an informed investment
decision.
The KIDs proposal has only recently been
agreed upon by the co-legislators (the vote on the agreed text took place in
European Parliament in April 2014), so it is too early to assess its use and
impact in the market. However, the measure is expected to improve the quality
of investor decision-making and reduce the amount of mis-selling of investment
products. As set out in more detail in the underlying impact assessment, product information the average retail investor can actually
understand and use for comparisons is fundamental for empowering consumers. Given
the potential scale of mis-selling of investment products, small changes in
investor behaviours and their investment decisions could have a huge impact:
even if product disclosure were taken to contribute only 1 % to changes in
investor behaviour, it has been estimated that this could still amount to
around a EUR 10 billion reduction in holdings of unsuitable products (or EUR 4
billion, if UCITS, already subject to KID requirements, are subtracted).[271] 
Better protection of investors in retail investment funds: Amendments
to the UCITS Directive 
In July 2012, the
Commission presented a proposal to enhance the protection of investors in
retail investment funds, referred to as undertakings for collective investment
in transferable securities (UCITS)[272],
by amending the UCITS Directive. The UCITS 5 strengthens the rules applying to
the funds' depositaries (i.e. the asset-keeping entities of the funds),
introduces new rules on the remuneration policies of fund management companies,
and strengthens the sanctioning regimes applicable to management companies and
depositaries.  
Problems in the market
The assets of a UCITS fund are entrusted with a depositary
for safe-keeping. However, currently, there is little clarity on the
institutions that are eligible to act as a depositary, and different depositary
standards can lead to differential levels of investor protection. Moreover,
current rules are unclear when it comes to the delegation of the custody
function, and there are no rules on due diligence checks and monitoring of the
delegate (sub-custodian). 
Importantly, the liability in the case of loss is unclear,
and liability standards are different in different Member States. The potential
consequences of these divergences came to the fore with the Madoff fraud, which
hit the headlines in December 2008. [273]
The brokerage operation of Bernard Madoff in the US was
revealed as a giant Ponzi scheme resulting in the largest investor fraud ever
committed by one individual. Huge sums that were allegedly invested by Bernard
Madoff turned out to have vanished with no corresponding securities in Mr
Madoff's investment fund. 
The consequences of the Madoff scandal are not confined to
the US. The issue has been particularly acute in some EU Member States. One
particular fund that acted as a 'feeder fund' for Madoff recorded losses of
around USD 1.4 billion due to Madoff investments which turned out to be
fictitious.[274]
In this case, both the management of investments and custody in relation to the
assets that belong to the fund were delegated to entities operated by Madoff.
The large scale of the Madoff fraud essentially went undetected for a long
period because the depositary responsible for the safekeeping of the fund
assets delegated custody over these assets to another entity run by Bernard
Madoff, the US broker "Bernard Madoff Investment Securities". 
The Madoff scandal revealed general uncertainties within
the UCITS framework in relation to the depositary's liability in case of
delegation of custody to a sub-custodian. While in some Member States, the
depositary was immediately liable to return assets in custody as a consequence
of fraud at the level of the sub-custodian, in other Member States the
situation is less clear and still subject to litigation. 
As a separate problem, the financial crisis revealed that the
remuneration and incentive schemes of the UCITS managers is, at least partly,
based on the short term performance of the fund, which fails to take proper
account of the risk in the portfolio. Such remuneration structures create
incentives to increase the level of risk in a fund's portfolio in order to
increase the potential returns. However, the higher level of risk can expose
the fund investors to higher potential losses that might materialize in the
medium-term to long-term.
Finally, there are significant divergences in sanctioning
regimes across the Member States, which also bear consequences for the
enforcement of rules and hence for the effective level of investor protection
(see also chapter 5.1).  
Summary of the measures
The revised UCITS, also approved at the last plenary of the
current Parliament in April 2014 following the political agreement between the
co-legislators, addresses these problems by ensuring, inter alia, that the
depositary's duties and liability are clear and uniform across the EU, that
there are clear rules on the remuneration of UCITS managers, and that there is a
common approach to sanction regimes. Taken together, the proposed measures will
enhance the level of investor protection in UCITS funds.
In relation to the depositary, the proposed harmonised
eligibility rules mean that only a credit institution or an investment firm can
act as depositary. Also, delegation of functions is only possible under strict
conditions and if the delegate satisfies certain minimum prudential, organisational
and conduct requirements. Moreover, the depositary is liable to return
instruments when they are lost in custody and also remains liable in case of
delegation. 
In relation to remuneration practices, the measures adopted
by the proposal require remuneration policies for all staff that can impact the
UCITS fund's risk profile. In addition, remuneration policies and the actual
remuneration of relevant staff must be disclosed to investors.   
Finally, in relation to sanctions, the proposal introduces
minimum rules on type and level of administrative measures and administrative
sanctions. 
Safer payments: Revision of the Payment Services Directive
(PSD II) 
In July 2013, the Commission published a legislative
proposal for a revision to the existing Payment Services Directive (PSD II)[275]. 
Problems in the market
The way European citizens shop and pay is radically
changing. Almost every account holder in the EU possesses a debit payment card
and some 40 % also own a credit card. Some 34 % of the EU citizens already shop
on the internet (2011 data) and more than 50 % possess a smartphone, which in
principle allows them to enter into the world of mobile payments.[276] 
It is already possible to purchase almost every good and
service online, with some economy sectors – like travel industry – making most
of their sales on the internet. Mobile payment services are increasingly
offering access not only to the digital content, but to the physical goods,
with e.g. mobile ticketing and car parking services roll out across Europe and
the terminals allowing for mobile payments being installed in the traditional
shops. These changes require certain adjustments to the existing legal
framework for payments in the EU, so as to increase the security of payment
transactions and better protect payments data. 
Summary of the measures
With the proposed PSD II, the scope of the existing
Directive is extended to cover new types of service providers (third-party
payment service providers, TTPs) and new services (payment initiation services)
as payment services. These services facilitate the use of online banking and
allow for low-cost internet payments outside the framework of credit cards.
This should increase consumer choice when paying online. The scope is also
extended to payments when either the payer or the payee is located outside the
EU, which should contribute in particular to making money remittances to non-EU
countries fairer and possibly cheaper, as a result of higher transparency.
Furthermore, intra-EU payments in all currencies will be covered, thus better
protecting the consumer. 
Banks and all other payment service providers, including
TPPs, will need to enhance the security of online transactions, and apply
strong customer authentication for payments (e.g. use dynamic, one-off
transaction confirmation codes). Obligatory risk management rules and incident
reporting for security risks is introduced. The EBA is tasked to issue
guidelines and draft regulatory standards on the security of payments
transactions. 
The new Directive will also ensure that consumers are
better protected against fraud, possible abuses and payment incidents (e.g. in
case of disputed and incorrectly executed payment transactions). They will face
only very limited losses – maximum 50 EUR - in cases of unauthorised card
payments. Finally, in case of consumers using TPP services, high protection is
ensured for private financial data, security rules are established and clear
liability for the transaction is ensured.
In addition to increasing payment security, the PSD II is expected
to enhance competition in the payments market, in particular by facilitating
new entry and reducing market access hurdles, which in turn benefits consumers
(see section 4.8).  
The proposal was put forward in the so-called “Payments
Package”, which also includes the proposal for a regulation on interchange fees
for card-based payment transactions (“MIF Regulation”)[277]. Applying
surcharges on card payments by merchants will become prohibited for all
consumer cards, in accordance with MIF Regulation.[278] 
Access to basic bank accounts: The Payment Accounts
Directive 
The Directive on Payment Accounts, presented by the
Commission in May 2013[279]
and approved at the April 2014 plenary session by the European Parliament after
agreement between the co-legislators, seeks to enhance access to a payment
account with basic features (including the provision of a debit card) for EU
consumers regardless of their residence and regardless of their financial
situation. It also aims at simpler switching of bank accounts and enhanced
transparency of bank fees.
Problems in the market
Full participation in modern society is difficult without
payment account. Yet 56 million Europeans over the age of fifteen have for
various reasons currently no access to a payment account.[280] A
separate problem is the current lack of transparency and comparability of bank
fees. Also, price levels for a simple payment account can differ significantly
from one Member State to another, varying between EUR 0 and EUR 256, which
seems incompatible with a competitive single market in financial services. Consumers
currently have difficulties switching bank accounts, both nationally and across
border. Moreover, they are often unable to open a payment account when they are
not residents of the country in which the provider is located. 
Summary of the measures
The Payment Accounts Directive will grant Europe’s
consumers the right to a basic payment account. This
will allow all consumers to make and receive payments, shop online, and pay
utility bills (telephone, gas, electricity). Consumers will receive a payment
card.. Overdraft may be provided as an optional service if the customer wants
it. In this case, a maximum amount and duration of the overdraft may be defined
at national level. Member States will have to designate a sufficient number or
all credit institutions to offer a basic account on their territory. The basic
payment account should either be free of charge or come at a reasonable cost to
be determined by Member States. Moreover, all EU consumers will have the
possibility to open and use a bank account anywhere in the EU. This is
particularly relevant for highly mobile citizens (e.g. students, workers,
pensioners, etc.) who aspire to take full advantage of free movement within the
single market.[281] 
The Directive will also introduce more transparency and
comparability in the payment account sector. To allow consumers to more easily
compare the types of products and services offered by banks, the Directive will
establish the use of standardised terms with respect to the most representative
services offered on a payment account. This standardisation will empower
consumers to better compare prices for payment account services both locally,
nationally and cross-border. The standardisation will also result in heightened
consumer choice and new business opportunities for banks in the single market.
However, the initiative is not expected to render all products and services
uniform. Particular local and national bank products and services to which consumers
are accustomed will continue to co-exist. Also, payment service providers will
offer to consumers a set of documents, including a price list for relevant
products and services, an ex post list of the services used in the course of
the year and a glossary, containing all the relevant information on the fees
they pay on their accounts. To further help consumer, the Directive establishes
principles to guarantee that comparison websites are available, which contain
reliable information on the fees charged by different providers. The website
supplier can either be private or public, but needs to be independent. Finally,
consumers should be informed about the price of each individual component of a
packaged account.
Better comparability would be of no use if the consumer
cannot switch easily between payment accounts. Fees do not necessarily
constitute the biggest hurdle for changing a payment account. Consumers feel
often discouraged to switch accounts due to burdensome administrative
procedures and for fear of being held liable for non-executed debit payments.
The Directive will therefore establish a streamlined step by step switching
process for consumers who switch accounts between two providers located in the
same Member State, where responsibilities are shared between the receiving and
the current payment service provider. Consumers are guaranteed that their
accounts will be switched at national level in a maximum of 12 business days.
[282] In addition, consumers who hold a payment
account with a provider and want to open another account in a different country
will benefit from assistance by the providers to facilitate the process. Any
financial loss for the consumer that results directly from delays or mistakes
by a payment service provider needs to made up for by the payment service
provider. 
Overall, the Directive will, once transposed, ensure that
every EU resident has a right to a basic payment account. Consumers will also
benefit from a high degree of market transparency of bank fees and from the
possibility to switch their payment accounts more easily, including across
borders. 
4.7.3
Addressing the weaknesses of credit rating agencies 
The financial crisis revealed significant
weaknesses in the methods and models used by credit rating agencies (CRAs).[283]
In particular, the CRAs failed to sufficiently consider the risks inherent in
more complicated financial instruments (notably, structured finance products
backed by risky sub-prime mortgages[284]).
It is now widely acknowledged that this failure, combined with investors' often
"blind" reliance on those ratings,[285]
significantly contributed to the crisis. This problem was amplified by the fact
that regulators and supervisors required institutional investors to invest into
rated securities.
A number of key underlying problems can be
identified as explanations for why the pre-crisis system based on
self-regulation by the CRAs themselves failed to work properly: The market is
highly concentrated and dominated by three agencies (Fitch, Moody's and
S&P), as shown in Table 4.7.2, so there is limited scope for competition on
the quality of the ratings produced. There are also misaligned incentives and
clear conflicts of interest. 

 First, CRAs are paid by the issuers or
     sellers of the financial instruments, rather than by the buyers who face
     the lack of information and knowledge. Consequently, the issuer may
     threaten to shop elsewhere for a better rating, if the CRA does not
     accommodate to the issuer’s expectations. Since
     CRA revenues are predominantly driven by rating fees paid by issuers, the
     revenue incentives are such that ratings may be biased upwards so as to
     meet issuer's expectations and thereby gain or keep its business. Also, CRAs sell multiple and often interdependent products and
     services. The issuer may hence put additional pressure on the CRA by
     conditionally promising more business. 
 Second, credit rating agency rating
     changes amplify procyclicality and cause systemic disruptions in some circumstances. This is
     exacerbated by important overreliance on external credit ratings by
     financial market participants. One of the underlying reasons for this
     over-reliance was the introduction over time of references to external
     credit ratings in some financial services regulation which reduced
     incentives for financial institutions to conduct their own credit risk
     assessment and rely exclusively and blindly on credit ratings. 
 Third, model risk is particularly
     important for structured finance products, given their complexity and
     absence of pre-crisis experience. The decades-long experience in deep and
     liquid corporate and sovereign debt markets has proven to be of limited
     value for rating complex, untested, OTC financial instruments. CRA ratings
     have been too narrowly focussed on default risk and expected loss (first
     moment of loss distribution). Market and tail risk was not reflected
     (second and higher moments of the loss distribution), leading to the
     situation that AAA senior CDO tranches were able to pay out higher returns
     than equally rated AAA corporate bonds.

Despite their major impact on financial
markets and the key role of credit ratings in the prudential regulation of
financial institutions, CRAs have not been subject to any formal control and
surveillance in Europe, neither at national nor at European level.    
The new EU regulations on CRAs
The new EU regulations on CRAs[286] contain a range of
different measures that overall aim to ensure the
independence and integrity of the rating process and to enhance the quality of
the ratings issued. In particular, since July 2011, the European Securities and
Markets Authority (ESMA) has been responsible for registering and supervising
CRAs, which now need to fulfil a number of conduct rules to reduce conflicts of
interest and improve the transparency of the ratings process. Additional
requirements came into force in June 2013 that, inter alia: reduce the reliance
on credit ratings by requiring financial institutions to strengthen their own
risk assessment and not to rely solely and mechanistically on credit ratings;
make CRAs more transparent and accountable when rating sovereign states; and
make CRAs liable in cases of gross negligence or intentional infringements of
the rules. The rules also seek to improve the independence of the ratings
process by introducing mandatory rotation for certain complex structured
financial instruments and requiring issuers to engage at least two agencies for
rating such instruments. Moreover, all available ratings will be published on a
European Rating Platform, available as from June 2015, so as to improve the
comparability and visibility of ratings. This in turn is expected to encourage
investors to make their own credit risk assessment and also contribute to the
diversity in the ratings industry. 
In addition, in the course of the sovereign
debt crisis it became evident that there was a need for an independent EU
structure with adequate resources and capacity or a new European CRA that would
issue credit ratings for sovereign issuers to provide market participants with
a greater variety of opinions on the credit worthiness of issuers. Sovereigns
would then get an additional rating from an independent and public source with
a strong signalling effect to financial markets. However, some concerns were
raised with regard to the credibility of a publicly funded body, particularly
as it would assess the creditworthiness of sovereign issuers which provide for
its funding. 
In a recent report,[287] ESMA
identified some deficiencies in sovereign rating processes, which could pose
risks to the quality, independence and integrity of the ratings and of the
rating process. Deficiencies were highlighted regarding independence and
avoidance of conflicts of interests; confidentiality of sovereign rating
information; timing of publication of rating actions; and resources allocated
to sovereign ratings. At this stage, ESMA has not determined whether any of the
report’s findings constitute a breach of the CRA Regulation, and may take
action as appropriate in due course. Taken into account the findings in the
last ESMA report, the Commission will reassess the feasibility of both an
independent EU structure and  European CRAs, as a follow-up of the
implementation of the new reform package
The rules contained in the new regulations
are proportionate and will enhance the independence and integrity of the rating
process as well as improve the quality of the ratings issued and contribute to
more diversity in the rating industry. 
First of all, new rules were adopted in
response to the FSB principles to reduce public authorities’ and financial
institutions’ reliance on credit rating agency ratings.[288] Concerns
were raised by some stakeholders on risks of mere removal of all references
without any alternatives in places. Therefore, the new rules encourage
financial institutions to strengthen their own credit risk assessment processes
and not to rely solely and mechanistically external credit ratings.[289]

As regards the new sovereign rating rules,
which require the publication of ratings to follow a calendar, CRAs are
concerned that they cannot conduct ratings whenever they consider this
necessary. The final rules impose the calendar on a “comply or explain” basis
only, i.e. CRAs can decide to adopt ratings on other timing if appropriately
justified and explained. This seeks to find the balance between enhancing the
predictability of the timing of the ratings and ensuring accurate and timely
ratings. 
As regards the CRA liability rules, CRAs
perceive a risk of being sued for “wrong ratings” which could result in very
big civil claims. However, in the final rules, liability has been limited to
gross negligence and intentional violations of the rules, and investors must
demonstrate damage due to the reliance on the wrong rating. This is deemed a
proportionate civil liability regime.
As regards the mandatory rotation of CRAs,
on the one hand, rotation makes the market more dynamic and provides
opportunities for smaller CRAs in the rating agency, thereby improving
competition. On the other hand, industry stakeholders have argued that rotation
of CRAs would limit the free choice of issuers to choose the CRA of their
preference and also create switching costs. The final rotation rule has
therefore been restricted in scope to a subcategory of structural finance
instruments only, which may be considered a test and leaves scope for further
extension of the rules at a later stage, if deemed necessary upon future
review.  
Finally, to enhance CRA independence, the
final rules impose limits on shareholdings in CRAs. While some have argued that
CRAs do not choose their shareholders and that there should be no intervention
in the ownership structure, there are clearly conflicts of interest if a CRA
rates the financial instruments of an important shareholder. The CRA rating may
not be as independent as it would otherwise be. There are also concerns that
the investing shareholder could obtain preferential information of future
upgrades or downgrades of financial instruments. In any case, the final rules
impose limitations for substantial shareholdings only (5 % or 10 % depending on
the provisions).
The new CRA regulations do not directly
require changes to the issuer-pays model of CRAs. Instead, the regulations seek
to limit the adverse consequences that arise from this and other structural
features in the market. Going forward, the Commission will review the situation
in the credit rating market and, according to the regulations, is required to
prepare a report to that effect by July 2016. 
Evidence of changes in market structure
As regards already observable changes in the
structure of the market, in addition to the big three, a number of distinctly
smaller CRAs have already emerged in Europe, and their number has further
increased after the introduction of EU legislation. ESMA registration
information shows that 19 out of the 22 CRAs are small and medium-sized.[290] However, to date,
these new market players often remain small in terms of scope. They tend to
operate with a clear focus on specific industry sectors (e.g. the insurance
industry), financial market segments (e.g. municipal bonds) or specific
geographical area. This is unlike the big three agencies, which cover the whole
range of rating classes considered. 
The three largest CRAs have a market share of
94 % if measured by the total number of ratings outstanding in 2013, somewhat
down from the 97 % share in 2008 (Table 4.7.3).The market share is lower if
measured in terms of new issues during 2012 and 2013 (85 %), suggesting
declining concentration and increase market participation by smaller CRAs.
Concentration levels vary by issuer segment. It is particularly pronounced for
the structured finance and covered bonds ratings categories, in spite of few
new entrants operating in those two segments, whereas it is less marked in the
non-banking corporate category. Looking at new ratings only, the large CRAs
covered 50 % of the overall corporate ratings. The structured finance and
covered bonds rating classes, however, remain dominated by the large CRAs,
which had covered practically 100 % of the EU market until the financial
crisis, with only a small number of new participants emerging since.[291] 
Table
4.7.2: Market share of the three largest CRAs
   || By outstanding ratings || By new issues 
   || 2008 S2 || 2013 S1 || 2012 S1 – 2013 S1 
 Total corporate || 86 % || 82 % || 53 % 
       of which: ||   ||   ||   
       - Insurance || 65 % || 70 % || 43 % 
       -  Other financials || 87 % || 83 % || 73 % 
       - Non-financials || 94 % || 85 % || 49 % 
 Sovereign || 82 % || 86 % || 60 % 
 Structured finance || 100 % || 96 % || 84 % 
 Covered bonds || 100 % || 99 % || 94 % 
 All rating types || 97 % || 94 % || 85 % 
Source: ESMA (2014), "ESMA report on trends, risks and
vulnerabilities", no. 1.
Smaller CRAs identified reputation and
insufficient visibility towards the investors’ and issuers’ community as the
most important barriers to entry and expansion in the market. The CRA reforms
contain provisions to tackle these barriers by helping smaller CRAs to build up
their reputation and be more visible on the market. Among other measures, the
registration and supervision by ESMA will act as a quality label, ensuring that
minimum standards are met and helping a new CRA to build credibility; there
will be a European Rating Platform which will contain all available ratings;
and there is a requirement for issuers to consider smaller agencies when
obtaining double ratings. 
The final impact and effectiveness of these
and other provisions on the CRA market is too early to assess, also because
some provisions will only become effective going forward and technical
standards remain to be developed. However, it is expected that the new CRA
regulations will increase the independence and integrity of the ratings process
and enhance the overall quality of the ratings.
4.7.4 Enhancing accounting standards[292] 
Insufficient information on off-balance
sheet financing, too late impairment of financial assets and the lack of
guidance on fair value measurement have contributed to increase the financial
crisis. This is the reason why the G20 required to the International Accounting
Standards Board (IASB) and the Financial Accounting Standards Board (FASB) to review
their standards to enhance accounting requirements.  
The EU institutions do not develop
international accounting standards. Rather, the EU decided to adopt the
International Financial Reporting Standards (IFRS) in 2002 and has since
endorsed new standards and amendments, drafted by the International Accounting
Standards Board (IASB). Nevertheless, the Commission and its technical advisor,
the European Financial Reporting Advisory Group (EFRAG), have regular contacts
with the IASB to promote European interests in the accounting standard setting.
In 2011 and 2012, the Commission endorsed: 

 New standards on consolidation (IFRS 10,
     11 and 12)[293]
     to improve the consolidation of securitisation vehicles and the
     disclosures on off-balance sheet financing relating to unconsolidated
     participations in "structured entities" like securitisation
     vehicles or asset-backed financing. 
 A new standard on fair value measurement
     (IFRS 13) providing a single definition of fair
     value measurement, enhancing transparency by requiring additional
     disclosure and offering clearer and more consistent guidance on the
     application of fair value measurement in inactive markets. 
 Amendments to improve the disclosure
     requirements devoted to the transfer of financial assets (amendment to
     IFRS 7)[294].

The review of the standard applicable to
financial instruments (IAS 39) is still ongoing, which should improve the
current requirements on impairment of financial assets that was criticised
during the crisis. The IASB is also developing a real IFRS standard on
insurance[295],
which is key for European insurance entities in order to get common accounting
requirements to enhance comparability and transparency of their financial
statements. 
These new standards are expected to enhance
the overall transparency and comparability of financial statements, not only
within the EU but also worldwide as IFRS are global standards.
The Commission also launched in 2014 an
evaluation of the IAS regulation. This evaluation aims to 1) assess how the IAS
regulation has been applied over the last 10 years and 2) review the European
organisation in accounting matters to strengthen its influence towards the IASB
in standard setting. The conclusions of this evaluation are expected by the end
of this year. 
4.7.5 Improving the audit process

High-quality and reliable audits are an
integral part of the financial reporting environment to ensure credible
financial statements on which investors, managers and supervisors can rely.
However, not only since the crisis, there has been unease about the value of
audit reports and their quality, independence and consistency. A number of
financial institutions failed only months after they had been given clean audit
reports. Audit inspections by national authorities confirmed significant weaknesses
in audit reports. For example, in Germany, 25 % of the inspections of audit
firms with a client base comprising financial institutions and listed companies
led to disciplinary proceedings during 2007 and 2010. In the UK, 11 % of audits
were assessed as requiring significant improvement at major firms. In the
Netherlands, the regulator identified weaknesses in 29 of the 46 audits
reviewed in the context of its regular inspections and concluded that the
quality of audits must fundamentally improve at the largest audit firms. 
 Chart 4.7.1: Concentration in the audit market 
 Notes: Based on global revenue in 2009. Source: Commission Services impact assessment on audit reform 
As with credit ratings (see above), there
is an inherent conflict of interest in that the subject of the opinion is also
the paying client. Coupled with limited rotation of auditors, this has led to a
situation where many audited companies have become comfortable with their
auditor, limiting auditor's independence and incentives for professional
scepticism. For example, in the UK, a FTSE 100 auditing
company remains in place for about 48 years on average; for the FTSE 250 the
average is 36 years. In more extreme cases, companies have used the same
auditing company for more than 100 years. In Germany, two thirds of the DAX 30
companies have not changed their auditor for the last 20 years. The problems are
exacerbated given the structure of the audit market, which is dominated by the
'Big Four' accounting firms (chart 4.7.1).  
The EU audit reforms
To address these and other concerns, in
November 2011, the European Commission adopted proposals to clarify the role of
auditors and introduce a number of stringent rules, in particular to strengthen
the independence of auditors and bring greater diversity into the audit sector.[296] 
One key proposal in this regard is the
mandatory alternation (rotation) of auditors. If auditors stay too long with
the same client, their independence is likely to be undermined and, as a
result, their professional scepticism is reduced. Rotation reduces this risk by
limiting the length of professional relationships. At the same time, however,
and as argued by critics of the reforms, auditor rotation imposes costs and may
decrease audit quality due to the loss of client knowledge in the first year
after the change of auditor. The recently adopted rotation requirement seeks to
balance the benefits against the costs by allowing for long enough periods of
audit engagements (final agreement rotation after 10 years, which under certain
conditions could go up to 24 years). This is long enough to motivate auditors
to invest into knowing their clients and imposes a reasonable cost by requiring
companies to carry out tenders every ten years. In addition, the loss of
knowledge in the first year of the engagement after the rotation is compensated
by the preparation of a hand-over file from the outgoing auditor.
Other rules to enhance independence and
diversity in the market include, among others, mandatory tendering for audit
mandates, the prohibition of clauses requiring services of the major auditing
companies only, strengthened audit committee's within companies and the
prohibition for audit firms to provide certain non-audit services to the same
client (a black list of prohibited non-audit services is introduced). In
addition, the rules seek to better coordinate and strengthen the supervision of
auditors in the EU. 
The measures, taken together, seek to
address current weaknesses in the EU audit market and will help restoring confidence
in the financial statements of companies. After provisional agreement between
the Parliament and the Member States was reached in December 2013, the proposal
was approved by the European Parliament in April 2014. 
Some of the positive impacts will take
several years in order to take effect in the market (i.e. rotation of
auditors). A first indication of a positive impact of the reform is the fact
that several listed companies in the UK that had very long relationships with
their auditors have recently decided on a voluntary basis to put their audit
services out for tender, and some have already changed their auditors. This is
only indirectly related to the EU audit reform, as it is consistent with and
supporting the outcome of the separate investigation by the UK Competition
Commission into the UK audit market. The increased rotation (whether voluntary
or mandated) brings some dynamics into the market, which can be expected to
have a positive impact on audit independence and potentially also on audit quality
to the extent that the new auditor will be reviewing with a fresh eye the work
of the outgoing auditor.
Overall, the
measures are expected to improve auditor independence and the quality of
statutory audits in the EU. Combined with improved accounting requirements, the
measures will thereby help restore the reliability of and confidence in
financial statements, in particular those of banks, insurers and large listed
companies.
4.8 Efficiency of the financial services sector 
Many of the reforms discussed so far that
contribute to financial stability, financial integration and market integrity
also improve the efficiency of the financial system. This section is therefore
kept short and only highlights some of the main mechanisms by which the new
reforms help enhance efficiency in the financial system.
In an efficient financial system, financial
intermediation helps allocating capital to its most productive use, transaction
costs are minimised, financial services are priced adequately to reflect their
risk and social costs and the expected returns on financial instruments
adequately reflect their risk. 
In this respect, the set of banking reforms
that work jointly to reduce the implicit subsidy enjoyed by too-big-to-fail
banks (in particular CRD IV package, BRRD and structural reform)  improve
efficiency by reducing the distortions caused by the implicit subsidy.
The subsidy allowed the benefiting banks to grow their balance sheets and
engage in risky activities beyond what would have been possible if funding
costs had not been implicitly subsidised by taxpayers (see box 4.2.5 for
quantification). To the extent that the reforms are successful in reducing the
subsidy, this will ensure that bank funding costs are more risk-reflective and
that resources are directed to uses that are more productive from a societal
point of view as opposed to those that maximise bank returns but at a societal
costs (see also box 6.1.1 in chapter 6).
Another example relates to the risk-based
prudential framework for financial institutions. While the CRD IV package
improves existing risk-based requirements by making them better capture all the
relevant risk elements in the banking sector, Solvency II will for the first
time introduce a risk-based prudential framework for the EU insurance sector.
Combined with improved risk management standards, this induces financial
institutions to internalise the risk of their activities and contributes to
more efficient (risk-reflective) pricing of financial services and products. 
The various measures aiming at increasing
the transparency of the financial sector via enhanced disclosure and
reporting requirements will reduce information asymmetries and thereby enhance
the efficiency of the financial system. These include, for example, the flagging
of short sales (in the short-selling regulation), reporting obligations to
trade repositories (EMIR, proposed SFT regulation), the improved disclosure
regime for issues in the Prospectus Directive, the increased transparency on
algorithmic trading activities and trading in commodity derivatives markets
(MiFID), and reporting and disclosure requirements in the area of investment
funds. Stricter disclosure requirements to supervisors will facilitate
monitoring of exposures and enable supervisory authorities to identify and
assess emerging risks at an early stage. Transparency will also be beneficial
for financial institutions and will contribute to better internal risk
management practices. Finally, and importantly, transparency improves
monitoring by the market and will lead to better-informed decisions by
investors and consumers.[297]

In addition, the different legislative
measures in the area of financial markets and infrastructure seek to enhance
efficiency along the whole securities trading chain, covering pre-trading
(Prospectus Directive), trading (MiFID, MAD/R, Transparency Directive) and
post-trading, including clearing (EMIR) and settlement (CSDR). The measures
seek to improve transparency, remove burdensome barriers to reduce trading
costs and enhance the resilience of financial market infrastructures. The
measures also prepare the ground for further initiatives increasing the
efficiency, e.g. the Target 2 Securities (T2S) project, which will consolidate
settlement across all countries in Europe.[298]

The resulting benefits have been estimated
to be significant. Focusing mainly on the CSDR, the Regulation is expected to
translate into lower costs for investors.[299]
The Commission Services draft working document on
post-trading from 2006 estimated between EUR 2 billion and EUR 5 billion of
aggregate excess cost of post-trading for investors.[300] Furthermore, EUR 700
million of cost reductions could be achieved through market consolidation.[301] Moreover, T2S is
expected to further reduce both domestic and cross-border costs (see section
2.7). The T2S economic impact assessment of 2008 estimates cost savings from
T2S of EUR 145 million to EUR 584 million. For
investors, the CSDR is expected to reduce significantly the current gap between
the costs of purely domestic and cross-border operations. It will not only reduce costs relating to CSDs (1.5  % of total costs
of transaction and custody)[302]
but also costs relating to intermediaries (including custodian banks) (22  % of
total costs) by simplifying and reducing levels of securities holding.[303] The issuers will benefit from the reduction of CSD costs in relation
to securities issuing and the management of their relationships with the
investors.
They will also benefit from a choice between various
CSDs: they can issue their securities in a CSD of their choice according to the
location of their investors, enabling them better access to investors.   
A combination of different reform measures
help to further enhance efficiency by improving the competitive functioning
of the financial sector. The competition measures work through different
mechanisms, including: 

 opening access to market
     infrastructures—access provisions contained in
     MiFID II, EMIR and the CSD Regulation reduce existing barriers to access
     to trading venues, CCPs and CSDs, respectively, and thereby enhance
     competition along the whole securities trading chain; 
 promoting entry in other markets— in the concentrated markets of CRAs, the reforms aim to
     promote competition by enhancing visibility of new entrants through registration
     and authorisation and the creation of a European Rating Platform for the
     publication of available credit ratings and by requiring issuers to
     consider using a small CRA in case they would employ more than one rating
     agency. In other areas, the reforms often contain waivers to the rules for
     small firms (or additional measures for the largest firms),[304]
     so as to reduce the relative burden for small firms and facilitate market
     entry by new firms;  
 facilitating market exit—A competitive and dynamic market does not only require easy
     market entry but also that inefficient or failing firms can easily exit
     the market. Better resolution tools (BRRD) for banks that are easier to
     resolve (CRD IV package, structural reform) reduce barriers to exit and
     thereby enhance competition; 
 reducing implicit subsidies —financial institutions that are perceived as being too big to
     fail and therefore benefit from an implicit taxpayer subsidy have a
     competitive advantage over those that do not. The package of banking
     reforms aimed at addressing the TBTF problem (in particular CRD IV package,
     BRRD and structural reform) helps correct these competitive distortions;[305]
       
 reducing information asymmetries—various transparency and disclosure requirements aim to reduce
     the informational disadvantage of consumers of financial services and
     thereby put them in a stronger position vis-à-vis providers (e.g. MiFID, CRD
     IV package, IMD 2, UCITS, MCD and PRIIPS); and
 improving competition in payment
     systems—The revised Payment Services Directive
     (PSD II) is expected to bring more competition to the electronic payments
     market, providing consumers with more and better choices between different
     types of payment services and service providers. Until now, entering the
     market of payments was complicated for third-party payment providers,[306]
     as many barriers were preventing them from offering their solutions on a
     large scale and in different Member States. With these barriers removed,
     many more new players are expected to enter new markets and offer cheaper
     solutions for payments to more and more consumers throughout Europe.
     Furthermore, PSD II will contribute to the reduction of charges paid by
     consumers for card payments.[307]

In addition, the measures discussed above
in section 4.6 on financial integration also contribute to competition and
efficiency in the market, by levelling the playing-field and facilitating EU
cross-border activities. For example, the creation of new passports in the
asset management sector (mainly the manager passport provided by AIFMD, but
also the passports provided by EuVECA, EuSEF and the one proposed in EuLTIF)
are adding to the existing single market for UCITS funds the possibilities for
fund managers to market non-UCITS investment funds throughout the EU without
additional national burdens.
Regulation imposes costs, and there is a
risk that regulatory reform reduces the efficiency of the financial system and
impedes its ability to carry out the key functions that are necessary in a well-functioning
modern economy and that contribute to economic growth. Chapter 6 discusses the
costs in more detail. However, it should be noted that the reform proposals
were generally drafted with the aim of addressing and correcting market (and
regulatory) failures that impeded the efficient functioning of the
financial system. This focus on market (and regulatory) failures follows the
principles of good regulation and minimises the risks and costs associated with
regulatory intervention. Also, proportionality is a fundamental
principle embedded within all the Commission proposals.[308]
While a major focus of the financial reform
agenda has been to restore stability of the financial system, careful
consideration has also been given to ensure that this does not unduly undermine
economic growth.  Recognising the vital role that financial markets play in
supporting the economy, it has been particularly important to strike a balance
between strengthening requirements to ensure financial stability and allowing a
sufficient and sustainable flow of finance to the economy to support growth and
investment.
An efficient financial system ensures
access to finance for all financial market participants at fair prices. For
all reform measures the impact on small and medium-sized enterprises (SMEs) has
been considered and various measures specifically aim at addressing specific
problems, in particular in the area of access to finance, faced by SMEs. SMEs
are the backbone of our economy and contribute more than half of the total
value added in the non-financial business economy.[309] SMEs have
historically faced significant difficulties in accessing funding to grow. These
difficulties have been reinforced during the crisis given their reliance on
bank financing.  Faced with significant bank deleveraging and fragmented
financial markets in the EU, this environment has led to a considerable
divergence of conditions for access to finance from country to country.  As set
out in an action plan in 2011 to address the financing problems faced by SMEs,[310]
the EU financial framework has been adapted considerably over the last three
years. Measures include: 

 Reducing the administrative burden and
     reporting requirements for SMEs: 
  The Accounting Directive simplifies the
      preparation of financial statements for small companies. The Directive reduces
      and limits the amount of information to be provided by small companies to
      satisfy regulatory requirements. The "think small first"
      approach of this Directive will enable companies to prepare profit and
      loss accounts, balance sheets and notes that are more proportionate to
      their size and to the information needs of the users of their financial
      statements. Of course, any small company remains entitled to provide more
      information or statements on a voluntary basis;
  The Market Abuse Regulation (MAR) adapts
      the disclosure requirements for issuers on SME markets to their needs.
      For instance, the issuers on such markets will be subject to tailored
      rules for the requirement to draw up lists of insiders. Issuers on SME
      markets will also benefit from the clarification of the scope of the
      reporting obligations in relation to managers' transactions and the new
      provisions with respect to the thresholds which trigger the obligation to
      report such manager's transactions;
  The Commission delegated act of 30 March 2012 to the amending Prospectus Directive
      implemented proportionate disclosure regimes aiming to increase the
      efficiency of the Prospectus regime by reducing administrative burdens
      for issuers where they were considered to be disproportionate. The
      reduction of disclosure requirements has been carefully calibrated in
      order to reach the right balance between the reduction of the
      administrative burden for the issuers and the need to preserve a
      sufficient level of investor protection;
  The revised Transparency Directive of 22 October 2013 abolishes the requirement to publish
      quarterly financial information with the aim to reduce the administrative
      burden for listed companies and encourage long term investment.
 Creating a dedicated trading platform
     (SME growth markets) to make SME markets more liquid and visible (MiFID II). In addition, SME growth markets benefit from certain
     exemptions in the CSDR (e.g. more flexible requirements on
     settlement and buy-in period) to better serve the needs of these markets, 
 Addressing the issue of SME risk
     weighting in the bank capital framework (CRD
     IV package) There are specific treatments for
     exposures to SMEs under both the standardised approach as well as under
     the internal rating-based approach to calculate capital requirements. Furthermore, the CRD IV package includes
     a correcting factor that lowers the capital requirements related to credit
     risk for exposures to SMEs. 
 Addressing the issue of SME risk
     weighting in the prudential framework for insurance businesses (Solvency II). Risk weights of relevance for SMEs are being
     reviewed in the preparation of the delegated acts for Solvency II, based
     on advice from EIOPA (see also section 6.5.1). Possible adjustments might include,
     inter alia, a less onerous treatment of certain
     types of investment funds which are newly-created by EU legislation
     (EuLTIFs, EuSEFs and EuVECAs) as well as investments in closed-ended,
     unleveraged alternative investment funds (e.g. certain private equity
     funds); a more favourable treatment of high-quality securitisation (see
     also section 7.6); and amendments to the treatment of unrated bonds and
     loans. 
 Introducing new EU investment fund frameworks for investment in venture capital (EuVECAs) and in social
     entrepreneurship funds (EuSEFs). The proposal on European Long-term
     Investment Funds (EuLTIFs) further aims to facilitate the long-term
     financing of SMEs. 

Further measures, also in the context of
ensuring the long-term financing of the EU economy are currently being explored
(e.g. crowdfunding). Improving access to finance and developing alternative
financing sources is a key area of focus for ongoing work, as set out in the
March 2014 Communication on long-term financing of the European economy (see
box 4.8.1).
Box 4.8.1: Communication on long-term financing of the European
economy[311]
The Commission adopted a Green Paper on the long-term
financing of the European economy on 25 March 2013[312] that opened a three
month public consultation. Its purpose was to initiate a broad debate about how
to foster the supply of long-term financing and how to improve and diversify
the system of financial intermediation for long-term investment in Europe.
Responses to the consultation contributed to further assessment by the
Commission of the barriers to long-term financing, with a view to identifying
possible policy actions and feeding the overall debate on this at European and
international level.
One year later, on 27 March 2014, the Commission
published the follow-up to this work: a Communication on long term financing of
the European economy proposing a set of actions of actions to mobilise private
sources of finance, make better use of public finance, further develop European
capital markets, improve SMEs’ access to financing, attract private finance to
infrastructure and enhance the framework for sustainable finance. An action
plan to implement the reforms will be put into place.
Private sources of long-term financing: The support of responsible bank lending
and the fostering of non-bank sources of financing, such as institutional
investors, including insurance companies, pension funds, traditional or
alternative investments funds, sovereign funds and foundations is crucial.
While banks will continue to play a significant role, the diversification of
funding is important in the short run to improve the availability of financing,
as well as in the long run, to help the European economy achieve its goal of
sustainable growth. Actions in this area include incentives to stimulate
long-term investment by insurers in the delegated act for Solvency II, and
examining the opportunities presented by the creation of a single market for
personal pensions. The legislative proposal for new rules on occupational
pension funds, adopted on the same day as the communication, should also
contribute to more long-term investment
Public funding: The public sector is a key contributor to gross
capital formation in the form of tangible and intangible investment. Efforts
are needed to enhance the transparency and efficiency in the use of public
funds, to maximise the return on public investment, its contribution to growth
and its ability to leverage private investment. Through the EU Semester process
the Commission will continue to monitor the fiscal policies of the EU28,
including the quality of public expenditure and compliance with the Excessive
Deficit Procedure. In addition, a wide focus, which addresses the activities of
national promotional banks and export credit agencies, is needed. Actions in
this area will involve providing guidance on general principles for national
promotional banks and to increase cooperation between them and with the European
Investment Bank (EIB); and to explore ways of promoting better coordination and
cooperation among national credit export schemes.
Financial markets: Policy will be developed to diversify
European financing channels. European capital markets are relatively
underdeveloped and are currently insufficient to fill the funding gap created
by bank deleveraging (see section 6.4.1). Appropriate financial instruments are
also required to allow financial markets to play an active and effective role
in channelling funds into long-term investment. This includes innovative
financial instruments linked to the key challenges of sustainable growth in
Europe, including specific instrument to address infrastructure, climate and
social challenges. Actions in this area include a review of the Prospectus
Directive and analysis on the role of covered bonds and private placement in
the single market. Further work will be carried out on the differentiation of
“high” quality securitisation products with a view to ensuring coherence across
financial sectors and exploring a possible preferential regulatory treatment
compatible with prudential principles (see section 7.6). 
SME finance: A key issue for SME finance is facilitating the
transition from start-up to SME to mid-cap, i.e. a transition up the so-called
“funding escalator”. As they progress through their life cycle, SMEs use a
combination of financing sources and often find it challenging to transition
from one mix to another. Between the different stages of growth, companies can
face “financing gaps” and “education gaps”.  This is particularly prevalent at
the early stage and at the growth stage, due in part to limited venture capital
funding in Europe. The actions set out in the communication include improving
credit information on SMEs, reviving the dialogue between banks and SMEs and
assessing best practices on helping SMEs access capital markets.
A separate communication has been presented on the
issue of crowdfunding,[313]
following the public consultation. It will aim to raise awareness and
information disclosure; promote industry best practices and facilitate the
development of a quality label; monitor the development of crowdfunding markets
and national legal frameworks. As this is an emerging source of finance, it
will be important that a regular assessment of whether any form of further EU
action – including legislative action – is necessary to support the growth of
crowdfunding.
Infrastructure finance: In addition to the already announced measures
as part of the Project Bond Initiative, further action will look at increasing
the availability of information on infrastructure investment plans and
improving the credit statistics on infrastructure loans.  
Cross-cutting measures: The ability of the economy to channel
funds to long-term financing is also dependent on a number of cross-cutting
factors, including corporate governance, accounting, taxation and legal
environments.  The general business and regulatory environment is important for
domestic as well as cross-border investment. 
For example, discrepancies between the insolvency laws
of Member States and inflexibilities in these laws create high costs for
investors, low returns to creditors and difficulties for businesses with
cross-border activities or ownership across the EU. These inefficiencies affect
the availability of funding as well as the ability of firms to get established
and grow, with particular impact on SMEs. In March 2014, the Commission issued
a recommendation on best practice principles to enable the early restructuring
of viable enterprises and to allow bankrupt entrepreneurs to have a second
chance.
Other actions for this workstream will include work on
corporate governance to increase shareholders’ and investors’ engagement; on
accounting standards; and on tax and legal issues.
[1] Communication on 'Driving European recovery'; COM(2009) 114 final. This followed the recommendations of a group of
high-level experts, set up by the Commission and chaired by Mr de Larosière
(Report of the High-level Group of Financial Supervision in the EU, 25 February
2009).
[2] Communication on 'Regulating financial services for sustainable
growth'; COM(2010) 301 final
[3] Communication on 'A roadmap towards a Banking Union' COM(2012) 510 final. Communication on 'A blueprint for a deep and
genuine economic and monetary union – Launching a European debate'; COM(2012)
777 final/2.
[4] The review only covers financial services regulatory reform and not
the other important reforms taken in response to the crisis. 
[5] Full references for the different measures
are provided in the relevant sections of the study.
[6] Communication on 'An action plan to improve access to finance for
SME's', COM(2011) 870 final
[7] COM(2014) 168 final
[8] COM(2014) 168 final
[9] High-level Group of Financial Supervision in the EU (2009).
[10] Communication on 'Driving European recovery'; COM(2009) 114 final
[11] Communication on 'Regulating financial services for sustainable
growth'; COM(2010) 301 final
[12] Communication on 'A roadmap towards a Banking Union' COM(2012) 510 final. Communication on 'A blueprint for a deep and
genuine economic and monetary union – Launching a European debate'; COM(2012)
777 final/2.
[13] Additional impact studies were prepared by international bodies, as
well as by industry associations and other bodies. See also annex 1.
[14] See annex 1 for a review of quantitative studies in the banking
sector.
[15] Indirect costs or unintended consequences of regulation are also difficult
to quantify.
[16] More than 400 delegated and implementing acts, binding technical
standards or empowerments for such acts are required, including about 100 for
the Capital Requirements Regulation and Directive IV, about 100 for the revised
Markets in Financial Instruments Directive, about 40 for the Bank Recovery and
Resolution Directive, and about 60 for Solvency II. 
[17] See annex 3.
[18] See for example Turner (2010).
[19] See box 6.1.1 for references to the academic literature.
[20]  See for example OECD (2010).
[21] The distinction is not always straightforward as intermediation via
financial markets also tends to be very intermediated, with issuers and
investors relying on advisers, investment managers, brokers and so on. Also,
there are significant links between the direct and indirect intermediation
channels, since banks, insurers, etc. are themselves heavy financial market
users (as equity and debt issuers and investors). 
[22] "Modern" financial intermediation using shadow banking is
presented in chapter 4.4.
[23]  For example, see: European Commission (2009). Economic crisis in
Europe: causes, consequences, and responses, European Economy No.7, September
2009; High-level Group on Financial Supervision in the EU (2009);  Claessens et
al (2014); Reinhart and Rogoff (2009); Acharya and Richardson (2009); Acharya
et al (2009); Roubini and Mihm (2010); Lo (2012); Gorton (2010); and Gorton and
Metrick (2012).  
[24] This growth had also been partly fuelled by the introduction of the
Euro, partly by the enlargement of the EU, but also by the boom of the US
financial markets and other factors (e.g. the rapid inclusion of China to the
global economy).
[25] While other studies highlight or prioritise different problems, the
ones listed are generally agreed to be among the main problems contributing to
the crisis. 
[26] While the main issuers of asset-back securities were US-based, many
EU financial institutions had built sizeable positions in these markets.
[27] Based on OECD (2010).
[28] For example, Acharya et al (2011) highlight four key aspects:
excessive risk-taking in the financial sector due to implicit government
guarantees; regulatory focus on individual institution risk rather than
systemic risk; opacity of positions in financial derivatives that produced
externalities from individual firm failures; and runs on the unregulated
(shadow) banking sector that eventually threatened to bring down the entire
financial sector. Other studies highlight also regulatory failures, such as:
the absence of appropriate resolution and crisis management tools;
inappropriately defined regulatory boundaries and unregulated shadow banking
activities; and capital requirements that contributed to the procyclicality of
the financial system.
[29] For a narrative of the crisis unfolding in Europe, see High-level
Expert Group on reforming the structure of the EU banking sector (2012). 
[30] This created in particular a problem where, prior to the
introduction of the euro, nominal interest rates had been high (e.g. Spain and
Ireland).
[31] This is why the European Commission put forward a Recommendation
for a new approach to business failure and insolvency (which is outside the
scope of this report). See C(2014) 1500 final.
[32] See ECB (2012).
[33] COM(2012) 777 final/2
[34] Trend GDP is calculated over a long time period to filter out any
artificial growth in the pre-crisis boom years.
[35] This is based on the total EU GDP in 2008 (Source: Eurostat).
[36] See also EFSIR (2012) for an overview of the impact of the crisis
on households.
[37] European Commission (2014), "Employment and Social
Developments in Europe (ESDE) 2013 Annual Review, January 2014, pp.
18-19 - http://ec.europa.eu/social/main.jsp?catId=738&langId=en&pubId=7684
[38] http://ec.europa.eu/public_opinion/archives/ebs/ebs_398_en.pdf
[39] Source: Eurostat
[40] European Commission (2014), ESDE 2013, p.
60; and European Commission (2014), ‘EU Employment and Social Situation
Quarterly Review’ (ESSQR), March 2014,
http://ec.europa.eu/social/main.jsp?langId=en&catId=89&newsId=2054&furtherNews=yes
[41] http://ec.europa.eu/europe2020/pdf/youth_en.pdf
[42] European Commission (2014), ESSQR 2014, p. 25
[43] See for example Kahn  (2010).
[44] For example, Helliwel and Huang (2011) confirm, using US data, that
the costs of unemployment go well beyond income losses for the unemployed but
significantly affect well-being of both unemployed and employed people. For the
unemployed, the non-pecuniary costs of unemployment are found to be several
times as large as those due to lower incomes, while the indirect effect at the
population level is fifteen times as large. For those who are still employed, a
one percentage point increase in local unemployment has an impact on well-being
roughly equivalent to a four percent decline in household income. The authors
also find evidence that job security is an important channel for the indirect
effects of unemployment.
[45] European Commission (2014), ESDE 2013, p. 55
[46] European Commission (2014), ESDE 2013, p. 13
[47] Social expenditure trends were negatively affected in this crisis,
in particular from 2012, neutralising the economic stabilisation function of
social protection systems in many Member States.
[48] See European Commission (2009).
[49]             Roughly speaking, the return on equity (RoE) equals
leverage multiplied by the return on assets (RoA). For a given ROA, say 1 %,
the RoE will approximately be the multiplication of the ROA with the leverage.
If banks have a leverage of 20, the RoE will amount to 20 %, whereas it would
be 10 % with a leverage of 10. 
[50]             Note that tax distortions in favour of debt issuance
cannot explain the high leverage of banks compared to non-banks. Debt tends to
receive a more favourable tax treatment than equity, but this argument also
holds true for non-financials. The argument that banks are prone to greater
agency problems compared to non-banks in the sense that bank managers are able
to expand the bank balance sheet aggressively and to take on tail risk is
valid, but does not explain the preference for greater (short term) debt
funding by banks. Academic papers such as Calomiris and Kahn (1991) claim that
short-term debt has a disciplinary effect on bank managers, but the crisis
experience has illustrated that short-term debt issuance would need to be
taxed, if anything, rather than being considered as a tool to contol bank
risk-taking. The Miller-Modigliani theorem states that the capital structure is
irrelevant, except in the presence of important and real frictions (see also
chapter 6.4). Admati and Hellwig (2012) and several others argue that the
presence of the (mis-priced) public safety nets is the sole explanation behind
the relatively high leverage of banks over non-banks.
[51] Data in this box correspond to the euro area aggregate. In broad
terms, the distribution of financing sources is similar both for the EU28 as a
whole and for individual countries.
[52] Directive 2013/36/EU of the European Parliament and of the Council
of 26 June 2013 on access to the activity of credit institutions and the
prudential supervision of credit institutions and investment firms, amending
Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC.
[53] Regulation (EU) No 575/2013 of the European Parliament and of the
Council of 26 June 2013 on prudential requirements for credit institutions and
investment firms and amending Regulation (EU) No 648/2012.
[54] Lehman Brothers, Northern Rock, RBS, Fortis and Dexia enjoyed
excellent regulatory capital marks, while being unsustainably leveraged and
vulnerable to funding liquidity risk.
[55] Banks whose capital instruments did not live up to the expectation
regarding their loss absorption, permanence and flexibility of payment capacity
include, amongst others, Allied Irish banks (IE), Bank of Ireland (IE), Bayern
LB (DE), Bradford and Bingley (UK), Caja Sur (ES), Commerzbank (DE), KBC Group
(BE), Lloyds (UK) and RBS (UK).
[56] See breakdown of write-downs on different investment banking
activities in Box 3 of BCBS (2012).
[57] Much of the counterparty credit losses in the crisis were suffered
not as a result of actual defaults of the counterparty, but because credit
market volatility negatively impacted bank earnings. In response, the BCBS
introduced the credit valuation adjustment (CVA) charge, aimed at improving
banks’ resilience against potential mark-to-market losses associated with
deterioration in the creditworthiness of counterparties to non-cleared
derivatives trades. The CVA charge applies to non-cleared trades as exposures
toward central counterparties (see section 4.3.2) are exempt from the CVA charge.
[58] The second consultative document, published in October 2013, sets
out a number of specific measures to improve trading book capital requirements.
This includes a revision of the boundary between the trading and banking books,
aiming to establish a better
alignment between the two and reducing the risk of regulatory arbitrage between
them. Moreover, it also incorporates the latest work trying to capture the risk
of extreme events taking place (known in statistics as "tail risk").
Additionally, it now foresees the incorporation of illiquidity risk by
introducing a "liquidity horizon" in the risk metric, as well as
revisions to the standardised and internal model based approach.
[59] See for example Haldane (2009) and Blundell-Wignall et al (2013).  
[60] Tier 1 capital is composed of core Tier 1 capital, which consists
primarily of common equity and disclosed reserves (or retained earnings), and
non-redeemable non-cumulative preferred stock. Tier 2 capital is supplementary
capital (e.g. also including some hybrid instruments).
[61] Miccossi, (2011) shows similar results for 2010. 
[62] The BCBS is also considering the merits of introducing the
standardised approach as a floor or surcharge to the models-based approach.
However, it will only make a final decision on this issue following a
comprehensive impact study, after assessing the impact and interactions of the
revised standardised and models-based approaches.
[63] See BIS (2013).
[64] Risk weights have also been criticised for not reflecting the
riskiness of sovereign bonds in the banking book. Within the banking book,
sovereign debt is subject to a preferential treatment. Independent of that,
during the crisis, banks have tended to reduce their cross-border exposure on
sovereigns, increasing sovereign exposure to their own governments. The
European legislators expressed the view that the Commission should, at an
appropriate time, evaluate if concentrations in sovereign debt are adequately
controlled. See Directive 2013/36/EU, recital 84: "The Commission should,
at an appropriate time, submit a report to the European Parliament and the
Council about any desirable changes to the prudential treatment of
concentration risk".
[65] See http://www.eba.europa.eu/risk-analysis-and-data/review-of-consistency-of-risk-weighted-assets.
Note also that the CRD IV package mandates at least annual benchmarking of
internal models.
[66] See
BCBS (2014).
[67] As part of the bank recapitalisation exercise, EBA required
national supervisors to ensure that banks' plans to strengthen capital led to
an appropriate increase of own funds rather than higher capital ratios being
achieved through excessive deleveraging and lending disruptions to the real
economy.
[68] Using the ECB's consolidated banking data, including data of
domestic credit institutions and branches and subsidiaries of foreign banks..
[69] See ECB banking structure report, November 2013.
[70] EBA (2014), Basel III monitoring exercise, March.
[71] "Group 1" include internationally active banks that have Tier 1
capital of more than EUR 3 billion, Group 2 banks refer
to the remaining banks.
[72] The shortfall in Tier 1 capital due to the leverage ratio would
amount to about EUR 100 billion for Group 1 and about EUR 27 billion for Group
2. The shortfall falls as banks increase Tier 1 capital to meet the risk-based
regulatory capital ratios.
[73] Liquidity risk was a Pillar 2 concern under Basel II.
[74] For a detailed review of the academic literature of the benefits of
liquidity regulation, see EBA (2013).
[75] A financial institution becomes insolvent when its going concern
value sinks below the expected market value of its liabilities. In times of
crisis, insolvency and illiquidity often get blurred and are hard to
disentangle. Asset prices become disconnected from expected future cash flows
and, instead, reflect only the prices that could be obtained if the assets had
to be sold promptly to the few investors prepared to buy such assets in such
times. Indeed, the term "illiquidity" is sometimes used to conceal
solvency problems. 
[76] In accordance with Article 510(3) of the Capital Requirements
Regulation (EU/575/2013).
[77] A number of academic studies have examined the problem of
procyclicality and called for reforms to capital regulation. For example,
Brunnermeier et al (2009) and Goodhart (2008).
[78] This assumes that the EUR 100 million sale or non-renewal of loans
does not give rise to further losses, as such an indirect effect would trigger
a further need to sell.
[79] See Adrian and Shin (2010a).
[80] See above for details on the Basel III leverage ratio.
[81] See BIS (2010)
[82] In addition to the mandatory buffer for globally systemically
important institutions, the CRD IV package provides for a supervisory option
for a buffer on “other” systemically important institutions (O-SII). This
includes domestically important institutions as well as EU important
institutions. In order to prevent adverse impacts on the internal market there
is framing in the form of the criteria used to identify O-SIIs, a notification/
justification procedure and an upper limit to the size of the buffer (2 % of
RWAs). The O-SII buffer is applicable from 2016 onwards but Member States
wanting to set higher capital for certain banks earlier can use the systemic
risk buffer. The optional O-SII buffer CET1 capital will be recognised for the
purpose of meeting the consolidated mandatory G-SII buffer requirement.
[83] Until 2015, in case of buffer rates of more than 3 %, Member States
will need prior approval from the European Commission, which will take into
account the assessments of the European Systemic Risk Board (ESRB) and the
EBA.  From 2015 onwards and for buffer rates between 3 and 5 %, the Member
States setting the buffer will have to notify the Commission, the EBA, and the
ESRB. The Commission will provide an opinion on the measure decided and if this
opinion is negative, the Member States will have to "comply or
explain". Buffer rates above 5 % will need to be authorized by the
Commission through an implementing act, taking into account the opinions
provided by the ESRB and by the EBA.
[84] Macro- and micro-prudential tools often operate through the same
channels and can be mutually reinforcing because the safety and soundness of
individual institutions helps reduce systemic risks and vice versa, i.e. the
greater resilience of the system can strengthen individual firms.  There can
also be tensions (see chapter 6).
[85] See case studies in High-level expert group on reforming the
structure of the EU banking sector (2012). 
[86] There has been some criticism that the introduction of this maximum
ratio could lead to an increase in fixed remuneration and therefore to less
flexibility for institutions to reduce fixed costs in a downturn. It should be
borne in mind that the requirements regarding the maximum ratio only apply to a
very small segment of the employee base, i.e. to material risk takers, so that
the overall economic impact can be expected to remain limited. In addition,
there is also a continuing legal obligation for institutions to ensure
consistency between their remuneration policy and sound and effective risk
management. 
[87] See for example KPMG (2014).
[88] For instance, central banks across the world worked well together
to coordinate monetary policy decisions, developing non-standard policy
measures and toolkits along the way.
[89] See Crockett (2012).
[90] The estate is still paying out to Lehman's former creditors http://dm.epiq11.com/LBH/Project#.
[91] Comments raised by Andrea Enria in an interview in the Frankfurter
Allgemeine Zeitung of November the 18th 2013.
[92] See FDIC (2011).
[93] Or where applicable 20 % of risk-weighted assets.
[94] For example, only if any of the following conditions hold: (i) the
institution does not infringe (or is not likely to infringe in the near future)
the requirements for continued authorisation of its operations; (ii) the
liabilities of the institution do not exceed (or are not likely to exceed in
the near future) its assets; (iii) the institution is not unable (or is not
likely to be unable in the near future) to pay its maturing debts or other
liabilities; (iv) conditions for resolution as specified in BRRD have not been
met; (v) there is no need to exercise any bail-in power for the institution to
remain viable.
[95] State Aid is defined as an advantage in any form whatsoever
conferred on a selective basis to undertakings by national public authorities.
To be State aid, a measure needs to have the following features: (i) there has been an intervention by the State or through State
resources which can take a variety of forms; (ii) the intervention gives the recipient an advantage on a selective
basis; (iii) competition has
been or may be distorted; and
(iv) the intervention is likely to affect trade between
Member States. See: http://ec.europa.eu/competition/state_aid/overview/index_en.html
[96] See Noss and Sowerbutts (2012), Oxera
(2011), Schich and Lindh (2012), Schich and Kim (2012), Haldane (2012),
Alessandri and Haldane (2009), and Ueda and Mauro (2012). Estimation
methodologies belong to two groups. First, “funding advantage” models, i.e.
ratings-based approaches that focus on the difference between support and
stand-alone credit ratings. Second, “contingent claim” models, i.e. option
pricing approaches that focus on the resemblance of implicit subsidies to put
options or look-back options and model them accordingly. Evidence for the
largest 26 global banks suggests an average credit rating uplift in the
2007-2009 period of approximately 2.5 notches (i.e. support rating are 2.5
notches above stand-alone financial strength ratings). Funding cost advantages
are not negligible and may exceed 100 basis points, depending on the time
period and stand-alone rating. Within a given country, the majority of the
subsidies are enjoyed by the largest banks. UK bank evidence for the period
2007-2009 suggests that small and medium sized banks only received 8.5 % of
total estimated implicit subsidies for UK banks, compared to 91.5 % for the top
5 UK banks (Haldane, 2010b).
[97] See the Commission's impact assessment on structural reform
(SWD(2014) 30 final) and chapter 3 of the April 2014 IMF Global Financial
Stability Review.
[98] SWD(2014) 30 final
[99] Moody’s (2011) stated on the UK ring-fence
plans that “the ring-fencing proposals would likely lead to a further
reduction in our assumptions of systemic support”. JP Morgan (2011)
analysts stated that “ring-fencing of retail operations will be a
transformational change for the UK banks and will most likely lead to the
undermining of the sector ratings, particularly for the entities excluded from
the retail ring-fence”, and anticipate that “the ratings associated with
the non-ringfenced entity should tend towards the stand-alone ratings of such
institutions”. HSBC (2011) reached a similar view.
[100] Cariboni et al (2013).
[101] See Stiglitz (2013.
[102] See Noss and Sowerbutts (2012) and Schick and Lindh (2012).
[103] Other measures to address the TBTF problem include measures
discussed below to better guarantee deposits (the revision of the Deposit
Guarantee Schemes directive (the "DGS"); measures to improve
transparency and address the risks of derivatives and to improve market
infrastructures (European Market Infrastructure Regulation (the
"EMIR") and related revisions to the Markets in Financial Instruments
Directive ("MiFID")). Additionally, in order to break the negative
feedback cycle between the sovereign and banking risks and to restore
confidence in the euro and the banking system, the European Commission has
called for further development of a Banking Union, building on the single rule
book that will be applicable to all banks in the entire EU, as also discussed
below.
[104] G20 Leaders, September 2013: “We recognize that structural
banking reforms can facilitate resolvability and call on the FSB, in
collaboration with the IMF and the OECD, to assess cross-border consistencies
and global financial stability implications.” G20 Ministers, October 2013:
“We will pursue our work to build a safe and reliable financial system by
implementing the financial reforms endorsed in our  Leaders’ Declaration, which
are aimed at  building upon the significant progress already achieved,
including in creating more resilient financial institutions, ending too‐big‐to‐fail, increasing transparency and market integrity, filling 
regulatory gaps,  addressing the potential systemic risks from shadow banking
and closing information gaps.”
[105] The HLEG also included other further recommendations.
[106]European Parliament (McCarthy 2013), Reforming the structure of the
EU banking sector, 2013/2021 (INI).
[107] COM(2014) 43 final
[108] These are banks that exceed the following thresholds for three
consecutive years: (a) the bank's total assets exceed EUR 30 billion; and (b)
the bank's total trading assets and liabilities exceed EUR 70 billion or
10 percent of their total assets. See the proposal for further detail on how
trading assets and liabilities are defined.
[109] Changes in the systemic importance and trading activities of the EU
banking groups in the next years may increase or decrease this number.
[110] Proprietary trading activities is narrowly defined in a legal sense
as desks’, units’, divisions’ or individual traders’ activities specifically
dedicated to taking positions for making a profit for own account, without any
connection to client activity or hedging the entity’s risk.
[111] Separation will be accompanied by a number of legal, economic,
governance and operation constraints. In particular, the separate entities need
to meet prudential requirements on an individual basis; they also need to issue
their own debt and operate with intra-group exposure limits; and contracts and
transaction between the two entities should be on an arm’s length basis. Banks
would need to demonstrate that the objectives of the structural reform are not
put at risk to “avoid” separation of their activities into a “trading entity”.
[112] The impact assessment (SWD(2014) 30 final) states that social
benefits exceed social costs even for the polar case in which all EU banking
groups within the scope of the regulation would be required to separate trading
activities such as proprietary trading (including bank-internal hedge funds),
market making, investing, sponsoring, and structuring activities related to
“complex securitisation”, and structuring, arranging or execution of “complex
derivative transactions” into distinct and dedicated subsidiaries.
[113] SWD(2014) 30 final
[114] See "An assessment of the long-term economic impact of
stronger capital and liquidity requirements", BCBS, August 2010. The
report uses bank data that are not restricted to EU Member States.
[115] An empirical study by the former UK Financial Services Authority
(2012) also concluded that there are positive net effects of prudential reforms
on the macroeconomy. The study shows an overall net benefit of increased
capital requirements (as per CRD III and the FSA's 98-6-4 recapitalisation
regime, including Basel III capital buffers and liquidity coverage ratio). The
net benefits are estimated at £11.9 billion annually.
[116] See also the impact assessment accompanying the structural reform
proposal for quantitative evidence (SWD(2014) 30 final).  
[117] The review of the Prospectus Directive is also relevant for
transparency and market efficiency, but is not discussed here (but it is listed
in annex 2). 
[118] G20 Leaders Statement: The Pittsburgh Summit, September 24-25,
2009, Pittsburgh, http://www.g20.utoronto.ca/2009/2009communique0925.html.

[119] It is difficult to disentangle the regulatory impact of MiFID on
capital markets from changes due to e.g. technological innovation and the
impact of the financial crisis. 
[120] For example, institutional investors increasingly seek to hide
their trading intentions from the public. It is not possible to clearly
identify one single underlying factor, but it is rather a multitude of factors
contributing to this trend (e.g. uncertainty created by the crisis, technical
innovations, fragmentation of trading, increased competition, available waivers
from pre-trade transparency). 
[121] Insufficient pre-trade transparency can hinder the price formation
process.
[122] This follows from a fact-finding exercise conducted by CESR, the
predecessor of European Securities and Markets Authority, in 2010. See impact
assessment of MiFID II: http://ec.europa.eu/internal_market/securities/docs/isd/mifid/SEC_2011_1226_en.pdf
[123] TABB Group (2013).
[124] See “The impact of market fragmentation on EU stock exchanges”,
Consob Working Paper No. 69, July
2011http://www.consob.it/mainen/documenti/english/papers/qdf69en.html?symblink=/mainen/consob/publications/papers/index.html‎
[125] This section only focuses on crisis-related elements of MiFID II. 
[126] See Appendix II and III at Gomber et al (2011) for a comprehensive
table of different definition by academia and regulators.
[127] See Jones (2013) and Gomber et al (2011) for literature surveys.
[128] See Bowley (2010). 
[129] Boehmer et al 2012, SEC report of Flash Crash, Jarrow and Protter
(2011), Cartea and Penalva (2010), Zhang and Powell (2011).
[130] Low-latency trading uses computers that execute trades within
microseconds, or "with extremely low latency" in the jargon of the
trade. Low-latency traders profit by providing information to their algorithms,
such as competing bids and offers, microseconds faster than their competitors.
See, for example, Budish et al (2013).
[131] While notional amounts provide a measure of market size and a
reference from which contractual payments are determined in derivatives
markets, they do correspond to amounts truly at risk. Gross market values
provide some measure of the financial risk from OTC derivatives. At the end of
2009, the total gross market value stood at USD 21.6 trillion.
[132] Derivative contracts bind counterparties together for the duration
of the contract, which can range from a few days to several decades. Throughout
the duration of a contract, counterparties build up claims against each other,
as the rights and obligations contained in the contract evolve as a function of
its underlying. This gives rise to counterparty credit risk, i.e. the risk that
a counterparty may not honour its obligations under the contract when they
become due, and that after the default of one counterparty, the other
counterparty has to replace the contract by a new contract concluded at a new
adverse price. (the definition did not include the concept of replacement
cost).
[133] For example, there is empirical evidence that during the 2008
crisis, a systematic re-pricing of counterparty risk was the main factor that
amplified the observed increase in correlation between credit default swap
(CDS) spreads. Changes in the fundamental determinants of credit risk accounted
for only a small fraction of the contagion experienced during that time. In
other words, complexity of the market meant that participants were no longer
able to judge properly the creditworthiness of their counterparties, which
contributed towards contagion effects. See Anderson (2010). 
[134] A handful of major dealers provide liquidity to the majority of the
market, limiting the number of potential trading partners for each party to
rebalance positions. The fact that practically all major financial institutions
are participants in this market has led to a high level of interconnection and
hence a high level of interdependence amongst these institutions.
[135] Also, the majority of bilateral collateral arrangements provided
only for the exchange of variation margin (covering fluctuations in the value
of the contract), but not of initial margin (covering the potential cost of
replacing the contract in case the original counterparty defaults.
[136] Trade confirmation implies verification of the terms of trade after
execution (affirmation) and final confirmation. On-exchange, this occurs
automatically within the exchange's matching system. The most standardised OTC
contracts use electronic third-party services.
[137] In response to the problems revealed by the financial crisis, the
Pittsburgh declaration of the G20 leaders in September 2009 stated that: (i)
all standardised OTC derivative contracts should be traded on exchanges or
electronic trading platforms, where appropriate, and cleared through central
counterparties; (ii) OTC derivative contracts should be reported to trade
repositories; and (iii) non-centrally cleared contracts should be subject to
increased risk management collateralisation and higher capital requirements.
[138] Non-financial counterparties whose OTC derivatives positions are
below a certain threshold are exempted from the EMIR requirements.
[139] Managing collateral with a wide variety of counterparties may be
challenging. In 2008, all major dealers started portfolio reconciliation for
all OTC derivatives between themselves and the major counterparties. This
process involves matching the population, trade economics and mark-to-market of
outstanding trades in a collateralised portfolio.
[140] In OTC derivatives, participants build up gross positions far
exceeding their net risk position. Portfolio compression is a process, whereby
mutually offsetting trades are eliminated, reducing the notional market size.
Thus, portfolio compression achieves lower counterparty credit risk,
operational risk and the cost of capital. The more standardised the contract,
the easier it is to match eligible trades and to compress them. In principle,
portfolio compression can be applied to all OTC derivatives with sufficient
liquidity. In practice, it is predominantly used in interest rate and CDS
markets. Portfolio compression can also be used to compress a CCP's portfolio,
facilitating default management. The smaller and less complex the defaulted
party's portfolio, the easier and faster it is to manage the consequences of a
participant's default.
[141] See ZEW (2011).
[142] Pirrong, C., “The Economics of Central Clearing: Theory and
Practice”, ISDA Discussion Papers Series No.1, May 2011.
[143] CCPs can mitigate the destabilising effects of the replacement of
defaulted positions by: (a) reducing (via position netting) the magnitude of
positions that need to be replaced; (b) transferring customer trades to solvent
CCP members; and (c) coordinating the orderly replacement of defaulted trades
through auctions and orderly hedging of exposures created by defaults. These
measures can reduce the knock-on price movements that result from a large
default or defaults precipitated by an asset price shock.
[144] The existing body of research provides divergent outcomes about
whether there is a link between speculation and commodities prices or not. In
the context of the CBA for the new rule on position limits proposed by the CFTC
on 5 November 2013, it received 130 studies examining the link between
speculation and commodities prices. According to the CFTC analysis, "about
a third of them say excessive speculation has an impact, about a third say it
doesn’t and about a third say they can’t tell”. See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister110513c.pdf
[145] See for instance Cheng and Xiong (2013).
[146] IOSCO Principles for Regulation and Supervision of Commodity
Derivatives Markets (2011). http://www.iosco.org/library/pubdocs/pdf/IOSCOPD358.pdf
[147] The intervention powers will contribute to orderly and stable
commodity markets and prevent market abuse. The Market Abuse Regulation (see
below) complements these reform measures by extending the market abuse regime
to cross-market abuses. In addition, measures have been introduced to reduce
the number of non-regulated entities to make sure that all relevant actors are
captured.
[148] Statistical release, OTC derivatives statistics at end-June 2013,
BIS, November 2013. It combines data from both the semi-annual BIS survey with
the more comprehensive Triennial Central Bank Survey, capturing more than 400
dealers in 47 countries
[149] Novation is the replacement of one contract with another. When a
CCP steps in between the original parties to the trade, two novations takes
place, leading to the creation of two new, perfectly offsetting contracts.
Because the two contracts offset one another, the CCP normally bears no market
risk (the latter is still borne by the original parties to the trade). However,
as counterparty to every position, the CCP bears credit risk in the event that
one of its counterparties fails. This risk is being managed through margin
requirements. Similarly, the CCP’s counterparties bear the credit risk that the
CCP might fail.
[150] Non-Cleared OTC Derivatives: Their Importance to the Global
Economy, March 2013, ISDA.
[151] OTC Derivatives Market Analysis, Year-End 2012, June 2013 (updated
August 2013), ISDA.
[152] ISDA reports the volume of compressed trades that are centrally
cleared on a net basis (as ½ of the amount) to adjust for double counting. As
an illustration, gross compression of interest rate derivatives totalled USD 80.5
trillion in 2012, of which USD 71.8 trillion related to CCP portfolios. ½ of
the latter figure equals the USD 35.9 trillion quoted in the main text above,
whilst the difference of USD 8.7 trillion relates to bilaterally cleared trades
under both net and gross reporting methodologies.
[153] Technical standards on initial and variation margin are yet to be
developed and adopted.
[154] ISDA Margin Survey 2013, June 2013.
[155] However, these agreements do not always include initial margins,
but include variation margin only.
[156] The MAG estimates that, prior to the reforms, the annual
probability of two or more large dealers defaulting and triggering a financial
crisis is 0.26 %. In all post-reform scenarios, exposures were found to be
sufficiently collateralised that no plausible increases in default
probabilities could generate a financial crisis through OTC derivatives
exposures. From this, the Group concludes that, following the implementation of
the reforms, the probability of such a crisis is negligible (absent the remote
possibility that a CCP fails – see also chapter 7 in this report), so the
expected cost of crises propagated by OTC derivatives exposures is almost zero.
[157] This estimate of crisis costs is based on the BCBS's LEI study
(2010) and refers to the median cumulative output losses estimated in a large
number of studies of international banking crisis. 
[158] International integration of EU and global financial markets
necessitated already in the 1960s for cross-border settlement and handling of
Eurobonds the establishment of the I-CSDs. Clearstream and Euroclear also serve
DE FR, and Benelux countries. Crest, Iberclear and Monte Titoli are the
significant players respectively in the UK, ES and IT. The data on volumes and
values is from ESMA (2014). 
[159] Settlement fails increase counterparty risk, market risk and
liquidity risk for market participants. Furthermore, they create disruptions
for corporate actions, for instance if a dividend payment occurs in the period
of delayed settlement.
[160] The T2S was launched by the Eurosystem to create a common technical
platform to support CSDs in providing borderless securities settlement services
in Europe. This is complementary to the regulation, which harmonises legal
aspects of securities settlement and the rules for CSDs at European level,
allowing T2S (http://www.ecb.int/paym/t2s/html/index.en.html)
– which harmonises operational aspects of securities settlement – to achieve
its goals more effectively. 
[161] Dematerialisation is the obligation for most securities to be
recorded electronically, in book-entry form through a CSD, at least from the
moment they are traded via an organised trading facility (i.e. non-OTC market)
or posted as collateral. In certain Member States, mainly in the UK and
Ireland, a certain number of securities are still held directly by the
investors in paper form. It takes more than three times longer to settle a
transaction in paper securities than a transaction in securities held in book
entry form. The key objective of dematerialisation is to ensure a quicker
settlement. Other benefits of this measure include: safety for holders, given
that there will be fewer opportunities for fraud and less risk of losing paper
certificates and ensuing indemnities; safety for issuers, custodians and third
parties, in that there will be a better 'reconciliation' between the securities
issued and the ones circulating and a better identification of the actual
moment of transfer of securities from one holder to another; and reduction of
costs for issuers, custodians and third parties, given that the management of
paper securities is more costly. An extensive period of time,
until 1 January 2025, will be envisaged for market participants to record all
existing paper securities in book entries, in order to facilitate transition
and reduce related costs.
[162] In Europe most securities transactions are settled either two or
three days after the trading day (T+2 or T+3), depending on each market. A
harmonised settlement period will reduce operational inefficiencies and risks
for cross-border transactions, while reducing funding costs for investors (for
instance, for those that have to deliver cash or securities at T+3 but can only
receive them at T+2). A shorter settlement period would have an important
advantage of reducing counterparty risk, that is, the period of time during
which an investor runs a risk that its counterparty will default on its
obligation to deliver cash or securities at the agreed settlement date.
[163] http://ec.europa.eu/internal_market/securities/docs/short_selling/131213_report_en.pdf
[164] ESMA (2013).
[165] US market evidence also shows a significant reduction of settlement
failures following the entry into force of a stricter regime for ‘naked’ short
sales. See Office for Economic Analysis (2009). 
[166]            Shadow banking should not be confused with the entirely
different concept of shadow economy. A less confusing term sometimes used by
Commissioner Barnier has been “parallel banking sector”. The term "shadow
banking” system is in fact quite new and credited to the economist Paul
McCulley in a 2007 speech at the annual financial symposium hosted by the
Kansas City Federal Reserve Bank in Jackson Hole, Wyoming: "Unlike
regulated banks […], unregulated shadow banks fund themselves with uninsured
commercial paper, which may or may not be backstopped by liquidity lines from
real banks. Thus, the shadow banking system is particularly vulnerable to
runs.” In McCulley’s talk, shadow banking mainly referred to nonbank financial
institutions that engaged in maturity transformation. Nowadays, it is generally
perceived to be broader in scope.
[167]            FSB defines “other financial intermediaries” as all
financial institutions that are not classified as banks, insurance companies,
pension funds, public financial institutions, and central banks.
[168]            FSB uses flow of fund data from 20 jurisdictions plus
ECB data for the euro area. Box 3 in Pozsar and Singh (2011) succinctly
summarise the limitations and data gaps of Flow of Funds data for measuring
shadow banking activities and entities.
[169]            ESRB (2014) aggregates funds (MMFs, bond funds, equity
funds, private equity funds, real estate funds, ETFs), financial vehicle
corporations engaged in securitisation, security and derivative dealers, and
financial corporations engaged in lending.
Tax arbitrage may have been another driver behind securitisation
growth. Certain shadow banking entities have been used as instruments to hide
illicit activities such as tax fraud or money laundering strategies (European
Commission, 2012). Alworth and Arachi (2010) investigate the impact of taxes
and tax avoidance activity on the recent financial boom and bust more broadly.
[171]            Margins and haircuts implicitly determine the maximum
leverage of a repo-funded financial institution. If the margin is 2 %, the
borrower can borrow 98 euro for 100 euro worth of securities pledged. Hence, to
hold 100 euros worth of securities, the borrower must come up with 2 euros of
equity. Thus, if the repo margin is 2 %, the maximum permissible leverage is 50
(=100/2). The liquidity impact of increased margins can be enormous. If margins
would increase from 2 % to 4 %, the permitted leverage halves from 50 to 25.
The borrower either must raise new equity so that its equity doubles from its
previous level (difficult in crisis times), or it must sell half its assets, or
some combination of both. The evidence in the crisis has been that margins on
repo agreements have increased rapidly from very low to high levels. Haircuts
on US Treasuries for example increased sharply from 0.25 % in April 2007 to 3 %
in August 2008, for invest-grade bonds from 0-3 % to 8-12 %, for prime MBS from
2-4 % to 10-20 %, etc. which imply massive and acute deleveraging pressure on
highly leveraged financial institutions, giving rise to price decreases and
endogenous second-round effects. Brunnermeier and Pedersen (2009) emphasise
that "funding liquidity", "market liquidity" and asset
values are linked in self-reinforcing procyclical cycles. The example also
makes clear that increases in haircuts will do most harm when they start from
very low levels. In this sense, the low risk premiums at the peak of financial
cycles are of particular concern. When haircuts rise, all balance sheets shrink
in unison, and there may be a general decline in the willingness to lend.
[172] COM(2013) 614 final
[173] COM(2009) 207 final
[174] Directive 2011/61/EU of the European Parliament and of the Council
of 8 June 2011 on Alternative Investment Fund Managers and amending Directives
2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No
1095/2010.
[175] For further details, see Directive 2011/61/EU.
[176] COM(2013) 615 final
[177] See impact assessment, COM SWD(2013) 315 final. 
[178] See ICMA (2013).
[179] See International Securities Lending Association.
[180] “Rehypothecation” is defined as any pre-default use of assets
collateral by the collateral taker for its own purposes. Rehypothecation is
used in bilateral transactions between commercial market participants (dynamic
rehypothecation) and between intermediaries and their clients (static
rehypothecation). When market conditions deteriorate, rehypothecation can
amplify market strains. Simply put, rehypothecation re-introduces counterparty
risk in case a trader fails. Rehypothecation increases the linkages between
traders. As dealers grow unsure of the quality of their counterparty, they
prefer to take precautionary measures regarding their collateral So it is
natural that in a time of crisis, dealers become reluctant to agree to
rehypothecation, to ensure that they know where their collateral is. This makes
traders wary about agreeing to rehypothecation when conditions deteriorate. As
a consequence, funding liquidity needs can increase, thus amplifying market
strains.
[181] See COM (2014) 40 final.
[182] See also Annex 13 of the impact assessment for further details
(SWD(2014) 30 final).
[183] Liquidity risk is less acute for insurers than banks, due inter
alia to the nature of policyholders' claims on insurers, which cannot be easily
liquefied on demand at short notice. Instead, their claims can normally only be
lodged following an insured event, the probability of which is generally
uncorrelated with the economic or financial market cycle; or by cancelling the
policy, usually only at the cost of a substantial fee. Insurers are nonetheless
at risk if they are forced to make major unexpected payouts due, e.g. to
natural disasters or increased surrender rates. Even in these cases, the lags
involved are normally such that investments can be sold opportunely, rather
than on a forced sale basis. However, there remains a risk that insurers are
unable to raise the funds they need, if their assets are illiquid and they are
required to make larger than expected cash outflows to meet margin calls on
collateralised business, claims and early surrenders.
[184] The main causes of failure have been, historically, poor liquidity
management; under-pricing and under-reserving; a high tolerance for investment
risk; management and governance issues difficulties related to rapid growth
and/or expansion into non-core activities; and sovereign-related risks. The
insurers that performed best in times of systemic stress were those with robust
franchises, solid liquidity management, and good capitalization. These
companies also display strong underwriting and reserving policies, competitive
cost structures and investment returns, and prudent risk management structures
and risk appetite. Standard & Poor's (2013), "What may cause insurance
companies to fail", June.
[185] For a discussion of financial stability concerns and other reasons
to regulate insurers, see Bank of England (2013). 
[186] For case studies of insurers affected in the crisis, see The Geneva
Association Systemic Risk Working Group (2010). 
[187] http://ec.europa.eu/internal_market/insurance/docs/solvency/proposal_en.pdf

[188] This is unlike legislation preceding Solvency II where prudential
requirements are largely volume-based and not risk-reflective and where
national approaches to implementation differ significantly. A survey of failed
insurers and ‘near-misses’ conducted in 2005 confirmed that the current
requirements do not provide sufficient early warning for an intervention to be
launched. In more than 75 % of the cases, the reported solvency ratio up to one
year before failure was more than 100 %, and in 20 % of the cases, the reported
ratio was over 200 %. See Committee of European Insurance and Occupational
Pensions Supervisors (2005), "Answers to the European Commission on second
wave of Calls for Advice in the framework of the Solvency II project".
[189] Some national authorities have helped speed up the adaptation to a
risk-based capital framework. For example, the Swedish FSA introduced a
"traffic light system", in the spirit of Solvency II, in 2006. Using
stress scenarios, insurers' exposure to various financial and insurance risks
are measured on both the asset and liability side. Also, UK introduced the
Individual Capital Adequacy Standards (ICAS) regime for general insurance
companies in 2005, which presented a step change to risk-based capital
requirements in line with Solvency II.
[190] Based on a survey of insurers for European Commission (2012),
"European Financial Stability and Integration Report", April, chapter
4. Various industry surveys also report progress of the industry towards
meeting the new Solvency II standards, e.g. Ernst & Young (2012) and
Deloitte (2012).
[191] In a 2012 survey, more than one-half of responding insurers (53 %)
say they expect either some or significant tangible benefits from Solvency II,
with an additional 20 % expecting some benefits in due course. See Deloitte
(2012).
[192] The measures were added via the Omnibus II Directive, which amends
Solvency II with respect to the powers of EIOPA, contains a number of
provisions to smooth the transition to the new regime and provides for the
modified treatment of insurance with long-term guarantees.
[193] It cannot be excluded however that, in the transition phase, the
higher degree of efficiency expected under Solvency II will to put pressure on
small and medium-sized insurance undertakings, where the most up-to-date risk
management and risk-based capital management practices are not yet as
widespread.
[194] In order to make the new solvency regime operational, it is
necessary for the Commission to adopt a large number of delegated acts foreseen
in the Solvency II Directive, which is expected for later in 2014.
[195] European Commission calculations using the macroeconomic model QUEST
II. More detail about the model is available at http://ec.europa.eu/economy_finance/publications/publication1719_en.pdf.
The QUEST model is also used in annex 6 to estimate the macroeconomic costs of
certain bank reforms.
[196] See ECB (2012). 
[197] Report of the High-level Group of Financial Supervision in the EU,
25 February 2009.
[198] European Parliament Resolution of 11 March 2014 with
recommendations to the Commission on the European System of Financial
Supervision (ESFS) Review.
[199] International Monetary Fund – Financial Sector Assessment Program
at EU level, March 2013.
[200] See Draghi (2014). 
[201] “Stressed countries” refer to Cyprus, Greece, Ireland, Italy,
Portugal, Slovenia and Spain.
[202] See http://europa.eu/rapid/press-release_SPEECH-12-494_en.htm?locale=en.
The Commission set out its vision of a gradually unfolding Banking Union in its
Communication of 12 September 2012 (COM(2012) 510 final). The Blueprint for a
deep and genuine economic and monetary union of 28 November presents a comprehensive vision for a deep and genuine EMU (COM(2012) 777
final). . 
[203] See in particular the Euro Area statement of 29 June 2012 and the
European Council conclusions from 29 June as well as the European Council
conclusions from March and June 2013. 
[204] See in particular the resolution of the EP on the Banking Union
(European Parliament resolution of 13 September 2012 Towards a Banking Union
(2012/2729(RSP)). 
[205] See Véron (2013). 
[206] See Schoenmaker (2011).
[207] See Draghi (2014).
[208] European Commission (2011): Single Market Act – twelve levers to
boost growth and strengthen confidence. Communication from the Commission; 13
April 2011. http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2011:0206:FIN:EN:PDF
[209] European Commission (2012): Single Market Act II – Together for
newgrowth. Communication from the Commission. 3.10.2012.
http://ec.europa.eu/internal_market/smact/docs/single-market-act2_en.pdf
[210] Regulation (EU) No 345/2013 of the European Parliament and of the
Council of 17 April 2013 on European venture capital funds.
[211] Regulation (EU) No 346/2013 of the European Parliament and of the
Council of 17 April 2013 on European social entrepreneurship funds.
[212] COM (2013) 462.
[213] COM(2013) 45 final.
[214] Capital Markets CRC Limited, Enumerating the cost of insider
trading, unpublished, 2010, p. 8.
These estimates are extracted from section 6.8 and annex 12 of the impact
assessment on the MAR/CSMAD proposals: http://ec.europa.eu/internal_market/securities/docs/abuse/SEC_2011_1217_en.pdf
[215] Example on the effect of insider dealing on capital markets from
FMA: http://www.fma.gv.at/en/companies/stock-exchange-securities-trading/special-topics/insider-dealing-effects-on-the-capital-market.html
[216] Charges against individual traders have been brought up in the UK
and the Netherlands among other jurisdictions: http://www.bbc.com/news/business-18671255,
http://www.ft.com/intl/cms/s/0/8d1e0978-7c94-11e3-b514-00144feabdc0.html#axzz2uFNHGmoX
[217] There is an ongoing investigation by the European Commission
services into a possible cartel in relation to the alleged submission of
distorted prices by contributors to some of Platts oil and biofuels products
published prices in order to manipulate those. See
http://europa.eu/rapid/press-release_MEMO-13-435_en.htm
[218] See http://www.bloomberg.com/news/2014-02-28/gold-fix-study-shows-signs-of-decade-of-bank-manipulation.html
[219] COM (2011) 651 and COM(2011) 654. 
[220] COM(2012) 421 and COM(2012) 420. 
[221] COM/2013/0641. 
[222] IOSCO Principles for Financial Benchmarks: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf
[223] “On 27 June 2012, the FCA fined Barclays Bank plc £59.5 million for
misconduct relating to LIBOR and EURIBOR. On 19 December 2012, the Financial
Services Authority (FSA), the FCA’s predecessor, fined UBS AG £160 million for
significant failings in relation to LIBOR and EURIBOR, and on 6 February 2013,
the FSA fined The Royal Bank of Scotland plc £87.5 million for misconduct
relating to LIBOR. On September 2013, the FCA fined ICAP Europe Limited £14
million and on October 2013 it fined Rabobank with £105 million”:
http://www.fca.org.uk/news/the-fca-fines-rabobank-105-million-for-serious-libor-related-misconduct

“The CFTC has now charged five global financial
institutions for LIBOR manipulative schemes, with nearly USD 1.8 billion in
penalties imposed by the Commission alone”:
http://www.cftc.gov/PressRoom/PressReleases/pr6752-13
[224] EC press releases:
http://europa.eu/rapid/press-release_SPEECH-13-834_en.htm and
http://europa.eu/rapid/press-release_IP-13-1208_en.htm 
See also:
http://www.ft.com/intl/cms/s/0/8a6a4b02-463d-11e3-9487-00144feabdc0.html#axzz2khc8HgXB
[225] Approximately USD 350 trillion of notional swaps and USD 10
trillion of loans are indexed to LIBOR. Measured by the notional value of open
interest, the CME Eurodollar contract is the most liquid and largest notional
futures contract traded on the CME and in the world. Euribor is used
internationally in derivatives contracts, including interest rate swaps and
futures contracts. According to the Bank for International Settlements, OTC
interest rate derivatives, such as swaps and forward rate agreements
("FRAs"), comprised contracts worth over USD 187 trillion in notional
value at the end of 2012: http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfrabobank102913.pdf

[226] See, for example, http://www.ft.com/intl/cms/s/0/eed0cf58-486d-11e3-8237-00144feabdc0.html#axzz2khc8HgXB

[227] http://www.esma.europa.eu/system/files/eba_bs_2013_002_annex_1.pdf
[228] Wheatley Review of Libor: http://www.fsa.gov.uk/doing/events/wheatley-review-libor
[229] FX benchmark group by the FSB:  https://www.financialstabilityboard.org/press/pr_140213.htm
[230] Please see press report on: http://ftalphaville.ft.com/2013/06/12/1533132/trading-market-making-speculation-or-manipulation-who-knows-anymore/
[231]  There is an ongoing investigation by the European Commission
services into a possible cartel in relation to the alleged submission of
distorted prices by contributors to some of Platts oil and biofuels products
published prices in order to manipulate those. See http://europa.eu/rapid/press-release_MEMO-13-435_en.htm
[232] See http://www.bloomberg.com/news/2014-02-28/gold-fix-study-shows-signs-of-decade-of-bank-manipulation.html

[233] See FT  press report at http://www.ft.com/intl/cms/s/0/081b5a80-a90a-11e3-9b71-00144feab7de.html?siteedition=intl#axzz2wEL0IZMr
[234] See Melecky and Rutledge (2011).
[235] http://www.bristol.ac.uk/geography/research/pfrc/news/pfrc1301.pdf

[236] SWD(2012) 187
[237] See Annex to the Joint Committee of the European Supervisory
Authorities (2013), "Joint Position of the European Supervisory
Authorities on Manufacturers’ Product Oversight & Governance
Processes", 28 November 2013.
[238] See also KPMG (2014).
[239] http://www.fca.org.uk/consumers/financial-services-products/insurance/payment-protection-insurance/ppi-compensation-refunds

[240] http://www.fsa.gov.uk/pubs/discussion/dp09_03.pdf

[241] http://www.bloomberg.com/news/2012-07-11/spanish-bank-bailout-means-forcing-losses-on-cooks-  
pensioners.html 
[242] Macro-prudential Commentaries, Lending in foreign currencies as a
systemic risk. Piotr J. Szpunar and Adam Głogowski, ESRB, December 2012.
[243] Germany’s public TV channel ZDF, ZDF ‘Zoom’, 30.1.2013:.
http://www.zdf.de/ZDFzoom/Beraten-und-Verkauft-26321688.html
[244] http://www.vzhh.de/versicherungen/151189/Oehler_Studie_Paper.pdf

[245] These and other cases are listed in Annex to the Joint Position of
the European Supervisory Authorities on Manufacturers’ Product Oversight &
Governance Processes, 28 November 2013.
[246] The following only includes the legislative measures adopted or
proposed as at end 2013 and does not capture the more recent developments in
the area of private pensions: on 27 March 2014, the Commission adopted a
proposal to revise the existing 2003 Directive on Occupational Pension Funds
(also known as Institutions for Occupational Retirement Provision or IORPs). 
The Commission conducted also in 2013 preparatory work for a possible
legislative initiative on personal pensions.
[247] Communication "On the application of the Unfair Commercial
Practices Directive – Achieving a high level of consumer protection – Building
trust in the Internal market' of 14 March 2013 (COM(2013) 138 final),
accompanied by a Report (COM(2013) 139 final).
[248] Directive 2014/17/EU of the European Parliament and of the Council
of 4 February 2014 on credit agreements for consumers relating to residential
immovable property and amending Directives 2008/48/EC and 2013/36/EU and
Regulation (EU) No 1093/2010. 
[249] For details, see impact assessment, SEC(2011) 356.
[250] The impact assessment also showed that ineffective, inconsistent or
non-existent admission and supervision regimes for credit intermediaries and
non-credit institutions providing mortgage credits had the potential to create
an uncompetitive environment and limited cross-border activity. This results in
a situation where consumers are therefore likely not to always obtain the
best/cheapest credit agreement offers.
[251] Directive 94/19/EC of the European Parliament and of the Council of
30 May 1994 on deposit-guarantee schemes.
[252] COM/2010/0368. 
[253] For details, see impact assessment, SEC(2010) 834.
[254] Directive 97/9/EC of the European Parliament and of the Council of
3 March 1997 on investor-compensation schemes.
[255] See impact assessment, SEC(2010) 845.
[256] COM(2010) 371. 
[257] The current MiFID was tranposed in November 2007 and provides
harmonised regulation for investment services in the EU Its main objectives are
increase competition and consumer protection in investment services: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32004L0039:EN:NOT
[258] See the impact assessment, SEC(2011) 1226
final. 
[259] Synovate (2011), "Final Report, prepared for: European Commission,
Directorate-General Health and Consumer Protection", recently assessed the
quality of advice across the EU based on a mystery shopping exercise.
Weaknesses emerged in the ability of advisors across the EU to recommend
suitable products to investors. Another study by Decision Technology Ltd, N
Chater, S Huck, R Inderst (2010), "Consumer Decision-Making in Retail
Investment Services: A Behavioural Economics Perspective", Final Report,
November, sought behavioural economics insights on different factors relevant
to investor decision making.
[260] Responses to Questions 15-18 and 20-25 of the European Commission
Request for Additional Information in Relation to the Review of MiFID,
CESR/10-860, 29 July 2010, p 6
[261] COM(2011) 656 and COM(2011) 652. 
[262] Directive 2002/92/EC of the European Parliament and of the Council
of 9 December 2002 on insurance mediation.
[263] COM(2012) 360. 
[264] See impact assessment, SWD (2012) 192 final.
[265] For example, the relevant parts in the MiFID II proposal, which lay
down conduct of business and conflict of interest rules for financial
instruments, served as a benchmark in drafting the relevant parts in the IMD II
proposal.  The aim is to limit regulatory arbitrage by having consistent
selling rules regardless of whether they are sold by an insurance intermediary,
an insurance company, or an investment firm.
[266] COM(2012) 352.
[267] Less burdensome information, registration and organisational
requirements would however apply. 
[268] Article 98a
[269] Directive 2013/11/EU of the European Parliament and of the Council
of 21 May 2013 on alternative dispute resolution for consumer disputes and
amending Regulation (EC) No 2006/2004 and Directive 2009/22/EC (Directive on
consumer ADR).
[270] http://ec.europa.eu/internal_market/finservices-retail/docs/investment_products/20120703-proposal_en.pdf

[271] See impact assessment, SWD(2012) 187.
[272] COM(2012) 350. 
[273] See impact assessment, SWD(2012) 185
[274] A ‘feeder fund’ is essentially a vehicle that collects investors’
money and then provides these monies to another financial service provider,
usually a broker or another fund, so that the latter can design and execute an
investment strategy.
[275] COM/2013/0547. 
[276] See impact assessment, SWD (2013) 288 final. 
[277] COM/2013/0550. 
[278] The possibility for merchants to surcharge for the use of payment
cards (and other means of payment) will be limited already by Article 19 of the
Consumer Rights Directive (2011/83/EU), which must be transposed and made
applicable in national laws by 13 June 2014.
[279] COM/2013/0266. 
[280] See impact assessment, SEC 2013/250.
[281] Payment service providers will be able to refuse to open an
account, however only if the consumer already has an account in the Member
State concerned or fails to comply with the Anti-Money-Laundering due diligence
test. Moreover, the directive allows Member States to define specific cases at
national level which may justify the refusal of a basic account. These include,
for example, abuses of the right to access basic accounts by the consumer.
Also, Member States may require that consumers show a genuine interest to open
a basic account, provided that such condition does not prejudice the exercise
of the consumers' fundamental freedoms guaranteed by the Treaty.
[282] With the consumer’s consent, the remaining positive balance will be
transferred to the new account and the previous account will be automatically
closed. Any closing fees must comply with the Payments Service Directive
(EC/2007/64), but the consumer may however also decide to preserve his or her previous
account.
[283] Even before this crisis, CRAs were already coming under close
scrutiny, and public authorities were aware of the pivotal role played by CRAs
in the financial system. For example, CRAs had been criticised for their
slowness to respond to the strains that ultimately gave rise to the Asian
crisis in 1997/8, and the high-profile failures of Enron, WorldCom and
Parmalat.
[284] By December 2008, structured finance securities accounted for over USD
11 trillion. The lion’s share of these securities was highly rated by rating
agencies. More than half of the structured finance securities rated by Moody’s
carried a AAA rating—the highest possible credit rating. In 2007 and 2008, the
creditworthiness of structured finance securities deteriorated dramatically; 36
346 tranches rated by Moody’s were downgraded. Nearly one-third of downgraded
tranches bore the highest "AAA" rating. See Benmelech and Dlugosz
(2010). 
[285] For example, Adelino (2009) shows that in the case of
mortgage-backed securities, investors only considered information published by
the ratings agencies for AAA-rated tranches (for lower-rated tranches,
proprietary information was also taken into account).
[286] The first EU Regulation on Credit Rating Agencies (Regulation (EC)
No 1060/2009 on credit rating agencies) was adopted in 2009 and entered into
force in December 2010. The Regulation was amended in May 2011 to adapt it to
the creation of the European Securities and Markets Authority (ESMA) which has
been attributed all supervisory powers over CRAs since July 2011 (Regulation
(EU) No 513/2011, amending Regulation (EC) No 1060/2009 on credit rating
agencies). Finally, in 2013, a
third regulation on CRAs was adopted to reinforce the regulatory framework and
deal with remaining weaknesses (Regulation (EU) No 462/2013, amending
Regulation (EC) No 1060/2009 on credit rating agencies). The discussion in this
study focuses on the three Regulations as a whole, without distinction.
[287] Deficiencies in the sovereign rating process are reported in ESMA
(2013).
[288] See Financial Stability Board (2010), 
[289] These principles were introduced in sectoral legislation in the
banking, insurance and the asset management sector. Additionally, national
authorities are encouraged to monitor the use of contractual references to
credit ratings by financial institutions and the ESAs have been requested to
review their guidelines and technical standards to ensure compliance with the
FSB principles. In addition, the Commission will continue reviewing the use of
references to external credit ratings in EU law that trigger or have the
potential to trigger sole or mechanistic reliance. The Commission will report
by end of 2015.
[290] See ESMA (2013)
[291] The greater level of concentration in these rating classes can be
explained by a number of factors, such as the need for appropriate governance
and specialist skills, including dedicated processes and methodologies, legacy
and/or long-standing relationships, including access to proprietary
information. See ESMA (2014). 
[292] Measures described relate mainly to accounting developments in
response to the crisis. Separately, at EU level, there has been a review of the
Accounting Directives which apply to limited liability companies in Europe that
are not in the scope of IFRS. The new Directive simplifies the preparation of
financial statements for small companies, thereby reducing their administrative
burden. The Commission also adopted a proposal on EU companies' transparency
and performance on environmental and social matters.
[293] Commission
Regulation (EU) No 1254/2012 of 11 December 2012 amending Regulation (EC) No
1126/2008 adopting certain international accounting standards in accordance
with Regulation (EC) No 1606/2002 of the European Parliament and of the Council
as regards International Financial Reporting Standard 10, International
Financial Reporting Standard 11, International Financial Reporting Standard 12,
International Accounting Standard 27 (2011), and International Accounting
Standard 28 (2011).
[294]
Commission Regulation (EU) No 1205/2011 of 22 November 2011 amending Regulation
(EC) No 1126/2008 adopting certain international accounting standards in
accordance with Regulation (EC) No 1606/2002 of the European Parliament and of
the Council as regards International Financial Reporting Standard 7.
[295]
The existing standard mainly refers to national accounting principles and
rules.
[296] The reform comprises two legal instruments a Directive (amending
the existing audit directive) with rules applicable to the whole audit market
and a regulation with stricter rules applicable only to PIEs (Public Interest
Entities - financial institutions, insurance companies and listed companies).
[297] The reforms also enhance non-financial
transparency of the certain large financial companies and groups will be
significantly enhanced as well following the Commission's proposal of April
2013 to amend the existing accounting directive to improve companies'
transparency on social, environmental and diversity matters. Large
public-interest entities with more than 500 employees will be required to
disclose in their management reports information on policies, risks and
outcomes as regards environmental matters, social and employee-related aspects,
respect for human rights, anti-corruption and bribery issues, and diversity on
boards of directors. This includes listed companies as well as some unlisted
companies, such as banks, insurance companies, and other companies that are so
designated by Member States because of their activities, size or number of
employees. 
[298] T2S will offer synergies with the CSD Regulation and eventual
harmonisation of securities law in the EU. T2S is also expected to spur
competition amongst CSDs, which should promote better service quality, more
efficient pricing and innovation to the benefit of all market participants. As
a matter of fact, it is expected that EMIR and T2S, in combination with other
EU regulation in the area of settlement, would deliver similar benefits in the
area of clearing and settlement to the ones MiFID delivered for the trading landscape.
If T2S proves to be efficient, it should offer significant economies of scale.
It is then likely that most securities traded in Europe would be settled in
T2S.
[299] For details, see impact assessment, SWD(2012) 22 final.
[300]   http://ec.europa.eu/internal_market/financial-markets/docs/clearing/draft/draft_en.pdf

[301] These numbers give an indication of orders
of magnitude but are probably overstated due to the fact that the gap between
CSD cross-border and domestic costs has already started to decrease since 2006.
[302] The costs borne by investors to the CSDs
are relatively modest.   For example, the costs incurred by an investment fund in relation to CSD services amounts to about 1.5 % of
its total costs of custody and transaction, excluding costs linked to the
management of the fund.  The rest is allocated as follows: the CCPs (1%), banks
in securities depositories (22 %), trading venues (4.5 %) and market intermediaries
(71 %).  See Oxera (2011).
[303] The possibility for issuers to issue directly in a CSD in another
Member State and provisions strengthening
the links between CSDs is expected to reduce the
chain of custody.
[304] By imposing additional requirements on the larger TBTF firms, the
reforms improve the relative position of small and medium-sized firms in the
market or new entrants. An example is the capital surcharge for systemically
important banks or the structural reform proposals that restrict certain
trading activities in these banks. As a result of these measures, smaller
competitors or new entrants not subject to the requirements may gain market
share. Of course, should the activities of these banks also become too
important and risky, they would in turn be submitted to the stricter rules, as
would be the case for the TBTF banks.
[305] The level-playing field argument also applies across Member States.
Banks in Member States that are in a better position to stand behind their
domestic banks are likely to benefit from a larger implicit subsidy than banks
in weaker Member States. Thus, weak banks in a strong Member State may not be
sufficiently disciplined by the market place and are at a competitive
disadvantage compared to banks that are potentially stronger but based in a
weaker Member State. In addition to the measures aimed at reducing the TBTF
problem, the Banking Union will help break the link between domestic banks and
sovereigns and thereby contribute to improved cross-border competition within the
euro area.
[306] During the past years new actors have emerged in the area of
internet payments offering consumers the possibility to pay instantly for their
internet bookings or online shopping without the need for a credit card (around
60 % of the EU population does not possess a credit card), establishing a
payment link between the payer and the online merchant via the payer’s online
banking module. These innovative and often less costly payment solutions are
already offered in a number of Member States (e.g. Sofort in Germany, IDeal in
the Netherlands, Trustly in Scandinavia). However, these new providers are not
yet regulated at the EU level. The new rules will cover these new “third party
payment providers” (TPPs”) and the “payment initiation services” they offer,
addressing issues which may arise with respect to confidentiality, liability or
security of such transactions.
[307] In all cases where the card charges imposed on merchants will be
capped, in accordance with the complimentary multilateral interchange fees
(MIF) Regulation, merchants will no longer be allowed to surcharge consumers
for using their payment card (see section 4.7.2).
[308] See Article 5 TEU.
[309]  Structural Business Statistics (Eurostat) 
[310]            See
http://ec.europa.eu/enterprise/policies/finance/files/com-2011-870_en.pdf.
[311] COM(2014) 168 final 
[312] COM(2013) 150 final
[313] COM(2014) 172 final
TABLE OF CONTENTS
TABLE OF
CONTENTS. 2
Chapter 5: The
complementarity of reforms. 3
5.1
Complementarities in achieving a given objective. 3
5.2
Complementarities between objectives. 9
5.3 Complementarities
between sectors. 11
5.4
Cross-sectoral synergies between reforms. 12
5.5
Complementarities Through Improved supervision and enforcement and better
governance  13
Chapter 6: The
Potential Costs of the reforms. 16
6.1 Costs to
financial intermediaries versus wider societal costs. 16
6.2 Transition
to a more stable, responsible and efficient financial system.. 19
6.3 Assessing
costs to financial intermediaries. 20
6.4 Impact on
bank lending.. 26
6.4.1 Bank deleveraging and reduced credit supply. 27
6.4.2 The impact of higher capital requirements on
credit supply. 32
6.4.3 The impact of liquidity requirements. 37
6.4.4 The impact of bail-in provisions and depositor
preference. 40
6.4.5 The interaction effects between different rules. 44
6.4.6 Summary of quantitative estimates of the impact
on bank lending. 47
6.5 Impact on
other sources of financing.. 50
6.5.1 The impact of Solvency II on insurers'
investment and asset allocation decisions. 51
6.5.2 The impact of regulations on market liquidity. 53
6.6 Impact on
risk transfer and risk management. 62
6.6.1 Impact on insurance provision. 62
6.6.2 Impact on hedging risks with derivatives. 63
Chapter 7:
Addressing new risks and potential unintended consequences of the Reforms. 65
7.1 Regulatory
arbitrage and shift of activities to less regulated sectors. 65
7.2
Concentration of risks in central counterparties. 68
7.3 Potential
risks in collateral markets. 70
7.4 Asset
encumbrance. 76
7.5 Disorderly
bank deleveraging.. 78
7.6 Developments
in securitisation markets. 80
7.7 Impact on
competition. 83
7.8 Impact on EU
competitiveness. 86
7.9 Consistency
of rules within the EU and Globally. 88
7.10 Potential
Tensions between banking union and the single market. 91
7.11 Complexity
of regulation. 92
7.12 Potential
conflicts and inconsistencies in the regulatory framework.. 94
Chapter 5: The
complementarity of reforms
This chapter builds on chapter 4 to further
highlight the overall coherence of the financial reform agenda and to summarise
how different reform measures complement each other and work together to meet
the overall aim of building a well-functioning financial system that is conducive
to sustainable economic growth. 
Many of the reform measures contribute to
delivering on more than one key objective of the reform, and the objectives
themselves interact to achieve a well-functioning financial system. What
follows should not be interpreted as a fully exhaustive list. Rather, the
chapter aims to illustrate why the different reform measures are overall
coherent and complementary in achieving the reform objectives and also to
highlight some aspects that were not covered in the analysis in chapter 4. 
5.1 Complementarities in achieving a given objective
No single reform measure would have been
capable of tackling the different underlying failures revealed by the financial
crisis and achieving the wider reform objectives. Different rules are required
to meet different objectives, and even the rules that aim at the same objective
are necessary to the extent that they address different underlying problems in
the market and/or reinforce each other in achieving the desired objective. The
EU, in close cooperation with its international partners in the G20, therefore
opted for a comprehensive set of measures to address the different failures. 
In the banking sector, a large number of
measures were needed to be taken to increase the stability and resilience of EU
banks. Some may argue that higher capital requirements for banks are an
all-encompassing solution to most financial stability considerations. However,
given the number and severity of failures observed in the financial crisis, it
is difficult to see how capital could be such a powerful tool.  While capital
can be used ex post to absorb losses of a bank when failure occurs, it does not
tackle the different underlying incentive problems that can give rise to
failure ex ante. Higher capital requirements enhance the resilience of
individual banks, but are not sufficient to enhance the stability in the market
as a whole. Moreover, given the size and leverage of bank balance sheets, the
levels of additional capital that would need to be raised to address the
different underlying problems could be so high that they would have disruptive
effects on the ability of banks to support real economic activity, at least in
the transition phase (see also chapter 6). In general, even if capital charges
were capable of achieving the desired effects, the required capital levels
would need to be set so high that the negative consequences would most likely
outweigh the stability benefits. Thus, complementing capital requirements with
further measures helps achieve the stability objectives while limiting
disruptive effects. That is, the combination of different measures allows
achieving the stability objective not only more effectively but also at lower
cost.   
Structural reform as a complement to
other bank sector reforms
Bank structural reform provides a good
example of how reform measures can complement each other in achieving a given
objective (in this case, greater stability and resilience of banks). As
discussed in section 4.2.6, various bank sector reforms are needed to address
the problem of too-big-to-fail banks. Higher capital requirements (Basel III,
as implemented in the CRD IV package in the EU) and the availability of bank recovery
and resolution tools (under BRRD) are necessary to reduce this problem. However,
they are not sufficient in particular for the large European banking groups
which are universal banks and typically combine retail/commercial banking
activities and wholesale/investment banking activities in one corporate entity,
or in a combination of interconnected entities. Thus, to complement existing
reforms, structural measures have been proposed by the European Commission in
January 2014 to reduce the probability and impact of failure of TBTF banks. 
Structural bank reforms, which seek to
require separation of significant high-risk trading activities from other
activities within the banking group, can complement the reforms related to
capital requirements as follows:
·        
Addressing TBTF problems by higher capital
requirements only would not address the fundamental inconsistency of, on the
one hand, "taxing" systemic risk and trading activities with capital
requirements while at the same time allowing these activities to be performed
by entities that enjoy explicit and implicit subsidies through coverage of
their activities by public safety nets. Structural bank reform addresses the
inconsistency and can eliminate undue implicit subsidies of activities that
contribute to systemic risk and excessive trading, in full alignment with the
prudential capital requirement framework; 

 Irrespective of the changes to the
     capital requirements that increase the amount of capital required for
     market risk, banks could still have significant incentives for engaging in
     trading activities given the particularly substantial profits of such
     activities.[1]
     This has induced a broad-based shift towards these activities, at the
     expense of traditional activities, with an increase in systemic risk being
     the consequence. As shown in section 4.2.1, the ratio of risk weighted
     assets to total assets is significantly lower for TBTF banks, which
     typically have an important trading book, than for other banks.[2] In addition, the capital requirements for market risk that are
     based on value-at risk ("VaR") model calculations can still be
     small compared to the size of trading assets.[3] Standard setters at both international and European level are
     currently critically assessing the consistency and accuracy of the
     risk-weighted asset approach;[4] 
 Whereas a (non-risk weighted) leverage
     ratio helps addressing TBTF risks, it is a blunt tool that helps as a
     backstop against RWA manipulation, but does not adequately tackle
     risk-taking incentives. It would have to be set at a high level to fully
     off-set the remaining incentives in favour of trading. Given the current
     size of the banks under consideration, ensuring that sufficient capital is
     funding the activities may pose difficulties. Structural reform
     complements capital adequacy regulation and may avoid such difficulties;  
 The prudential framework for banks is
     complex. This complexity also stems from the increased variety and
     complexity of bank activities that have been regulated via complex capital
     standards (Hoenig and Morris (2011)). These complex standards are
     difficult to monitor and understand for banks, supervisors, and the
     market. Structural reform may help to simplify supervision and enforcement
     of capital requirement regulation;
 Capital requirements do not address
     potential conflicts of interest between banks and their customers and
     misalignments between a commercial banking and an investment banking
     culture within a single “unstructured” banking group;
 Structural reform facilitates market
     monitoring, as envisaged in Pillar 3 of the capital adequacy framework, by
     providing more transparent group structures that match the main business
     lines, and by providing more disclosure of the data of the segregated
     business entities. This also allows a more effective and transparent
     tailoring of capital requirements to the different legal entities. A
     structural separation would entail different entities holding separate
     capital and liquidity buffers, aligning the prudential requirements more closely
     with the risk. This promotes market discipline.

Structural bank reforms can also complement
the reforms related to bank recovery and resolution in a number of ways:[5]

 Structural bank reform is an ex-ante tool
     to address a broader set of objectives beyond facilitating the orderly
     recovery and resolution of a banking group. Structural reform also aims at
     reducing the complexity, interconnectedness, cultural problems and
     conflicts of interest between the different banking entities within a
     given group, and aims at reducing the excessive growth of bank balance
     sheets by constraining the coverage of the public safety nets to specific
     activities only;
 As regards impact of failure,
     implementation of the BRRD will pave the way for
     the orderly resolution of average EU banks and thus will significantly
     reduce the impact of failure of such banks on public finances. However, the resolution powers may be challenging to exercise for TBTF
     banks, given their particularly large, complex and integrated balance
     sheets and corporate structures. Structural reform
     will increase the options available to authorities when dealing with
     failing banking groups, because the banking group balance sheet will be
     better structured into more distinct and autonomous building blocks. By
     increasing the resolvability of a bank, it will also increase the
     credibility of bank resolution, leading to improved market discipline and
     bank balance sheet dynamics. Also, structural
     reform could limit the scale of the task on an entity basis and thereby make
     it more feasible to apply the different resolution tools. This could also
     allow a swifter resolution process, as it would be easier to identify
     problems and apply targeted solutions. The resolution planning offers a
     vehicle to address potential impediments to resolution. In the absence of
     a more clearly structured corporate group structure, it might be difficult
     for a resolution authority to exercise its discretionary judgment and
     impose, for example, a divestment of a part of a large and complex diversified
     banking group. All this may explain market perceptions of remaining
     implicit subsidies and calls for further clarity as regards structural
     measures;[6]
 Structural reform can potentially curtail
     contagion by clearly mapping and controlling intra-financial sector
     exposures. If left uncontrolled, bail-in may give rise to undue contagion
     (as bail-in related losses may create losses and distress at other linked
     financial institutions), although the BRRD provides for tools to avoid
     widespread contagion when bail-in is applied. Structural reform may
     enhance the effectiveness of the bail-in tool to the extent that it
     further curtails contagion.

Other complementarities in achieving a
given objective 
Examples of complementarities in the rules
also exist in relation to other objectives. For instance, as regards consumer
protection, the reforms are based on a cross-sectoral approach to ensure that
consumers can access financial markets on fair grounds and benefit from the
required protection irrespective of whether they consume banking, insurance or
investment products and services. Hence, among other consumer protection
legislation, the reforms introduce standards for better information and better
financial advice in relation to all main retail financial products and services
– e.g. mortgage loans (MCD), bank deposits (DGS), payment accounts (payment
accounts package), investment services and funds (MiFID II, PRIIPs and UCITS)
and insurance products (IMD II). 
As regards efficiency in financial
services, the access provisions contained in MiFID II, EMIR and the CSDR reduce
existing barriers to access to trading venues, CCPs and CSDs, respectively, and
thereby enhance competition along the whole securities trading chain. Combined
with the other efficiency enhancing measures (see also section 4.8), the three
pieces of legislation together seek to improve the structure and transparency
along the trading chain and jointly contribute to further reducing the barriers
and costs to trading and post-trading in Europe. 
Without going into the detail presented in
chapter 4, Table 5.1.1 provides an overview of the main reform measures and how
they complement each other in reaching the relevant reform objectives. 
Table 5.1.1:  Complementarities
in achieving the objectives
 Primary objective || And how it is reached 
 A stable financial system ||   
 Avert bank runs || CRD IV package (increased loss absorbency; better liquidity management; improved internal governance) DGS (strengthening the safety net for depositors in case of bank failures) BRRD (orderly resolution, depositor preference) 
 Prevent the build-up of systemic (macro-prudential) risks || Establishment of the ESRB Macro-prudential elements in CRD IV package (e.g. systemic risk buffer) EMIR (central clearing; conservative margin requirements and haircut policies; prudential requirements for CCPs) increased disclosure requirements (e.g. MiFID II, SSR, CRD  IV package, AIFMD) 
 Reduce pro-cyclicality || ESRB Macro-prudential elements in CRD IV package (e.g. countercyclical capital buffer) CRA regulations (reduced mechanistic reliance of investors on external ratings ) EMIR (stable margin requirements and haircut policies through the cycle) 
 Reduce interconnectedness || Banking sector: Structural reform proposal; CRD IV package; BRRD (ensures resolvability of banks) Securities markets: EMIR (mitigation of counterparty risk); MiFID (circuit breakers); SSR (restrict short selling in extraordinary circumstances, ban on uncovered short sales) Asset management: AIFMD (regulation and supervision of previously unregulated actors); MMF Regulation Business environment: CRA regulations (improved quality of ratings); audit reform (ensure high-quality audit reports) 
 Prevent regulatory arbitrage and close regulatory loopholes || Globally consistent rules for main reforms (e.g. EMIR, CRD IV package, BRRD, MiFID II) Regulation of previously unregulated sectors (e.g. AIFMD, shadow banking)   Overall increased transparency vis-à-vis supervisors and market participants 
 Ensure resolvability || BRRD, SRM for Euro area+ and those joining voluntarily Bank structural reform Forthcoming: proposal for resolution of non-banks, in particular CCPs 
 Address too-big-to-fail || Banking sector: CRD IV package; BRRD; SRM; Structural reform EMIR (by shifting risks from the banking sector to CCPs) Forthcoming: proposal for resolution of non-banks, in particular CCPs 
 Align incentives || Cross-sectoral policy elements (e.g. sanctions, securitisation, governance incl. remuneration) Central clearing of derivatives transactions; trading on organised, transparent venues (EMIR, CRD IV package, MiFID II) Requirements for investments in securitisation positions (CRD, AIFMD, Solvency II) Internal governance and remuneration (CRD IV package, MiFID II, UCITS, AIFMD, benchmarks) Sanctioning regimes (e.g. CRD IV package, MIFID II, AIFMD, UCITS) Reduce conflicts of interests: CRA regulations; audit reform; MiFID II (trading platforms; investment advice) Forthcoming: review of the Shareholders Right Directive 
 Stable and resilient financial market infrastructures || MiFID II EMIR CSDR 
 A stable shadow banking sector || CRD IV package; Solvency II AIFMD MMF regulation Transparency of securities financing transactions 
 A stable and resilient insurance sector || Solvency II; Omnibus Establishment of EIOPA 
 Financial integration ||   
 A reinforced single market  facilitating the financing of the economy || Single rule book EuVECAs, EuSEFs, EuLTIFs 
 Enhanced supervision and enforcement || Strengthening the powers of competent authorities (e.g. CRD IV package; MiFID II) Establishment of the ESFS Ensure appropriate supervision of all actors (e.g. CRA regulations, audit reforms, AIFMD, MMF regulation) Horizontal approach on sanctioning regimes SRM, SSM for Euro area+ Member States and those joining voluntarily 
 Breaking the adverse feedback loop between banks and sovereigns || SRM, SSM for Euro area+ Member States and those joining voluntarily 
 Market Integrity and confidence ||   
 Countering market abuse || MAR/CSMAD Proposal on benchmarks/financial indices 
 Protection of consumers and retail investors || EU-wide creditworthiness assessment and responsible lending standards (MCD) Standards for better information about financial products and services and higher standards for financial advice (MiFID, PRIIPs, IMD II, MCD, UCITS, PAD) Better protection of the assets of consumers (DGS, ICS, rules on asset safekeeping in UCITS and AIFMD) More secure alternative payment methods (PSD II)  Prohibition of surcharges (MIF regulation) Streamlined switching processes and ensuring access to basic payment accounts (PAD) 
 Enhancing the reliability of financial information and credit ratings || CRA regulations Audit reform Accounting reforms 
 Countering money laundering and terrorist financing || AML framework 
 Efficiency ||   
 Reducing the implicit subsidy for TBTF banks || CRD IV package Bank structural reform BRRD, SRM 
 Securing more risk-reflective pricing || CRD IV package Solvency II EMIR 
 Enhancing competition and efficiency || CRAs (facilitating market entry) MiFID II, EMIR, CSDR (opening access to market infrastructures) BRRD (facilitating market exit) 
 Reducing information asymmetries || EMIR MiFID II, PRIIPs, IMD II, DGS, MCD SSR AIFMD Prospectus Directive 
 A financial framework reactive to financial innovation and technological development || ·         ESMA/EBA/EIOPA (powers to temporarily prohibit certain products or practices) MiFID II (safeguards for algorithmic and high frequency trading; OTF); reinforced by MAR Transparency Directive (to cover Contracts for Difference) Payments package 
 Ensuring access to finance || Reducing the administrative burden and reporting requirements for SMEs (e.g. Prospectus Directive, Transparency Directive, Accounting Directive, MAR) Creating a dedicated trading platform to make SME markets more liquid and visible (MiFID II) Addressing SME risk-weighting in the bank capital framework (CRD IV package) Introducing new EU frameworks for investment in venture capital (EuVECAs) and in social entrepreneurship funds (EuSEFs) 
Source: Commission
Services
5.2 Complementarities between objectives
Many of the reform measures contribute to
delivering more than one of the four main objectives of the EU financial
regulation agenda. Moreover, the objectives themselves interact and only in
combination achieve a well-functioning financial system. 
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 is focused on
correcting market failures. As already set out in chapter 4.8, a number of
measures contribute to both financial stability and efficiency: 

 A transparent financial system allows better
     monitoring of transactions and market developments by supervisors as well
     as proper market analysis and monitoring by investors. Enhanced disclosure
     and reporting requirements (e.g. the flagging of short sales, reporting
     obligations to trade repositories, the improved disclosure regime for
     issues in the Prospectus Directive, the increased transparency on
     algorithmic trading activities and trading in commodity derivatives
     markets) will reduce information asymmetries and thereby enhance both the
     stability and efficiency of the financial system (and also contribute to
     its integrity). Stricter disclosure requirements to supervisors (e.g.
     AIFMD, MiFID II, SSR) will facilitate monitoring of exposures and enable
     supervisory authorities to identify and assess emerging risks at an early
     stage. Transparency will also be beneficial for financial institutions and
     will contribute to better internal risk management practices and lead to
     better-informed decisions by investors and consumers. Again, this benefits
     both stability and efficiency in the system by providing better control
     and market discipline in order to avoid excessive risk-taking and instead
     ensure that risk is properly taken into account by all market
     participants.
 The package of reforms aimed at
     correcting the TBTF problem in the banking sector (in particular CRD IV
     package, BRRD and structural reform) contributes to financial stability because
     a reduction in the implicit subsidy for TBTF banks reduces incentives for
     excessive risk-taking. At the same time, the reform package enhances
     efficiency by reducing distortions in competition between banks that
     benefit from an implicit subsidy. It also helps redirect resources to more
     productive uses from a societal point of view as opposed to simply maximising
     bank returns. 
 Similarly, the improved prudential
     framework for banks as well as the new risk-based capital requirements for
     insurers in Solvency II, combined with improved risk management standards,
     will induce financial institutions to internalise the risk of their
     activities. This will not only improve stability (by reducing incentives
     for excessive risk-taking) but also contribute to efficiency (by promoting
     efficient, risk-reflective pricing).

As regards the objective of market
integrity and consumer confidence, this also interacts with and reinforces
financial stability (as well as the efficiency and integration objectives). For
example, the different reform measures to reduce abusive market practices and
better protect consumers and investors will enhance their trust and confidence
in the financial system, which in turn is a pre-condition for the system to
function in a stable (and efficient) manner.     
The market integrity and the efficiency
objectives are similarly and strongly related. For example, the audit reforms
mandate the rotation of auditors. This aims at increasing auditor independence
by tackling the risk of conflicts of interest due to familiarity, thereby
enhancing integrity in the audit market. This also has the positive effect of
bringing more dynamics in the concentrated audit market, which potentially can
open the market to more audit service providers in some segments. Similarly,
the black list of prohibited non-audit services is tackling the potential risk
of conflict of interest, and at the same time it provides market access to
provide those services to other providers than audit firms (in the current
market situation the provision of audit services is often used by audit firms
as an access to the client, allowing afterwards the provision of even more
lucrative non-audit services). Therefore, to the extent that they target the
underlying market failures (namely, conflicts of interest due to asymmetric
information and lack of competition), the reforms are expected to bring about
benefits in terms of both greater integrity and enhanced competition
(efficiency) in the audit market. A similar point can be made in relation to
the new CRA regulations. 
As another example, the various
transparency and disclosure requirements in retail financial services aim to
reduce the informational disadvantages of consumers and thereby put them in a
stronger position vis-à-vis the providers of financial services. This is likely
to not only improve the competitive functioning of the market (i.e. benefiting
efficiency) but also reduces the risk of unfair and abusive market practices
(i.e. benefiting market integrity and consumer protection). 
Finally, financial integration needs to go
hand in hand with the financial stability objective. As the crisis experience
has shown, financial integration needs to be complemented by a strong
regulatory and supervisory framework to avoid that cross-border capital flows
become a source of financial instability (see also chapter 3.3 and chapter 4.6).
The reforms of the institutional framework to strengthen the single market and
the functioning of monetary union (single rulebook, ESFS, Banking Union)
therefore target both financial integration and stability. 
The potential frictions between financial
integration and stability, in the absence of an appropriate regulatory and
supervisory framework, extend to the global level. Given the global nature of
many financial services markets, regulation and supervision cannot stop at
national level. Rather, there is a need for globally consistent rules in
markets that are global in scope. The EU is closely cooperating with its
international partners – both at multilateral level (G20, FSB) and also
bilaterally (e.g. regular financial market regulatory dialogues with major
jurisdictions) to encourage jurisdictions and regulators to defer to each other
– when it is justified by the quality of their respective regimes - in order to
avoid extra-territorial applications and duplications of rules. The financial
reforms also aim at overcoming the existing barriers to entry for third country
(i.e. non-EU) market participants and to ensure a level-playing field by
introducing third-country equivalence regimes in various pieces of legislation
(e.g. MiFID II, EMIR, AIFMD, CRA, benchmark regulation). The system based on
the concept of equivalence has been significantly refined in recent years, and
should be further improved in the future.
While significant progress has been made
toward a global framework (e.g. implementation of Basel III, OTC derivatives),
work is still ongoing in several policy areas (e.g. shadow banking, too big to
fail, resolution) as well as to ensure effective, convergent and consistent implementation
of the agreed reforms. The latter is particularly important to avoid regulatory
arbitrage and overlapping and inefficient cross-border regulatory regimes (see
chapter 7.9). 
5.3 Complementarities between sectors
Most regulatory reforms target a specific
sector and seek to enhance the functioning of that sector by making it more
stable, responsible and efficient.  Different sectors are highly interlinked
and connected: banks and insurers offer their services and provide finance to
each other; banks raise short-term funding from shadow banks; financial markets
and infrastructures facilitate the issuance and trading of financial
instruments by financial institutions; and so on. Thus, reforms that are
targeted at increasing the stability, integrity or efficiency in one sector
will indirectly benefit those sectors that have a claim on or customer
relationship with it. 
A particularly relevant example relates to
how large banking groups are intertwined with shadow banking entities and
activities through their asset and liability side, both on and off balance
sheets. As already noted in chapter 4.4, shadow banks
provide up to 7 % of banks’ total liabilities in the EU, and banks hold up to
10 % of the assets issued by the shadow banking system (ESRB, 2014). Measures to enhance the stability of the shadow banking sector will
therefore also contribute to a more stable banking sector. For large European
banks made losses linked to their MMF activities amounting to hundreds of
millions of euro.[7]
In this respect, the MMF regulation will reduce the contagion links between
MMFs and their sponsors, both by strengthening the liquidity and capital
standards and by introducing rules on external support. 
Similarly, the proposed measures to enhance
the reporting and transparency of securities financing transactions will shed
light and allow better control of a key source of contagion for banks (and
other financial institutions engaged in such transactions) via the shadow
banking sector. 
The banking sector is also closely
connected with the insurance sector, including in the provision of finance to
each other. There is evidence that insurers' understanding of the complexity
and risks of banks reduced their willingness to hold bank equity and debt,
especially since the start of the crisis. In this regard, the reforms that
ensure safer and more transparent banks may enhance the willingness of insurers
to invest in banks.[8]

Financial markets and infrastructures are
critical for many transactions within the financial sector itself (and with the
wider economy). More resilient (and efficient) infrastructures are beneficial
for other financial institutions in their role as traders, investors or issuers
of financial instruments.  
More generally, the financial regulation
agenda seeks to strengthen the overall resilience of the financial system both
by making individual sectors more stable (e.g. capital requirements for banks)
and by reducing risks of contagion between sectors (e.g. transparency
requirements for OTC derivatives and securities financing transactions). Given
the interlinkages in the financial system, strengthening one part of the system
generally also reduces risk in other parts of the system (also because the
reforms seek to avoid that risks are merely shifted from one part of the system
to another). 
These interlinkages are also relevant when
it comes to market integrity and confidence. As seen during the financial
crisis, evaporation of trust quickly spills over from one sector to the next
and can adversely affect the whole financial system.  Reform measures to
enhance confidence and trust in one sector help building confidence in the
financial system as a whole. 
5.4 Cross-sectoral synergies between reforms 
Given the links between sectors, the
financial regulation agenda is based on a cross-sectoral approach that aims at
consistent rules and a common supervisory and enforcement framework across
sectors. Also, some reforms that target specific sectors have been drafted to
create synergies with reforms in other sectors. Reforms with significant
cross-sectoral synergies include the following: 
·        
There are synergies between the CRD IV package
in banking and the EMIR reform of derivatives markets. The former imposes
higher capital and collateral requirements on banks for derivatives that are
not cleared centrally. This will encourage a critical mass of contracts
clearing via CCPs. In turn, this increases the probability that CCP clearing
can effectively mitigate counterparty risk, as intended by EMIR.[9]  
·        
The legislative framework on CRAs ensures better
supervision of CRAs, improves the quality and transparency of credit ratings
and strengthens market discipline. The new CRA regulations are reinforced by
measures to reduce mechanistic reliance on ratings in all EU sectoral legislation
(e.g. AIFMD, CRD IV package, EMIR, UCITS, Solvency II). These measures combined
contribute to reducing pro-cyclicality.
·        
The reforms introduce cross-sectoral
requirements for risk retention, due diligence and monitoring for investments
in securitisation positions. These were introduced in CRD III and consequently
extended in a consistent manner to Solvency II, AIFMD and UCITS. The provisions
contribute to align the interests of originators and investors. The
cross-sectoral approach reduces the scope for circumventing the requirements by
shifting exposures to less regulated sectors. The resilience of the
securitisation market has been further enhanced by the regulation of CRAs when
rating structured finance products and greater transparency for securitisations.
The interactions between reforms and the
resulting synergies are difficult to quantify. However, any such
complementarities imply that the total benefits of the financial reforms taken
together are likely to exceed the sum of the benefits of each individual
reform.
5.5 Complementarities Through Improved supervision and enforcement
and better governance
The effectiveness of the financial reform
agenda critically depends on the effective supervision and enforcement of the
new rules. As discussed in section 4.6, the ESFS, and in particular the three
European supervisory authorities (EBA, ESMA and EIOPA), are instrumental for
ensuring consistent supervision and appropriate coordination among national
supervisory authorities. The new supervisory framework is therefore a critical
complement to all the EU reform measures taken.   
In response to the gaps identified in the
course of the financial crisis, the reforms are ensuring more appropriate
supervision of all market participants (e.g. CRAs; AIFMs, auditors, MMFs),
markets and infrastructures (e.g. CCPs, CSDs, other trading facilities) and
instruments (e.g. OTC derivatives, structured products). The new comprehensive,
internationally coordinated framework closes regulatory gaps and loopholes and
reduces opportunities for regulatory arbitrage.
Also, the supervision of financial
conglomerates has been strengthened through the first revision of the Financial
Conglomerates Directive (FICOD I), which was proposed in August 2010 and
adopted in November 2011. FICOD I amends the sector-specific directives to
enable supervisors to perform consolidated banking supervision and insurance
group supervision at the level of the ultimate parent entity, even where that
entity is a mixed financial holding company.[10]
It is expected to enhance the effectiveness of supplementary supervision and,
among other benefits, reinforce the risk management of financial conglomerates.
In addition, enforcement of rules has been
strengthened by a new approach to sanctioning regimes. Efficient and
sufficiently converged sanctioning regimes are the corollary to the new
supervisory regime. Sanctions provide a deterrent and act as a catalyst to
ensure that EU legislation is complied with. They can help ensure better
enforcement of EU financial services rules. The assessment of the coherence,
equivalence and actual use of sanctioning powers in the Member States by the
Commission in 2009/10 revealed a significant degree of inconsistency and
divergences across Member States. In its Communication "Reinforcing
sanctioning regimes in the financial services sector" of December 2010,
the Commission presented areas for potential improvement.[11] The new horizontal
approach on sanctioning regimes aims to ensure minimum standards at European
level to ensure effective, proportionate and deterrent sanctioning regimes. A
sanctioning regime has been systematically introduced in EU legislative acts
across the whole financial services spectrum (e.g.  CRD, MiFID II, Solvency II,
MAR/CSMAD, UCITS, CSDR) while taking sector-specific issues into account. Key
elements of these minimum standards include: appropriate types of
administrative sanctions, publication of sanctions, a sufficiently high level
of administrative fines, the criteria for applying sanctions, and appropriate
mechanisms supporting the effective application of sanctions. 
Stricter rules, combined with improved
supervision and enforcement, can only go some way in improving market behaviour
and outcomes. The EU financial regulation agenda is therefore complemented with
requirements to improve the internal risk management and governance of
financial institutions. Effective risk management and governance practices
are essential to achieving and maintaining public trust and confidence in the
financial system.[12]
The financial crisis has revealed significant weaknesses in the risk management
and governance of financial institutions, which contributed to excessive
risk-taking, failures and a loss of confidence in the financial system. In
order to address these shortcomings, a horizontal approach has been taken to
improve the corporate governance framework, aiming at ensuring cross-sectoral
consistency and limiting the scope for regulatory arbitrage. To that end,
similar provisions have been introduced in various pieces of legislation (e.g.
CRD IV package, MiFID II, AIFMD, UCITS), covering amongst others remuneration
policies, improved oversight of risks by boards and enhanced authority and
independence of the risk management function. 
The legislative proposal on non-financial
reporting[13]
presented by the Commission in 2013 and approved by the European Parliament in
April 2014 after agreement between the co-legislators, complements these
measures and will improve the quality of corporate governance reports. In
addition, the upcoming review of the shareholder rights directive will further
add to improved corporate governance by strengthening shareholder rights and
long-term engagement (e.g. by improved transparency on remuneration and
granting shareholders the right to vote on remuneration policies and the
remuneration report) and by encouraging proper interaction between companies,
their shareholders and other stakeholders. Taken together, these measures will
significantly strengthen the risk management and governance of financial
institutions across all sectors, thereby complementing the regulatory and
supervisory framework.  
Chapter 6: The Potential
Costs of the reforms
The broad scope and significance of the
regulatory reform agenda raises questions about the costs arising from the
reform initiatives, both as individual initiatives and in their combination.
Given the inherent complexity and special nature of financial institutions and
markets, as well as the fact that many costs are dynamic in nature, no
quantitative model exists that can reliably, precisely and comprehensively
estimate all such costs. 
This chapter reviews the available evidence
and draws from the economic literature to provide insights into some of the
main areas of concern. There are necessarily limitations to what can be covered
in this document. In particular, it is beyond the scope of this study to
consider all costs and impacts arising to specific stakeholders, so the study
takes a wider approach and covers the main themes at a general level. The chapter
shows that while the reforms impose costs, these are often costs to financial
intermediaries (and their shareholders and employees) that arise in the
transition to a more stable financial system and are offset by wider societal
benefits. The reform agenda has been mindful of minimising costs by allowing
longer phasing-in and observation periods and adjusting rules where significant
costs are anticipated.    
6.1
Costs to financial intermediaries versus wider
societal costs 
When analysing the impact of regulation, it
is important to distinguish “private” (i.e. stakeholder-specific) costs from
the wider “societal” costs (i.e. costs for society as a whole).  Whereas
private costs cover the impact on financial intermediaries (and their
shareholders and employees), societal costs are broader in scope and encompass
a more general measure of total or aggregate welfare by incorporating the
impact on all stakeholders in society, including customers (e.g. depositors,
borrowers and consumers of financial services), creditors, and taxpayers (i.e.
the public finances of governments). 
Private costs to financial intermediaries
may in fact not present a cost to the wider economy. Indeed, an increase in
these costs may indicate a sign of the effectiveness of the reforms. For
example, a number of reforms in the banking sector are aimed at reducing the
implicit subsidy that too-big-to-fail banks enjoy given the expectation or
market perception of the possibility of tax-payer bail-out. A reduction in the
implicit subsidy will undoubtedly increase the funding cost of the affected
banks, which is a private cost. But this cost is offset by tax-payer savings
and wider financial stability benefits, as described in section 4.2. 
Similarly, the reforms induce a re-pricing
of risks which again creates costs, but these are matched by the benefits of
avoiding excessive risk-taking due to underpriced risks in the market. For
example, in the pre-crisis securitisation boom, the financial system was
producing CDOs in increasing quantities simply because the private cost did not
fully reflect the associated risks (and related societal cost). The
underpricing of risks contributed towards the build-up of systemic risk which
was not included (i.e. internalised) in the pricing of such CDO products. Had
this been the case, banks would not have produced such large volumes of CDOs.
More generally, the financial system grew and certain activities expanded in a
way that would not have been possible if risks had been properly priced in the
market. A re-pricing of risks, even if it brings costs to certain market
participants, can therefore not be considered a net cost to the economy as a
whole because it is matched by societal benefits. 
It follows that costs should not be
examined in isolation from benefits. A number of studies only focus on the
costs of regulation to the financial services industry and often measure these
costs with respect to pre-crisis market conditions. However, this fails to
appreciate that pre-crisis conditions cannot serve as the relevant benchmark,
as the system was increasingly fragile, overleveraged and about to implode. 
Since regulation serves society as a whole,
regulators necessarily have to focus on wider societal costs and not on the
impact on financial intermediaries (and their shareholders and employees). In
particular, the costs of regulation that really matter are the wider costs that
may arise if the regulations impede the ability of the financial system to
fulfil its key economic functions (financial intermediation, payment services,
risk transformation and insurance, as discussed in chapter 2) and if they detract
from the overall objective of having a stable, responsible and efficient
financial system.
This chapter presents estimates of the costs
to financial intermediaries, but for the above reasons focuses it focuses on
the wider societal impacts of the reforms. It argues that many of the costs
incurred by financial intermediaries do not translate into societal costs and
that, overall, the costs are expected to be outweighed by the benefits of the
reforms. Also, even if financial intermediaries pass on some of the cost
increase to their clients, governments can always avoid this by explicitly,
directly and transparently subsidising certain activities or instruments, instead
of indirectly subsidising excessively leveraged banks or other parts of the
financial system. 
This chapter also seeks to argue against
a number of frequently made claims, which are not always fact-based and
can be countered. Evidence shows that a larger and more profitable financial
sector does not automatically lead to higher long-term growth (see Box 6.1.1). The crisis demonstrated
that credit provision can be excessive and contribute to over-indebtedness and
misallocation of resources. Sustainable economic growth over the long-term
depends on a resilient and stable financial system that is able to fulfil
efficiently its essential economic functions at all times. Substantial part of
the pre-crisis balance sheet expansion was intra-financial sector business and
a reflection of increased complexity, interconnectedness and asset inventories
built up by the universal banks engaged in capital market activity. At the end
of 2013, loans of euro area banks to households and non-financial corporations
(NFCs) made up 31.4 % of their aggregate balance sheet. Large European banks
expanded and leveraged up rapidly in the run-up to the crisis, including by
effectively intermediating between US savers and US borrowers (see Shin
(2012)). Therefore, scaling back of their international transaction-based
banking activities, for example, must not in any way impede their ability to
continue providing finance to the EU economy. Thus, it is not appropriate to
maintain that bank deleveraging can only be achieved at the expense of real
economy lending and reduced economic growth. See section 6.4.1 for a more
detailed discussion.
A related claim is that higher capital and
capital requirements imply less lending. This claim is not justified. On the
contrary, better capitalised banks with stronger balance sheet seem to have
a greater ability to support the economy (see chart 6.4.7). However,
raising capital can indeed be difficult and costly in the transition period to
higher capital levels, especially for banks with a debt overhang and weak
balance sheet. See section 6.4.2 for a more detailed discussion.
Finally, critics often defend the idea that
liquidity generating activities, such as trading, are always beneficial. However,
such activities are only beneficial up to a point. Whilst delivering private
benefits to intermediaries engaged in such activities, it is not proven that
more trading always implies societal benefits. The position-taking and
speculation in some markets can even be harmful and produce destabilising
effects. Much of the pre-crisis liquidity can, in fact, be considered
‘artificial’ and a reflection of rapidly expanding bank balance sheets that
contributed to the boom-bust cycle. As such, the pre-crisis liquidity
conditions in the market are not the relevant benchmark, as they
characterised an over-leveraged system that ultimately collapsed. See section
6.5.2 for a more detailed discussion.
Box 6.1.1: The relationship between financial sector size and
economic growth 
The financial sector
serves the economy by intermediating funds between savers and borrowers,
providing payment services, and allowing effective management of risks. A
resilient and stable financial sector is a pre-condition to fulfil these
essential functions and to allow for sustainable economic growth. There is
substantial empirical evidence on the positive relationship between financial
development and long-term economic growth (e.g. Fisman et al (2007)). Among
other things, financial deepening alleviates financing constraints at the
company level and supports creative destruction (e.g. Brown et al (2009)). 
However, there does not
seem to be a uniformly positive effect on economic growth at all levels of
financial intermediation. Several recent studies actually find that the
positive relationship breaks down, once the financial sector has grown beyond a
threshold in the range of 40-150% of GDP (see OECD (2014), BIS (2014),
Cecchetti et al (2012), Arcand et al (2012)). Furthermore, OECD (2014) finds a
causal link from more financial intermediation to lower GDP growth. BIS (2014)
also identify a threshold of 95 % for the turnover ratio, expressed as the
value of total shares traded to average market capitalisation. 
OECD (2014) lists
several possible channels to explain this negative association. Implicit or
explicit public guarantees or oligopolistic competitive conditions in the
financial sector can create rents, which can divert resources to financial
activities away from the rest of the economy (see also Bolton et al (2012)).
This could lead to inefficiently high lending by banks and borrowing by
households. Excessively high financial-sector earnings could also attract
highly-skilled individuals at the expense of other sectors, even though returns
from their work at the whole economy level may be higher in other occupations. Many bank
employees have strong science or engineering backgrounds. They are perfect
candidates to support manufacturing, information technology or other high-tech
start-ups of the kind that Europe needs (see also Cecchetti and Kharroubi
(2012), Baumol (1990), Murphy, Shleifer and Vishny (1991), Philippon (2013)).
An overly large financial sector may also be conducive to growth-reducing
boom-and-bust cycles. Arcand et al (2012) advance the hypothesis that
excessively large financial systems reduce economic growth because of the
increased probability of a misallocation of resources, the increased
probability of large economic crashes, or the endogenous feeding of speculative
bubbles. Philippon (2008) observes that outstanding economic growth was
achieved in the 1960s with a much smaller financial sector. In addition, more
finance may disproportionately benefit collateral-rich but low-productivity
activities (such as construction), at the expense of high-productivity projects
(especially in sectors with high R&D intensity) where future returns are
uncertain and collateral is scarce. 
These findings are
compatible with empirical evidence showing that banking sector expansion exerts
a positive influence on economic growth at earlier economic development stages.
Whilst OECD (2014) suggests that it is the overall level of financial
development rather than the debt structure that explains these economic
outcomes, particularly in OECD countries, bank lending is associated with
poorer economic performance than other forms of credit (see also BIS (2014)),
with housing-related credit having a particularly strong negative link with
economic growth. Furthermore, Kaserer et al (2014) provide new evidence that
increased capital market size positively impacts economic growth in Europe, especially as regards equity markets. Demirguc-Kunt et al (2013) conclude that
banks provide different services to the economy than those provided by capital
markets. Banks have a comparative advantage in financing standardised,
shorter-term, lower-risk and well-collateralised transactions. As the economy
develops, its sensitivity to the banking sector decreases, whilst its
sensitivity to the capital markets increases. Overall, the study finds that
deviations in the economy’s actual financial structure from its estimated
optimum are associated with a reduction in economic output. 
6.2
Transition to a more stable, responsible and efficient financial system 
The transition to a more stable,
responsible and efficient financial system requires adjustments, which inevitably impose costs: banks need to improve their capital
and liquidity positions and enhance their risk management practices; insurers
need to implement new solvency standards; retail financial intermediaries need
to meet new consumer protection rules; large banking groups need to introduce
more transparency and order in their legal and operational structures; and so
on. These adjustments are intended and the associated costs to financial
intermediaries are inevitable, although efforts have been taken to facilitate
the transition. 
It is important to differentiate potential
short-term transition costs and one-off costs from the expected long-term
effects of the rules. Moreover, costs that stem from current market conditions
and the poor state of the EU economy cannot be used as a valid reason not to
implement rules that would bring about social benefits in the form of a more
stable financial system in the longer-term. As is further discussed below,
the ongoing difficulties in the market and wider economy cannot be attributed
to the regulatory reforms. Instead, they are directly related to the
problems that built up before the crisis and the crisis' consequences (e.g.
evaporation of trust in the market and related liquidity squeezes, weak bank
balance sheets, high private and public debt levels, low interest rates, the
recession and weak growth prospects). 
Moreover, financial intermediaries do not
just face pressure from regulation and current market conditions. The need to
adjust to a number of wider economic, societal and technological changes
may profoundly affect the financial intermediation business model. This
includes, for example, demographic changes (population ageing) that may affect
customer demands, technological developments that are predicted to change the
world of retail financial services (mobile banking, big data, crowd-funding),
or the growth of banks from China or other BRIC countries, which are
increasingly competing in some of the international markets served by European
banks.[14]

In other words, the many changes to come
for financial intermediaries are more far-reaching and comprehensive than what
may follow from the regulatory reforms. It would, therefore, be quite disproportionate
to attribute the main changes and adjustment costs solely to financial reform.
However, this is not always evident from current policy debates. Whilst one
should not downplay the significance of the impact of the reform agenda on the
financial sector, one needs to put it into perspective. Also, where possible, efforts
have been made to minimise costs (for financial intermediaries and the wider
economy), particularly through measures to reduce frictions and costs in the
transition to a more stable, responsible and efficient financial system.

 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 require 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, long-term guarantee package in Solvency II) or exemptions
     have been applied (e.g. pension funds and non-financial corporates in
     EMIR, SME growth markets established in CSDR). 
 Where rules entered uncharted waters, observation
     periods have been applied (e.g. leverage ratio, liquidity ratio). 
 Review clauses have been introduced in all major pieces of legislation (see
     annex 3) to allow adjustments where deemed necessary.

In addition, costs for financial
intermediaries have been further lightened by: 

 Developing a common European approach
     to financial reforms in response to diverging national initiatives, with
     a single rulebook to avoid multiple and overlapping requirements
     especially for cross-border business and unlevel playing field concerns;
     and, for the same reason,
 Striving for international regulatory
     convergence both in terms of high-level commitments and detailed
     implementation (see also section 7.9). 

6.3
Assessing costs to financial intermediaries
The financial regulation agenda has a
significant impact on financial intermediaries. The reforms require adjustments
in the way they conduct business, which triggers both one-off costs to adjust
to the new requirements and recurrent costs of complying with the new standards
on capital, liquidity, risk management, disclosure, and so on. Although some of
these costs seem large in absolute amounts, they should be viewed against the
size of the financial system. Moreover, the level of costs to meet regulatory
requirements appears to be far less than the costs incurred by industry as a
result of fines and redress costs related to market manipulation and other past
wrong-doings (see Box 6.3.1).
Box 6.3.1: Redress costs for past wrong-doings
exceed regulatory compliance costs 
Post-crisis redress costs and associated fines
represent one of the biggest, if not the biggest private cost that the industry
is currently facing. Pre-crisis misconduct has resulted in increasing amounts
of actual and potential redress costs and settlement payments made by financial
intermediaries, substantially affecting balance sheet provisions and
profitability. In October 2013, 40 % of respondents to an EBA bank survey had
already paid out amounts in excess of EUR 100m, whilst 16 % had paid out
amounts in excess of EUR 1 billion[15].  
According to KBW (2013), this has cost the global
investment banks some EUR 33 billion since 2012, and possible civil redress in
the three cases of LIBOR/EURIBOR, foreign exchange market manipulation and the
US Federal Housing Finance Agency (FHFA) could cost them another EUR 73 billion
over the next decade. See section 4.7.1 for a description of some of these
cases. Hence, when looking at the pre-crisis return on equity in the financial
sector, one has to adjust the pre-crisis profit figures by these redress costs
and fines as a minimum, let alone the legacy losses on toxic assets and
non-performing loans[16]. An alternative way would be to deduct
these costs when assessing banks’ current profitability. Table 6.1 below
provides a non-exhaustive[17]  overview of estimates for selected EU
banks. 
Table 6.1: Past fines and estimated future redress
costs at selected EU banks
Note:
Barclays avoided a EUR 690m fine in the LIBOR/EURIBOR case due to a leniency
programme.
Source: KBW (2013),
JPMorgan, Commission Services
The Commission Services' impact assessments
on the individual legislative measures contain an assessment of the cost
implications for financial intermediaries, along with the potential
implications for the EU economy. Without unduly repeating the results, in order
to give an illustration, the following lists estimates of compliance cost
resulting from some of the main legislative measures in the area of financial
markets:

 European Markets Infrastructure
     Regulation (EMIR)[18]

ESMA estimated that
the costs of establishing new trade repositories and of upgrading existing ones
would be in the range of EUR 9m to EUR 15m for one-off investments and EUR 2.2m
to EUR 6m in recurrent costs. These costs include connection costs and fees to
trade repositories, as well as the costs of hiring additional staff to handle
the reporting process. This cost impact is expected to be mitigated
significantly, especially for smaller market participants, through delegation
of the reporting to their counterparties – in most cases, the bigger
institutions with whom they usually enter into OTC derivative contracts. Where
these bigger institutions already voluntarily report their contracts, the
marginal cost of reporting on behalf of their counterparties would be close to
zero.
The costs of CCP
clearing include fees, margin payments and costs linked to the segregation of
clients' accounts. As part of its regulatory technical standards, ESMA estimated
the additional initial margin requirement to be in the range of EUR 6.3 billion
to EUR 8.3 billion, implying one-off costs in the range of EUR 252m to EUR 332m
and recurrent costs in the range of EUR 441m to EUR 582m. At the same time, the
expected cost of the additional collateral will depend on the final market
structure of the CCP clearing industry and the magnitude of netting effects.
Finally, the more rigorous bilateral clearing requirements could also lead to
increased costs for market participants due to collateral funding.

 Markets in Financial Instruments
     Directive review (MiFID II)[19]

The Commission
estimated that the MiFID review would impose one-off compliance costs of
between EUR 512m and EUR 732m, as well as recurrent costs iof between EUR 312m and
EUR 586m, representing 0.10 % to 0.15 % and 0.06 % to 0.12 % of the total
operating costs of the EU banking sector, respectively, as set out in the below
table. 

 Market Abuse Regulation and
     Directive (MAR/CSMAD)[20]

The annual costs
of implementing the package have been estimated at EUR 300m, in addition to EUR
320m of one-off costs in the first year to comply with the information
obligations. At the same time, the MAR/CSMAD proposals are expected to generate
net benefits of an estimated EUR 2.7 billion per year.

 Regulation on indices used as
     benchmarks in financial instruments and contracts[21]

The estimated
compliance costs for EU benchmark administrators consist of one-time costs of
about EUR 49m (EUR 98 000 per administrator) and recurring costs of about EUR 17m
(EUR 34 000 per administrator per year). The estimated compliance costs for
benchmark contributors consist of one-off costs of EUR 13m (EUR 26 000 per
contributor) and recurring costs of about EUR 3.5m (EUR 7 000 per contributor
per year). These costs only apply to contributors that are regulated entities,
which are predominantly large sized financial institutions.

 Short-selling Regulation[22]

One-off
compliance costs related to notification of the short positions (including CDS)
were estimated at approximately EUR 137m. They concern mainly the requirement
for banks and investment firms to make one-off investments in information
technology and information systems (IT/IS) development, training and compliance
procedures. The recurrent compliance costs were estimated at approximately EUR 15.8m
per year, including the annual costs to maintain IT/IS of EUR 13.7m and
disclosure costs of short positions in shares of approximately EUR 2.1m per
year. The one-off compliance costs to implement the sovereign bond position
disclosure requirement were estimated at EUR 34.2m. The recurrent EU-wide
compliance costs for disclosure of sovereign bond positions were estimated at EUR
5m per year, including the annual costs to maintain IT/IS of EUR 3.4m and the
disclosure costs of sovereign bond positions, estimated at EUR 1.6m per year.
Furthermore, a number of industry reports
have been prepared that seek to estimate the cumulative costs resulting from
the combination of rules, especially in the banking sector. Box 6.3.2 below
provides an illustration of such estimates compiled by KPMG. Annex 1 presents a
summary of the main cost quantification studies in the banking sector and their
results.  
Box 6.3.2: Examples of industry estimates of regulatory compliance
costs 
KPMG has performed
several bank surveys at national level to gauge the regulatory compliance costs
for banks[23].
The methodology employed focuses on costs in the transition period. Also, it
does not appear to distinguish between compliance costs that merely reflect a
good business practice (with benefits to banks themselves) from those that
represent true incremental costs that can be attributed to regulation alone.
The estimates appear to include costs of regulations that banks would have had
to bear anyway, e.g. as a result of lessons learned from the crisis and market
pressure. The studies focus on costs to financial intermediaries and do not
take into account wider societal costs and benefits. 
1. A KPMG survey of 20
German banks representing 60 % of the total banking sector by assets revealed
progress in improving financial stability through a reduction in the scale of
high-risk business activities and through higher capital and liquidity
reserves. Banks were asked to identify direct costs of regulation as part of
2010-2015 project budgets along with the related administration expenditure in
fields such as risk management, IT and organisation, compliance, accounting and
internal audit. Extrapolating the survey results to the entire banking sector,
KPMG estimated regulatory costs to the German banking industry of EUR 8.6
billion (i.e. EUR 1.4 billion p.a.). 
Overall, banks estimated
the negative impact on their return on equity (ROE) to be 2.4 percentage
points, with the capital and liquidity requirements of Basel III playing the
most prominent role. Based on the average ROE figure of 7.1 % in the 2010-2012
period, KPMG estimated the full cost of regulation at EUR 8.4 billion p.a. (not
including the German bank levy). At the same time, the estimates made by respondents
varied greatly, depending on the size and business model of banks surveyed. The
estimates by smaller credit institutions were much more moderate and hardly any
influence was expected by those with a conservative business model. This
underlines the point that regulatory reform is achieving its intended
objectives by reducing the riskiness of the most risky banks, with a corresponding
decrease in their ROE, as the risk-return trade-off would predict. 
2. Local banks in the Netherlands and Belgium identified the CRD IV package, Financial Transaction Tax, bail-in debt and
the pre-funding of deposit guarantee schemes as the four most significant
regulations likely to have the greatest impact on banks. Quantitative analysis of
the impact of these four regulations on banks’ capital, leverage and liquidity
ratios, and the impact on net income, profitability and cost-income ratios also
assessed the extent to which banks could mitigate the impact of these
regulations by taking management actions, such as reducing costs, re-pricing
loans, issuing new capital, retaining profits by not paying dividends, changing
the structure of assets (holding more high quality liquid assets) and
liabilities (raising long-term wholesale funding), and reducing the size of their
balance sheets. KPMG conclude that banks could not both meet all the minimum
regulatory requirements and achieve an 8 percent return on equity by cost
reductions alone. In the central scenario, this would require the following set
of management actions: 
• A 9 percent reduction in the size of the balance sheet; 
• An increase in the price of loans by 80–90 basis points;
• No payment of dividends; 
• A 5 percent reduction in costs; and 
• Replacing
the equivalent of 2.5 percent of total liabilities with long-term wholesale
funding. 
KPMG conclude that such
a set of management actions would have implications for customers of the banks
and for the financing of the wider economy, in particular through less and more
expensive credit and the provision of fewer risk management products and
services. 
Even though these costs are an important
element of any impact assessment, private costs on specific financial
intermediaries should not be the main metric from a public policy perspective.
As explained above, what really matters is whether the reform delivers net
societal benefits and results in a more stable, responsible and efficient
financial system as a whole. The direct (compliance) costs are typically
concentrated on a few (the financial industry) and are comparatively easy to
quantify, whereas most of the benefits are dispersed (e.g. taxpayers, consumers
of financial services) and are often less tangible and more difficult to
quantify. This often tilts the balance in the current policy debate.   
Estimates of private costs of financial
reforms require careful interpretation, as there is a risk that such costs may
be overemphasised and overestimated. First, many of the costs are one-off
transition costs, which are amortised over many years and which should be
distinguished from recurring costs that financial intermediaries would incur on
a regular basis to meet the stricter regulatory requirements. As noted above,
the transition to the new system clearly presents disruptions and adjustment
challenges, especially given current market conditions, which is why longer
phasing-in periods have been granted to reduce the burden on industry. 
Second, many compliance requirements (e.g.
investments in better data processing and risk management systems) also provide
private benefits to the management of financial institutions by giving them a
more detailed understanding of their own positions and risks and allowing
greater access to funding sources as a result of the greater transparency
offered to potential investors. Thus, costs are often attributed to
regulation when instead they are just reinstating good business practice. 
Identifying the true incremental impact
of regulation on financial intermediaries is challenging. For example, banks decide on their target capital and liquidity
levels based on a number of factors, and not just regulatory requirements. Other
factors include their own economic risk models and the demands of rating
agencies, counterparties and financial markets. Since the start of the crisis,
banks have adjusted their own economic risk models to reflect substantially
higher risk perceptions. Rating agencies have become more conservative and now demand
higher safety margins if banks are to maintain their credit rating. Finally,
counterparties, financial markets and customers are more risk-aware (and risk
averse) and themselves demand higher capital and liquidity or collateral to
back up their exposures. Therefore, any observed increase in capital and
liquidity levels since the start of the crisis cannot solely be attributed to regulatory
changes. Doing so would risk unfairly attributing costs to regulatory
changes that would have been incurred anyway. 
The required adjustments can increase costs
or reduce revenues for financial intermediaries, thereby reducing profits.
However, as noted above, reduced profitability can also reflect reduced
riskiness and the reduction of inappropriate and distortionary implicit
subsidies. 
Higher costs to financial intermediaries
can be passed on to customers of the financial services and products provided,
e.g. in the form of higher prices or restricted supply. However, the cost
pass-through (and hence the transmission of the financial intermediary costs to
the wider economy) is far from straightforward. It depends on the general
macroeconomic environment and the competitive conditions in the market. It will
also depend on the intermediaries' own actions in response to the increase in
costs. Below is a selection of possible actions, using banks and other credit
providers as an example, but similar possibilities would apply to other
intermediaries[24].
The below list of potential responses suggests that there are ways to adapt
without damaging customer interests: 

 Cutting costs

The most obvious
way to offset the cumulative impact of regulatory reforms would be to cut
operational costs elsewhere. This could include greater efficiency of processes
and data management through investment in IT systems; branch closure and staff
reductions; simplified legal entity and operating structures; outsourcing and
specialisation;[25]
and reductions in salaries and bonus payments.[26]

 Lowering returns to shareholders  

Since the
regulatory reforms aim to make banks more resilient and safer, investors should
be willing to accept a lower return as long as the risk-return trade-off has
not deteriorated. Indeed, a number of industry reports are highlighting an
emerging downward trend in bank equity costs, often referring to a new
equilibrium range of 8-10 %, because of the combined impact of reduced bank
asset risk and reduced leverage[27]. Historically, UK evidence shows that the
average ROE of UK banks was 7.0 % p.a. in the period 1920-1970 and increased to
20.4 % p.a. in the period 1970-2007, with significantly greater volatility
(i.e. risk) (6.9 % vs. 2 %, respectively)[28].
This suggests that reduced shareholder profitability to more sustainable levels
is not abnormal from a historical perspective and that a reduced profitability
need not be a concern when analysed in a risk-return framework. 

 Adjusting product supply 

Banks may
respond to higher costs by restricting products and services supplied. This may
not necessarily result in a societal cost. For example, banks may choose to
eliminate overly complex (and hence costly) products and services. They may
also tighten their credit standards or simply charge more for their loans or
other products. To the extent that the product mix was overly complex prior to
the crisis, and credit risk was underpriced and credit standards too lax, this
change should not be interpreted as a cost to the economy. Rather, the
pre-crisis credit growth and the proliferation in product supply cannot be a
relevant benchmark.
From a public policy point of view,
regulatory impacts on financial intermediaries are of relevance to the extent
that the reforms impede their ability to perform their key economic functions
and serve the economy in a sustainable and responsible manner.
Therefore, the following sections review the financial regulation agenda with
respect to its potential adverse social consequences on:[29]

 Bank lending to the economy (section
     6.4);
 The provision of other (non-bank) finance
     to the economy (i.e. impact on other intermediation channels) (section
     6.5); and
 The provision of insurance and hedging in
     derivatives markets (section 6.6). 

6.4
Impact on bank lending 
It is often argued that regulation has gone
too far and that the overall package of reforms is having a major adverse
impact on the provision of finance to the economy, with adverse consequences on
growth and employment. These concerns have been raised in particular in the
context of banking sector reforms and their impact on flow of bank credit to
the economy, in particular to SMEs which are particularly dependent on bank
finance. 
The first part of this section reports on
the ongoing bank deleveraging and the changes in bank lending since the onset
of the crisis and shows that regulatory reform has not been the only, nor
indeed the main driver of bank deleveraging. The remainder of the section
then examines the potential impact of different rules on bank lending, focusing
on:

 Higher capital requirements as per CRD IV
     package;
 Liquidity requirements as per CRD IV
     package;
 Bail-in provisions and depositor
     preference as per BRRD;
 The interplay of different rules, in
     particular CRD IV package, BRRD and Solvency II.

6.4.1 Bank deleveraging and reduced credit supply 
Since the onset of the crisis, the EU
banking sector has started a process of deleveraging and downsizing its balance
sheets. From a microprudential perspective, this is clearly desirable in order to
enhance the resilience and stability of the banking sector. However, from a
macroprudential perspective and as emphasised by those arguing against stricter
microprudential requirements, the collective deleveraging process may tighten
credit conditions, thereby reinforcing the recession or hindering economic
recovery. The collective bank deleveraging process that has occurred in Europe has to a large extent been driven by changes in bank strategies and de-risking and
by the difficulties for banks to obtain funding in the market, and not so much
by regulation. It is worth bearing in mind that a disorderly deleveraging
process has also been avoided through ongoing state aid and central bank
support.    
Irrespective of the underlying reasons, the
more important point is that deleveraging does not have to involve
reduced flows of lending to the economy. ‘Good’ deleveraging entails banks
cleaning up their balance sheets by writing down the troubled assets that were accumulated
before the crisis and reducing excessive interconnectedness and complexity. If
the size of banks' balance sheets shrinks because losses are recognised and
accounting values are adjusted downwards, this adjustment may better support
the economy from a medium-term perspective. Not recognising the losses from
non-performing assets may actually prolong the period of stagnation and give
rise to debt overhang problems and the ever-greening of bad loans.[30] Widespread forbearance poses the risk that banks will devote scarce
resources for lending to unhealthy corporates, crowding out lending to
healthier and more productive firms. Also, when a universal bank with extensive
investment and wholesale banking activities decides to de-risk away from market
activities, the balance sheet will shrink. But again, the impact on lending may
be limited, and the shrinking of the balance sheet may deliver de-risking benefits.

A number of policy actions have been
taken to ensure that mainly ‘good’ deleveraging takes place. For example,
the new risk-based capital framework (the CRD IV package) provides for higher
capital charges against market risk and trading book exposures, which gives
incentives to focus deleveraging on these more risky assets that contributed to
the build-up of vulnerabilities in banks' balance sheets prior to the crisis.
Also, the ECB and other central bank liquidity operations performed since the
crisis alleviated pressures on bank funding and helped banks to continue
granting credit to the economy. Another example is the EBA recapitalisation
exercise in 2012 which required banks to form a capital buffer to sustain
systemic risk arising from the sovereign debt crisis and which provided detailed
guidance to prevent banks from simply curtailing lending. As a final example,
the Vienna 2.0 initiative seeks to limit the impact of deleveraging in Central,
Eastern and South Eastern Europe where EU cross-border banks may otherwise be
induced to withdraw or cut back lending in the region. 
 Chart 6.4.1: Bank deleveraging, changes in assets of euro area MFIs since May 2012 
 Source: ECB Financial Stability Review, 2013 Notes: NFPS refers to non-financial private sector. Monetary financial institutions (MFIs) are split between stressed and non-stressed countries. 
As analysed in the ECB's Financial
Stability report of November 2013, the total assets of monetary financial
institutions located in the euro area have fallen by 10 % (EUR 3.5 trillion) on
aggregate since May 2012 (chart 6.4.1). Only a relatively small part of this can
be accounted for by reductions in loans to the real economy. Indeed, while such
loans declined significantly in the stressed countries of the euro area, banks
in non-stressed countries recorded an increase in loans to the economy. The
largest driver in the balance sheet decline is accounted for by 'remaining
assets', which mainly reflects a fall in the market value of derivatives. Banks
also reduced their deposits with the Eurosystem (which reflects repayments of
funds obtained from ECB long-term refinancing operations), interbank loans and
non-euro area assets (which, of course, may include loans to the real economy).
Prior to the crisis, aggregate bank balance
sheets in Europe grew more rapidly than customer deposits in banks (on the
liabilities side) or customer loans (on the asset side), as is shown in charts
6.4.2 and 6.4.3. As noted above, part of this balance sheet expansion can be
attributed to increased intra-financial business and the building up of asset
inventories by banks in relation to their trading activities. At the end of
2013, loans of euro area monetary financial institutions (MFIs) to
households and non-financial corporations made up only 31.4 % of their
aggregate balance sheet. 
 Chart 6.4.2: Evolution of liabilities of MFIs (euro area, EUR  billion) || Chart 6.4.3: Evolution of assets of MFIs (euro area, EUR  billion) 
 || 
 Source: ECB data. || Notes: Customer loans include all loans to households and non-financial corporations. Source:  ECB data. 
Thus, there is no one-to-one
relationship between changes in the size of banks' balance sheets and the
provision of loans to the economy, let alone sustainable economic growth.
Put differently, balance sheet reductions and deleveraging can be achieved
without reducing real economy lending – for example through reductions in
intra-financial system exposures and by cutting lengthy intermediation chains. 
This is not to say that the crisis did not
put a break on the aggregate credit flows to the economy. Charts 6.4.4 and
6.4.5 show the development of loans to households and non-financial corporates
of MFIs in the euro area, both in terms of the level and the percentage change
on the previous year. With the onset of the crisis, the growth in bank loans
observed prior to the crisis stopped markedly, with a particularly sharp
reversal in the trend observed for lending to non-financial corporations. 
 Chart 6.4.4: Loans of MFIs to non-financial private sector (euro area, EUR  billion) || Chart 6.4.5: Loans of MFIs to non-financial private sector (euro area, % change on previous year) 
 || 
 Notes: Shows stock of loans of euro area MFIs to households (HH) and non-financial corporations (NFC). Source: ECB data. || Notes: Shows percentage change in loans compared to previous year. Source:  ECB data. 
The change in aggregate bank credit
patterns partly reflects corrections of pre-crisis excesses. As explained in chapters 3 and 4, prior to the crisis, banks were operating with levels of capital and liquidity
resources that were insufficient to absorb solvency and liquidity shocks. There
was a general mispricing of risks in the market. Credit seemed abundant, but
this abundance turned out to be unsustainable, and it contributed to the crisis
and ultimately resulted in banks and other parts of the financial system not
being able to carry out their critical economic functions. This is what really
constrained credit intermediation and growth, not regulation. Therefore,
pre-crisis credit provision cannot serve as the relevant benchmark, since
credit at that time was often excessive and built on a system that was
unsustainable and which ultimately collapsed. 
The lack of credit noted since the onset of
the crisis, especially in the stressed economies, reflects the interplay
between:

 Constrained credit supply, because bank balance sheets are still weak, suffering from
     excessive leverage (debt overhang), legacy assets and high levels of
     non-performing loans (see charts 3.3.5 in chapter 3), and because raising
     significant amounts of bank equity in primary markets (rather than through
     bank profit retention) can be difficult under the current circumstances;
     and 
 Weak credit demand, which stems from excessive indebtedness of firms[31]
     and households (see charts 3.3.3 and 3.3.4), as well as from generally
     weak economic conditions and growth expectations.

While banks have tightened credit
conditions since the start of the crisis (with some improvements recently), reductions
in credit have also been significantly driven by lower demand. Europe's economy is highly indebted (see chapter 3.3). Public and private
sector debt is high and, in many cases, excessively high and unsustainable. 
Credit demand is also held back because of
weak economic activity, low investment, borrowers' risk and persistently high
levels of economic uncertainty. Recent ECB bank lending surveys all suggest
that these demand factors significantly weigh on credit.  
There is no general credit shortage in Europe (also due to large-scale public intervention and central bank liquidity
support). In fact, nominal and real interest rates are extraordinarily low, and
financing is very cheap in many parts of Europe. Nonetheless, there are some important
areas of concern in credit supply: the first is access to finance for SMEs,
which tend to be particularly dependent on bank finance and less able to tap
alternative funding sources (and which also tend to face higher lending rates,
see chart 6.4.6). Consumers, and in particular more vulnerable ones, face
similar problem of access to credit. In short-term and low value lending, the
financial institutions, which do not have the status of credit institutions and
thus are not subject to prudential regulation, often fill up the gap of credit
supply. However, this usually implies a higher cost of lending and may also
result in consumers potentially being exposed to unfair commercial practices. Much
of the underlying problem in SME finance is asymmetric information where
potential providers of finance find it difficult to assess the quality of the
borrower and where acquiring such information is costly. 
 Chart 6.4.6: Spread between lending rates on small and large loans in the euro area (bps, 3-month moving averages) 
 Source: ECB Note: small loans are below EUR 1m, large – above. 
The second area of concern is that costs
and access to finance differs significantly across the EU and within the
euro area in particular (chart 6.4.5). This reflects the ongoing challenges of
adverse feedback loops between the banking sector, sovereign debt and the real
economy in the stressed countries of the euro area. While sovereign debt
problems have eased somewhat, significant challenges remain.
In the stressed countries, weak banks
with thin buffers and relatively high funding costs have been exacerbating the
problems in the real economy by tightening credit conditions, rationing
credit and increasing interest rates on new loans (see chart 3.3.6 in chapter
3). At the same time, weaknesses in the real economy have exacerbated the
problems of weak banks. The corporate sector (and in some countries the
household sector) is heavily indebted, and this high leverage has interacted
with weak profitability to create debt-servicing difficulties. This, in turn, has
led to an increase in non-performing loans, worsening the assets on bank
balance sheets. Banks with weak balance sheets will be less able and willing to
recognise losses and so will become more likely to forbear on loans.[32]
Widespread forbearance poses the risk that banks will devote scarce resources
to unhealthy corporates (‘zombie’ firm lending), crowding out lending to healthier
and more productive firms.
Breaking this vicious feedback loop requires
tackling both the weak bank balance sheets and the debt overhang in the economy.
The required orderly deleveraging will take time and presents significant
transition challenges. As already noted above, this is why many rules are
phased in over time and why continuous monitoring is required to address any
unintended consequences, given the on-going adverse market conditions.   
The above discussion illustrates that the
observed evolution of bank lending since the start of the crisis is not only
(or even mainly) driven by regulation. To say otherwise – as is often done
by some in an attempt to lobby against tighter rules – is misleading. The next
sections focus on the potential incremental impact that the regulatory reforms
may have on bank funding costs and bank lending to the economy (i.e. the
incremental impact over and above the other influencing factors).   
6.4.2 The impact of higher
capital requirements on credit supply
The banking
sector routinely stresses the impact of EU regulatory reform initiatives on
their ability to support the economy. In particular, it is argued that higher
capital requirements will result in higher funding costs, because “equity is
more costly than debt” as a funding source; as a result, this higher cost will
either be passed on to clients, or banks will respond by lowering the quantity
of credit provided. 
Higher capital could particularly harm low
margin business such as global transaction banking, which is of
particular importance for trade. Eight of the world’s top ten trade finance
banks are categorised as globally systemically important financial
institutions, requiring them to add a specific capital buffer on top of the
general capital requirement (see section 4.2.4). The reforms recognise this and
reduce the capital charge by calibrating the credit conversion factors for
medium-to-low risk and medium risk trade finance products at 20 % and 50 %,
respectively. 
Also, specific concerns have been raised
about the impact on bank lending to SMEs. As already noted in chapter 4.8,
policy efforts are being taken to fill the funding gap for SMEs and ensure an
appropriate flow of bank credit. As regards bank capital rules, the CRD IV package
provides for specific treatments for bank exposures to SMEs, through lower risk
weights and capital relief, to allow banks to increase lending to SMEs. Thus,
rules have been adjusted to mitigate potential costs and to strike the
balance between strengthening prudential requirements to ensure financial
stability and allowing the financial sector to provide a sustainable flow of
finance to the economy. 
It is important to recall that bank capital
levels were far too low in the run-up to the crisis (see section 4.2). EUR 1.5
trillion of EU state aid provided to banks (Box 3.4.1). Contingent taxpayer
support, in terms of total parliamentary approved aid (as opposed to aid
actually used) was higher and reached EUR 5.1 trillion, representing some 13.8
% of total EU banking assets. As such, the regulatory capital requirements and
total loss absorption capacity demanded from banks under the new capital
adequacy rules (and the bail-in provision of BRRD) are below the contingent
public support provided to banks during the crisis. 
A number of leading academics and
policymakers have made the case for higher capital requirements.[33] Some have even called for capital requirements that are higher than
the Basel III requirements implemented in the EU through the CRD IV package.
They also argue against the claim that issuing more equity would lead to a
higher cost of capital to banks and result in less lending to the economy, on
the following grounds.
First, the required return on equity and on
issued debt should decline when more equity is used to fund bank activities. In
line with the Modigliani-Miller (MM) theorem,[34] an increase in capital should lead to a decline in the equity
risk premium, because the same risk (assuming no change on the asset side
of the balance sheet) is distributed over a larger equity base. Moreover,
increased equity funding also lowers the required rate of return for holders of
debt instruments. Under the MM theorem, the impact of higher equity on the
banks’ weighted overall cost of capital should, in principle, be zero, under
certain conditions (i.e. in the absence of taxes, subsidies, etc.). Any
argument or analysis that holds the required return on equity and debt fixed
when evaluating changes in equity capital requirements is therefore flawed and
goes against the basics of financial economics. 
Second, capital is not set aside and thus
is not unavailable for lending. Rather it is a source of funding, and the funds
can be freely used in financing any asset. That is, higher capital
requirements by themselves do not limit banks’ activities. However, banks at
risk of failure may indeed prefer to forego lending opportunities funded with
equity, because equity issuance would improve the position of existing
creditors and it may also be interpreted as a negative signal on the bank’s
health. Moreover, undercapitalised banks have incentives to “gamble for
resurrection” by issuing even more debt and increasing their riskiness, because
the equity holders face all the upside in the event that the bank recovers,
whereas they have little to lose in the event that the bank fails because losses
will primarily be borne by taxpayers in the absence of credible and effective
resolution frameworks. Thus, debt overhang problems can only be tackled
decisively if regulators require the recapitalisation of undercapitalised
banks. Well-capitalised banks make better lending and investment decisions because
they face less balance sheet constraints and thus have fewer incentives to take
excessive risk.
Third, just because financial institutions
choose to fund themselves primarily with debt, and have high levels of
leverage, does not mean that this form of financing is optimal from a societal
point of view. Instead, the observed funding decisions are partly driven by tax
incentives and the implicit subsidy from public safety net coverage, as
previously discussed. It is also related to frictions related to conflicts of
interest between shareholders, debt holders and bank managers (i.e. the
so-called agency costs). The annual return on equity has long been an
industry-wide metric for the variable part of management compensation (i.e.
bonus schemes). The easiest way to boost short-term return on equity is by
increasing risk either through investment in riskier assets or by increasing
bank leverage (see chapter 4.2). 
Fourth, the return on equity is itself a
performance metric that does not correct for the underlying riskiness of bank
activities. Consequently, when leverage and hence risk is high, the required
return on equity is high, whilst it is lower at lower leverage and risk levels.
The risk-adjusted return on equity may be similar for both instances. Thus, the
change in return on equity is commensurate with the change in the risk borne by
equity holders and does not mean that shareholder value is lost or gained,
because the risk-adjusted return on equity remains constant. There is no free
lunch: shareholders cannot boost return on equity without taking additional
risk (unless of course they can shift the downside risk to taxpayers, in which
case it is privately optimal for managers and shareholders to leverage up). 
Finally, there are theoretical models that
show that short-term debt can sometimes play a disciplining role on bank
managers. However, arguments against higher capital requirements based on this
notion are very weak given the recent financial crisis experience. High
leverage actually creates many frictions and systemic risk. In particular, it
creates incentives for banks to take excessive risk. Any purported benefits
produced by debt in disciplining managers must be measured against the
frictions created by short-term debt. Moreover, the notion that debt plays a
disciplining role is contradicted by the events of the last decade, which
include both a dramatic increase in bank leverage (and risk) and
interconnectedness through a short term debt surge, culminating in an
unprecedented financial crisis. There is little or no evidence that banks’
debt holders provided any significant discipline during this period. Also,
the supposed discipline provided by debt generally relies on a fragile capital
structure funded by short term debt that must be frequently renewed. Reduced
fragility, which is a key goal of capital regulation, would be at odds with the
functioning of this purported disciplining mechanism. 
At the same time, it is true that the MM
theorem only holds perfectly in the absence of frictions, such as taxes and
implicit subsidies. The favourable fiscal treatment of debt over equity
(interest is tax deductible, whereas dividends are not) allows banks to reap
certain benefits from substituting equity for debt. Debt financing is hence
subsidised through taxes. More importantly, implicit guarantees originating
from public safety net coverage also favour debt over equity financing (see
Box 4.2.2 for a quantification of the implicit subsidies). As explained, the
reforms seek to reduce these subsidies. Miller (1995)[35] has also acknowledged that raising equity can be expensive,
especially for smaller banks, if only due to the flotation and underwriting costs
that are involved. The MM propositions are propositions that are concerned with
having equity, as opposed to raising equity. Furthermore, stock
offerings usually come at a discount, mainly due to the asymmetric information
faced by the potential investors who do not know the real state of the bank as
well as its management does.[36] In addition, there is a limit to the funds available for investment
in bank stocks over a specific period of time, possibly requiring an even
deeper discount to attract investors. 
The post-crisis market conditions may make
it particularly challenging for raising substantial amounts of bank equity,
especially for the banks with weak balance sheets or subject to major
litigation risks. Hence, higher capital requirements could raise the overall
cost of banks’ capital, especially in the transition phase to reach the higher
standards. This, in turn, could have an impact on the lending rates to the
extent that costs are passed through to clients. However, other regulatory
initiatives incentivise banks to reduce the overall riskiness of their
balance sheets, contributing to a general lowering of their cost of capital, so
that the risk-adjusted return of both debt and equity investors may remain
unchanged. Moreover, the new capital requirements are phased in over time,
giving banks time to make the required adjustments and thereby limiting costs
in the transition phase. On balance, therefore, one should not expect
any significant impact of higher capital requirements on banks’ aggregate cost
of funding and even less so on the lending rates. 
For example, Elliott (2009)[37] estimates that, all else being equal, the loan rate would have to
increase by 77 bps to compensate for the higher costs stemming from a 4
percentage point rise in the capital level. Elliot concludes that constraints
on competitive lending sources would render such lending rate increases
unfeasible or at least very difficult, and considers that a mere 20 bps
increase is more realistic, as a result of banks adjusting also other
variables, namely the return on equity and debt, the credit spread,
administrative costs and customer-related benefits (e.g. from cross-selling).
The author also reiterates the fact that regulatory capital requirements are
not the only determinants of the capital levels that banks choose to hold.
Other factors include desired credit rating levels and banks' internal economic
capital models.
The BIS (2014) has examined how banks are
adjusting to the higher capital requirements of Basel III based on a sample of
94 large banks from advanced and emerging economies for the period end-2009 to
end-2012. The dataset includes 35 European banks and all of the 29 institutions
identified by the FSB as globally systemically important banks, covering 64 %
of the assets of the top 1000 global banks as listed by The Banker.
European banks achieved roughly a 2.5 percentage point increase in the
regulatory capital ratio by: (i) reducing risk-weighted assets (contribution of
2 percentage points) and (ii) raising capital (contribution of some 0.5
percentage points). As for the latter, retained earnings account for some 58 %
of the overall increase in capital. 
Banks do not appear to have cut back
sharply on asset or lending growth as a consequence of higher capital
standards. Moreover, banks with high capital ratios
or strong profitability at the start of the process showed above average
growth, underlining the importance of solid bank balance sheets in support of
real economy lending. In this context, there has been a pronounced shortfall in
lending growth on the part of European banks, though European banks have
accumulated other assets in the form of cash and securities. Some banks have
cut back on their trading portfolios. These conclusions lend evidence to the
view that any observed shortfall in lending is not so much the result of higher
capital requirements, but rather due to other factors. 
 Chart 6.4.7: Relationship between capitalisation and loan growth 
 Notes: The sample includes the largest 45 European banks and excludes banks that merged during the period. Loan growth is % change in stock of gross loans to customers during end 2011 and end 2012. Ratio of market capitalisation to total assets is based on consolidated data in December 2011. Source: SNL Financial and Commission services calculations. 
Chart 6.4.7 presents the correlation
between bank capitalisation and loan growth for a sample of 45 large European
banks. Bank capitalisation is measured by its market capitalisation, relative
to total bank assets at the end of 2011.[38] Loan growth is measured by the percentage change in the loans on
banks' balance sheets.  The positive correlation between capitalisation and
loan growth illustrates the point that the stronger the balance sheet of a bank
is, the stronger is its ability to support the economy. 
Buch and Prieto (2012) analyse the link between bank capital and
bank loans in Germany
during 1960-2010 and conclude that there is a positive long-term
relationship between capital and lending. More specifically, a one percent
increase in the level of bank capital is found to increase bank loans by about
0.22 percent.[39] Similar evidence has been found in other empirical studies,[40], where it appears that higher levels of bank capital are associated
with higher lending and liquidity creation by large banks, bigger market shares
and lower probabilities of default for banks, as well as higher bank values.
However, an increase in regulatory capital requirements may be associated with
small effects in terms of reduced lending, non-trivial transitional costs and a
shift of lending from regulated to unregulated sectors. 
The IMF (2012)[41] finds that higher economic growth and less growth
volatility is associated with higher capital and liquidity
buffers within banks. The effects of buffer variables are non-linear, showing
the trade-off between economic growth and stability. But this trade-off becomes
material only at very high capital levels: higher capital buffers up to a
threshold of above 25 % are all positively associated with economic growth, and
the relationship reverses only beyond that threshold. 
All of the above empirical evidence suggests
that the main challenge banks face is not higher capital levels as such, but
the transition to move away from excessive leverage towards a more stable
and safer banking system. The costs generated by the crisis present ample
evidence for the need to move forward (with appropriate phasing-in and
observations periods). As summarised in PwC (2013): "There will be
disruptions and adjustment costs, but concerns about economic viability under
the additional capital load (including at product level) are unfounded –
reduced leverage is bringing down the cost of bank equity and this trend will
continue." 
6.4.3 The impact of liquidity requirements 
Mismanagement and mispricing of liquidity
risk due to excessive leverage and severe asset liability mismatches was at the
core of the financial crisis (section 4.2.2). Adequate asset-liability matching
and stable funding is sound business practice, so it is difficult to object to
the principles of liquidity regulation. However, various concerns about the
costs of the Liquidity Coverage Ratio (LCR) and
introduction of the Net Stable Funding Ratio (NSFR) have been raised:
·        
Reduced bank profitability: Requiring banks to hold more sizeable pools of liquid assets would
reduce bank profitability (and hence their resilience to sustain solvency
shocks).
·        
Crowding-out of long-term illiquid assets: Liquidity requirements may incentivise a shift to shorter maturities
across all types of assets. This would also affect loans to corporates. While
larger corporates can get funds from corporate bond markets or from mutual
funds (including money market funds) and unregulated financial institutions,
SMEs depend very much on bank lending. 
·        
Increased borrower spreads: In times when the interbank market dries up and funding is
difficult, banks might also respond to the liquidity requirements by trying to
attract more deposits. When the rate that a bank has to offer to gather
deposits is higher than the rate earned on liquid assets, the bank's marginal
funding costs will increase. The higher costs may be passed through to the loan
interest rate.
·        
Reduced credit supply and the impact on
interbank lending and bank maturity transformation: Since it requires longer-term assets to be funded by stable funding
sources, the NSFR will reduce incentives to engage in interbank market
operations (and more generally short-term funding) and hence reduce the ability
of banks to engage in maturity transformation of banks. There is a positive
economic role of maturity transformation, as savers want near-instant access to
a (significant) portion of their funds whilst on the other hand the vast part
of economic projects has long maturity. However, at the same time, the crisis
has revealed the risks of poor liquidity risk management and excessive maturity
transformation, so there are considerable benefits of improved asset-liability
maturity matching, as intended by the NSFR.  
·        
LCR might not work as a buffer: LCR is criticised as a rigid rule, which cannot work as a buffer due
to its assumptions that the trigger factors (e.g. deposit flight, ratings
downgrade) remain constant during the entire stress period. In addition, the
calibration is based on the increased volatility in the aftermath of the
crisis, which may turn out to be excessive, should the volatility wane with the
recovery.
·        
Pool of eligible assets for the LCR is too
restrictive: There is criticism that the definition
of eligible assets is too prescriptive and restrictive (and that the scope of
eligible assets for the LCR pool is narrower than the ECB eligible pool of
assets). It is argued that some financial instruments supporting the financing
of companies and individuals, like corporate bonds, covered bonds or
asset-backed securities (ABS), are not sufficiently considered as eligible.
While it is understandable that banks want to expand the pool to lower funding
costs, there are also good reasons to limit the eligible assets. For example,
it is well known that some securities can be highly illiquid and there is no
market price on a continuous basis. 
As explained in section 4.2.2, the
liquidity regulation seeks to curtail inadequate asset-liability matching and
excessive short term wholesale funding. The potential costs to banks arising
from the rules need to be distinguished from the corresponding societal costs. EBA (2013) finds that most studies overestimate the
societal costs of the LCR requirement, because the studies fail to take
account of implicit subsidies and the fact that some of the
increase in costs to banks represents foregone tax subsidies. The costs imposed on banks by the LCR partially reflect decreased
societal costs (i.e. societal benefits). As noted in section 4.2.2, the NFSR
remains under development and subject to an observation period.
Other things being equal, restrictions on
banks to engage in maturity transformation are likely to limit their ability to
turn short-term deposits into longer-term loans to the economy. However, much of the pre-crisis liquidity can, in fact, be
considered ‘artificial’ and contributed to a boom-bust cycle. Market
developments since the crisis were driven by evaporation of trust in the
creditworthiness of counterparties and selected sovereigns, which dwarf any
potential adverse effects of regulations.
There are means to create liquidity, such
as financial engineering to overcome funding liquidity problems (which is
likely to shift risks elsewhere) and central bank measures (e.g. relaxed
eligibility rules on collateral), and replacement of absent private liquidity
with public liquidity. This can help in the transition phase and address
confidence issues, but it cannot solve liquidity problems that are driven by
weak fundamentals and excessive leverage. Relaxing liquidity rules in the
short-term may help, but at the cost of increased financial instability in the
longer term. 
In its recent impact
assessment of the LCR,[42] the EBA (2013) shows that the LCR as specified
is not likely to have a material detrimental impact on the stability and
orderly functioning of financial markets or on the economy and the stability of
the supply of bank lending. To a large extent, this can be explained by the
fact that EU banks already show an average LCR of 115 per cent (i.e. exceeding
the minimum requirement of 100 %). However, the potential impact differs
depending on the business model[43]. EBA concludes that the
calibration of the LCR as defined by BCBS is generally appropriate also across
the EU. It should be noted that the BCBS revised
the calibration of the LCR in January 2013 to avoid a potential shift from
lending (loan assets that are illiquid) to more liquid assets (e.g. cash,
central bank deposits). Also, among other things, the EU has sought to limit
unintended consequences on trade finance by reducing the run-off rate for
deposits related to this activity to 0-5 %. Moreover, the inflow rate for all
trade finance receivables maturing within the 30-day reference period has been
increased from 50 % to 100 %.
EBA (2013) estimates that the
aggregate long-term costs of the LCR are negligible and in the order of
magnitude of 0.03 % of EU GDP. The additional demand for high-quality
assets spurred by the LCR is unlikely to have a material detrimental impact on
the stability and orderly functioning of financial markets (see also sections
7.3 and 7.4). It is also not likely to affect negatively either the economy
or the supply of bank lending, including lending to SMEs. As regards the
latter, the data analysis shows evidence that banks with larger SME exposures
do not necessarily have lower LCRs and banks that became compliant did not do
so through a reduction in lending to SMEs. EBA (2013) finds that neither the
data, nor case studies, nor the empirical literature suggest that the implementation
of the LCR could lead to a disruption in the credit supply.[44]
Other studies have
also considered both the costs and benefits liquidity requirements (see Annex 1
for a literature review). An IMF study by Elliot et al
(2012) examines the effect of Basel III liquidity requirements on bank lending
rates and reaches the conclusion that it is likely to be relatively small: LCR
increasing lending rates by 8bps in the long term and the NSFR by 10 bps,
with the combined effect amounting to about 14 bps, given some overlapping
effects. The LCR was recalibrated in 2013, further reducing these cost impacts.
Consistent with the approach taken by the
BCBS, the EU reform agenda is being mindful of potential adverse consequences
of liquidity regulation, especially in light of on-going adverse market
conditions. Careful calibration is warranted, and so are the phasing in and
observation periods granted under the CRD IV package. 
The Commission is
required by 30 June 2014 to adopt a delegated act specifying the general liquid
coverage requirements. When adopting that delegated act, the Commission must
take into account the reports submitted by EBA, including the above mentioned
impact assessment, the Basel III rules as well as EU specificities. 
The CRD IV package provides for the
phased-in implementation of the LCR and introduces a long observation period
before any legislative proposal on the NFSR. Implementation of the LCR and the current international discussions
on the definition of the NSFR seek to find the right balance between improving
the resilience of the banking sector to liquidity shocks and avoiding excessive
restrictions on maturity transformation that discourage long-term financing.
Thus, the Commission delegated act on LCR and the final calibration of the NSFR
will aim to not unduly restrict the provision of finance by banks. In addition,
full advantage can be taken of the monitoring period in the CRD IV package to
adjust and address potential unintended consequences of the new liquidity rules
for long-term investment.
6.4.4 The impact of bail-in provisions and depositor preference 
As discussed in chapter 4.2.5, bank
resolution and the bail-in tool have been developed in the BRRD to improve
dealing with bank failures outside of formal bankruptcy process, to minimise
the cost of bank failures and in particular to how losses are passed-on to
taxpayers. At the same time, however, the possibility of bail-in has
an impact on bank funding costs, as a result of the greater likelihood that
creditors will suffer losses. Moreover, this is compounded by further changes
that have been adopted in the BRRD to protect deposit claims vis-à-vis others,
impinging on ordinary creditors. Together, the resulting cost increase on
banks, if not compensated by a fall in other funding costs and if
passed-through, could have repercussions on bank lending.

 Removal of uncertainty

On a first
instance, it is important to bear in mind that uncertainty regarding the point
at which EU Member States would support a bank played a role during the crisis.
Such uncertainty worked to increase the cost of debt and provoke spike premiums
of insurance against default at times of stress. The BRRD provides greater
consistency and clarity and removes uncertainty from financial markets with
regards to the behaviour of public authorities.

 Costs to banks versus societal costs

Bail-in is meant
to curb the practice whereby creditors are rescued from facing losses incurred
by a bank in case of failure, because external public resources are provided to
save the bank (i.e. creditors are the ones usually bailed-out). In this regard,
it is obvious to note that bail-in will necessarily imply a greater risk and
cost for creditors and that they will try to pass on that cost to banks, by
requiring higher returns for purchasing their debt issues. At the same time,
such greater risk and cost for bank creditors is matched by the benefits for
taxpayers from providing lower contingent support to them. Moreover, if as a
result of acknowledging bail-in, creditors get to internalize the cost of banks
risky choices, its provisions will contribute to reduce risks ex ante
(i.e. will lead to more sustainable dynamics in banking) and lower the overall
costs if resolution of a bank becomes necessary.

 Bail-in builds on previous reforms to
     reinforce banks' balance sheets

Wrapping up
together with the previous points, the bail-in tool builds on previous reforms
to reinforce banks' balance sheets and ensure the banking system as a whole
remain a going concern. Hence, as a consequence of reforms to increase capital
and loss absorbency; improve liquidity buffers and prevent excessive maturity
transformation; and reduce pro-cyclicality and systemic risk (see chapter 4);
the likelihood that creditors will face losses has diminished. Thus, the
overall impact on creditors' risk and resulting costs because of the bail-in
tool is ambiguous: it could lead to (i) a fall in the cost of funding, if
banks' balance sheets are sufficiently reinforced to make the possibility of a
bank failure very unlikely and limited in cost; or, alternatively, it could
result in (ii) an increase in the cost of funding, if the increased risk due to
the possibility of loss absorption by debt offsets the reduced risk due to
reinforced balance sheets.

 Cost benefits from low deposit returns

In addition to
the above points, the BRRD has reinforced the claims of depositors with regards
to other creditors. In deciding how to allocate their savings, households do
not bear in mind the same considerations as wholesale financial market
participants. The explicit guarantee present on deposits across the EU plus the
expectation that governments will support depositors in case of bank failure
has de facto become part of households' beliefs when planning how to
save[45]. To reinforce such beliefs, the BRRD has raised the rank of
deposits vis-à-vis other creditors. In particular, guaranteed deposits are now
excluded from being bailed-in in case of resolution and general depositor
preference has been affirmed with respect to senior unsecured debt. This rule
further increases the likelihood that, upon a bank failure, creditors will be
forced to take on losses. At the same time, banks benefit from households
having such beliefs regarding deposits: the return households demand from their
deposits is not on a par with the (previous) pari passu standing of
deposits vis-à-vis senior unsecured debt. Thus, the overall impact of such
reforms on the cost for the banking system is ambiguous: if households were to
doubt on the safety of their savings, the banking system would be bankrupt. At
the same time, the evidence presenting the minimum necessary to ensure that
such doubts do not arise is scant or non-existent: depositor preference (and
qualified exclusion) has been established to ensure such doubts never arise.
The above present the overall costs that
can and will arise because of resolution, the bail-in tool in resolution and
depositor preference. Nevertheless, it is important to bear in mind how
financial market participants have interpreted the above change in the rules of
the game.
As explained in box 4.2.5, according to the
issuer credit rating methodology applicable to banks, a positive likelihood
that a bank would receive future extraordinary support in a crisis from their
sovereign may enhance their standalone credit profile, resulting in a
‘government support uplift’. For a private-sector commercial bank, the
likelihood of such government support is estimated by drawing on assessments of
both the bank's systemic importance and the government's tendency to support
private-sector commercial banks. For example, the introduction of bail-in in Denmark directly affected local banks’ credit ratings, because the ‘government support
uplift’ to their standalone credit profiles (arising from the expectation of
State aid in a crisis) was reduced: some banks lost it altogether, whilst the
largest Danish banks retained only one notch. This was estimated to have
resulted in a 25 to 50 basis points increase in bank funding costs.
More recently, Standard & Poor's has
announced a review of its European bank ratings by mid-2014 in response to the
progressive implementation of bank resolution and creditor bail-in plans.[46] Any resulting near-term rating actions are likely to consist of
revisions to the ‘support uplift’ mentioned above. Medium-term rating actions
would likely affirm or lower ratings by one to two notches. As mentioned in
section 6.4.2, this has been an implicit government subsidy to funding costs of
banks. If bail-in removes this subsidy, it will have merely removed a
previously existing market distortion.
It is important to realise, as has been
mentioned above, that the increase in senior unsecured debt funding costs could
be countered by a fall in the cost of other instruments. This is the case with
respect to the beneficial position that covered bonds encounter under bank
resolution frameworks. Fitch has recently made public that these funding
instruments are likely to benefit from an uplift of 1-2 notches above the
banks’ issuer default rating. The resulting adjustments would be implemented in
parallel with any revisions to the ‘support uplift’. Out of 129 programmes
publicly rated by Fitch, 92 are expected to be eligible for such uplift, with
42 % benefitting from a two-notch uplift and 30 % from a one-notch uplift.[47]
In general, investors appear to be
willing to invest in bail-in-able debt. These
indications originate from markets in: (i) financial instruments with an
embedded ex ante (i.e. contractual) possibility of being bailed-in,
known as contingent convertible (“CoCo”) capital instruments; as well as (ii)
subordinated and senior unsecured debt, after authorities signalled the
possibility of being subject to bail-in in case there is not enough equity to
absorb losses. For in 2013, European banks issued some EUR 10 billion of CoCos
– double the amount compared to 2012. Moreover, analysts expect[48] between EUR 30 billion and EUR 50 billion of CoCo issuance by
European banks in 2014. Issuance has been supported by robust investor demand,
because CoCos offer relatively high yields of up to in excess of 7 % on
investment grade banks. For example, Santander raised EUR 1.5 billion with a
coupon of 6.25 % and Danske raised EUR 750 million at 5.75 %. The latter coupon
is the lowest issue price to date. The Nationwide Building Society became the
first non-listed financial institution to issue a coco, with a £1 billion bond
paying a coupon of 6.87 %[49]. Barclays estimated[50] that the European CoCo market could grow to as much as EUR 400
billion – similar in size to the current European bank subordinated debt
market.
Nevertheless, according to the BIS (2013),
so far the bulk of demand has come from retail investors and small private
banks, with large institutional investors staying on the side-lines. This may
be due to specific idiosyncratic features of CoCos, which differ by their loss
absorption capacity (i.e. whether they convert into equity or directly absorb
losses upon trigger) and by the triggers of conversion (i.e. book value, market
metrics value or bank's supervisor's discretion). Some CoCos convert to equity
once a specific core tier one capital threshold is triggered, whilst others
simply write down investors’ principal. This lack of standardisation has made
them attractive to specific niche investors and they are yet to develop deeper
pools of funding. 
Investors are already familiar with subordinated
debt that can be bailed in (or quasi bailed in, depending on the
legislation present at the time of the action) through a number of cases in the
EU (e.g. Amagerbanken, Anglo Irish Banks, Banco CEISS, Banco Gallego, Banco
Grupo Caja, Bank of Cyprus, BFA-Bankia, BMN, Catalunya Banc, Fjordbank Mors,
Liberbank, NCG Banco, SNS Reaal). This did not prevent banks from issuing more
than EUR 90 billion of subordinated debt in 2013 – a volume not seen since 2008
when more than EUR 122 billion was issued. The demand could be explained by the
fact that the probability of default (PD) has come down (as a result of banks
having strengthened their balance sheets), offsetting the increase in the loss
given default (LGD) parameter of subordinated debt.
With regard to senior unsecured debt
has traditionally been the mainstay funding instrument for banks in wholesale
financial markets. Hence, it is critical that it retains its standing in
investors' minds. The demand pool has included banks as well as institutional
investors, such as insurers and pension funds. The latter have traditionally
had mandates requiring a minimum investment grade rating, which represents a
critical constraint for banks to keep tapping such demand. As pointed out by
IMF (2013), investor demand for senior debt critically depends on whether the
issuing banks maintain investment grade ratings. According to a 2013 investor
survey by JPMorgan, 34 % of investors in European bank debt would reduce
their investment in senior unsecured debt if it became a bail-in
instrument, while 63 % of them would maintain it as is. Survey
participants indicated that the most important factor determining their
decision would be whether the debt would still carry investor grade ratings.
Recent guidelines provided by rating agencies suggest that only issuers with
high stand-alone ratings would have investment grade senior bail-in debt. If
that is the case, the investor base for senior debt may shrink. Hitherto, more
than 90 % of the senior unsecured debt issued by banks has been investment
grade.
Finally, the Commission services performed
analyses regarding the impact bail-in and bail-in with depositor preference on
banks' costs and, in particular, to what extent the increase in the cost of
funding for a particular debt instrument translates into an increase in the
overall cost of funding for a bank and if it is fully absorbed by the decrease
in the cost of funding for other instruments. According to the European
Commission's BRRD impact assessment, some pass-through to lending rates could
indeed take place. However, the overall effect was limited with clear lower and
upper limits estimated at 5 to 15 basis points, respectively.
Building on the BRRD impact assessment and
on further evidence regarding the funding structure of 13 European banks
presented by Morgan Stanley, the Commission services further analysed the
extent to which depositor preference made a difference with respect to the above
conclusions. In particular, Commission services assumed that in case pari
passu between senior debt and deposits was kept, depositors would become
more selective after the crisis regarding their savings and raise questions on
the risk and reward trade-offs. Moreover, some depositors would move their
savings to other assets, given that they would no longer view deposits as safe
as they previously believed. Accordingly, the Commission estimated the increase
in return that depositors would require for maintaining their savings levels in
deposits at 190 basis points. In terms of implications for the overall bank
funding costs, this would translate into a cost increase equivalent of between
12 to 18 basis points.
6.4.5 The interaction
effects between different rules 
As with the benefits (where rules often
work to reinforce each other to deliver the overall objectives, see chapter 5),
the aggregate costs of the financial reforms will be different from the sum of
the stand-alone impacts. In particular, concerns have been raised that the many
different reforms taken together are overburdening banks (and other parts of
the financial system) and reduce banks' ability to lend to the economy. These
are important concerns that call for on-going review of the interaction between
different rules. It is, however, of note that the interaction effects do not
necessarily work to increase costs to banks and therefore do not necessarily
imply adverse repercussions for bank lending that are bigger than those
assessed if adding the stand-alone effects of the different rules. In fact, the
opposite can be the case.
For example, focusing on the capital and
liquidity requirements discussed above, these are necessary to discipline banks
to hold sufficient safety margins with respect to both capital and liquidity.
But the combined costs are less than the sum of the individual requirements.
Higher capital requirements generally help to meet liquidity requirements, and
vice versa. The instruments qualifying as capital under the CRD IV package have
long maturities and therefore do not carry with them any NSFR liquidity
requirements. Similarly, if banks improve their liquidity positions, e.g. by
switching into assets that are safer and more liquid, this will often have the
effect of helping to meet capital requirements, since these assets also carry
lower risk-weightings for capital purposes.
In an IMF study of the costs of financial
regulation of the different reforms affecting the banking sector, Elliot et al
(2012) conclude that "the interactions tend to ameliorate the costs of
each individual item. That is, the regulatory reforms provide a number of
incentives to move towards safer operations, so that creating higher safety
margins in one area will often automatically move a bank partway towards
greater safety by other measures, reducing the cost of adjustment in that other
area of regulation. Thus, the cumulative cost of the suite of regulatory
reforms is probably modestly less than the sum of the parts approach".
Specific concerns about interaction effects
have been raised regarding the interplay between bank capital and liquidity
requirements in the CRD IV package, the bank resolution proposals (BRRD) and
Solvency II. Other main areas of interaction (including criticisms of
inconsistencies between rules) are discussed further below, as they are not
specific to impacts on bank funding costs and bank lending capacities. 
The
interaction between the CRD IV package, the BRRD and Solvency II[51]
Insurance companies are the largest
institutional investors in Europe. They are also significant investors in the
securities issued by banks, in particular bank bonds. Given these (and other)[52]
interactions and the fact that both sectors are subject to a significant
overhaul of the prudential frameworks, concerns have been expressed about
potential adverse repercussions between the different sectors. More
specifically, it is claimed that Solvency II discourages insurers' investment
in bank bonds, especially debt of longer maturities[53] and that
this, in turn, conflicts with banks' requirements under the CRD IV package to
build up higher capital and liquidity buffers. [54] Moreover,
the bank resolution proposals and expectation of bail-in is seen to further
reduce the attractiveness of bank debt to insurers.  
The impact of Solvency II on insurers'
asset allocation is further discussed in section 6.5.1 below. A number of
studies are indeed critical of Solvency II and predict that insurers will
change their demand for debt issued by banks, shortening the maturity demanded
and focusing on the highest quality.[55]
However, these studies do not reflect some important adjustments to the
Solvency II framework. Moreover, there is other credible research refuting
these findings. 
Firstly, studies critical of Solvency II
assume that capital requirements are binding on insurers' behaviour. A study by
Höring (2013) compared the market risk requirements of the standard formula in
Solvency II to those of Standard & Poor's requirements for its rating model
for an A-rated company for a representative European life insurer. Höring found
that the rating agency model required 68 % more capital (even for a target
rating of BBB the capital required was 27 % more than the Standard Formula),
suggesting that the Solvency II standard formula will not impose any
additional constraints for most life insurers.
Secondly, many of the studies critical of
Solvency II are partial in that they focus on credit spread risk. They do not
take into account the interest rate risk charge (which captures the risk of mismatch
between the duration of assets and liabilities) and which gives incentives for
insurers to hold a matched portfolio where assets broadly match the generally
long maturity of insurance liabilities. The studies also do not allow for
diversification effects, which incentivises the holding of a diversified asset
portfolio, including securities issued by banks. 
Gorter and Bijlsma (2012) conclude that the
attractiveness of bank debt is not strongly affected by Solvency II, mainly
because what constitutes ‘long-term’ debt for banks tends to be shorter than
the ‘long term’ for insurers. Similarly, Zähres (2011) concludes that senior
bank bonds remain attractive for insurers. Insurers have revealed their
preference for short to medium-term bonds with maturities between 3 and 5
years, which coincides with banks' issuing preferences. Longer-term maturities
do not seem to be frequently chosen by banks. 
Therefore, Solvency II – especially
considering further adjustments as part of the long-term guarantee package (see
section 4.5 above and section 6.5.1 below) – does not appear to impose any
barriers to insurers' investments in bank debt. However,
the CRD IV package and BRRD are expected to lead to material changes in the
equity and debt issuance of banks, and this could affect the demand for such
instruments from insurers. In particular, BRRD introduces the possibility that
unsecured debt can be written down or converted if the supervisor deems the
institution failing or likely to fail, no reasonable prospect exists for
alternative private sector or supervisory measures, and resolution is in the
public interest. Bail-ins will introduce losses to senior unsecured
debt-holders while the issuer is still a going concern. 
In general, bonds that convert to equity
may not have attractive features for insurers, since income streams will be
less predictable. As already noted in the previous section, survey evidence
suggests that investors regard senior bail-in debt as an investible asset
class[56].
Also, the price of those bail-in bonds will be an important factor for insurers
(and other investors). If returns are attractive then insurers may be willing
to allocate assets not covering technical provisions or regulatory capital
requirements to these bonds to earn higher returns. A distinction needs to be
made for the behaviour of unit-linked investors, since in this case it is the
decision of policyholders rather than the insurer per se that matters for asset
allocation[57].
The returns available on these types of bail-inable bond may prove attractive,
particularly at a time of low interest rates.
There are various factors that will affect
the returns banks offer on their debt. For large banks that have benefited from
being perceived as 'too big to fail', then BRRD might change investors’
perception into not expecting the implicit subsidy, with the result that higher
returns are required for unsecured debt. As noted above, the reduced implicit
subsidy is a cost to the banks seeking to raise funds, but not a societal cost.
Moreover, the additional capital and liquidity requirements as per the CRD IV
package – and other measures to improve the resilience and stability of banks –
will reduce the risk of default from the investors’ perspective. Combined with
the prospect of improved recoveries compared to what they otherwise might have
been, this acts as an off-setting factor for increases in the cost of unsecured
debt. 
If insurers do not increase their
investments in bank debt (or reduce it for fear it will be bailed in), then
there is an open question of who would increase their holding of bank debt
(e.g. hedge funds, mutual funds, pension funds), and whether this is desirable.
Based on the above, however, it would seem premature to conclude that the
overall effect would be significantly negative and enhanced through adverse
interactions between Solvency II, the CRD IV package and the BRRD.  The
overall dynamics are complex and difficult to predict, which calls for
on-going monitoring (like with other parts of the reform). In any
case, the potential risks and related costs must be balanced against the
longer-term prospect of a banking system where funds are allocated more
efficiently to better managed institutions, as investors realise that there is
a more realistic prospect of large banks being allowed to fail. 
6.4.6 Summary of
quantitative estimates of the impact on bank lending
It is too early to give a final
assessment of how the regulatory reforms will
impact on bank funding costs and what this means for bank lending. Nonetheless,
a number of studies have aimed to predict the likely impact of different rules
on bank lending, using various modelling techniques.   
Elliot et al (2012), in an IMF paper,
consider the combined effect of higher capital and liquidity requirements,
derivatives reforms, and various other rules affecting the banking sector.[58]
The long-term estimates provided show that the average cost of bank lending
could rise by 18 bps in Europe.[59]
These results are similar to studies from the OECD and the Basel Committee of
Banking Supervisors. The OECD uses a macroeconomic model to translate the
credit spread increases into declines in expected growth, concluding that the
major economies' GDP would be about 0.16 % and for Europe 0.23 % lower after
five years.[60]
The LEI report of the BCBS estimated that a 1 percentage point increase in
capital requirements (with no change in liquidity ratios) would reduce the
long-run steady-state level of economic activity by 0.14 % annually for the
euro area and 0.2 % when the NSFR are also met.[61] 
The Macroeconomic Assessment Group (MAG)
(2010), established by the FSB and BCBS, estimated that bringing the global
common equity capital ratio to the agreed minimum level would result in a
maximum decline in the GDP level of 0.22 % after 35 quarters, relative to
baseline forecasts. This is followed by a recovery in GDP towards the baseline.
In terms of growth rates, annual growth would be 0.03 percentage points below
baseline for 35 quarters, followed by a period during which annual growth is
once again 0.03 percentage points higher. In other words, the potential
negative effects of higher capital requirements on GDP are temporary and are
later fully eliminated. These results also include the impact of spill-overs
across countries, reflecting the fact that many or most national banking
systems would be tightening capital levels at the same time. 
Whilst the actual impact could be greater
if banks attempt to meet the stronger requirements ahead of the regulatory
timetable, other factors not modelled by MAG might lead to an offsetting
impact. For example, banks have a number of options for responding to the
higher capital requirements, such as cost reduction or shifting their
portfolios towards safer assets, as discussed in section 6.3. This would
correspondingly reduce the need for higher loan spreads and/or lower lending
volumes, thereby reducing the assumed impact on real activity. 
Higher macroeconomic estimates are
reported in industry studies, such as the
industry-financed Institute of International Finance (IIF). IIF (2011) predicts
significant increases in the price of bank credit, which are estimated to
result in GDP levels that are 0.6 % lower in Europe by 2015 and 0.4 % by 2019
than would have been the case without the comprehensive financial reforms. This
study focuses on transition effects more than the long-term effects. Also, the
baseline against which changes are measured appears largely to reflect
pre-crisis capital and liquidity levels, meaning that much of the costs of
shifting to a more stable financial system are attributed to regulation even if
they are due to market-driven adjustment. In addition, the model may translate
too much of the cost increase to banks into higher lending rates for the
economy.[62] 

When interpreting the results of macroeconomic
cost studies, it is important to realise that the baseline forecasts do not
envisage any future financial crises – i.e. they only look at the costs and not
the benefits of reform. It is also important to understand that the models are
subject to significant modelling uncertainty. Also, the studies often assume a
fixed cost of equity and debt (criticised above), full variable cost
pass-through to clients (which applies only in fully competitive markets),
static balance sheet (i.e. unchanged loan demand at a higher cost level), and a
negative causal link between higher lending rates and economic growth via the
credit channel. As such, these modelling techniques do not fully reflect
the economic reality.
As regards especially the link between
lending rates and credit growth, whilst the positive link between investment
and economic growth is empirically well established, there is no conclusive
evidence that higher lending rates hurt economic growth in advanced
economies, even though they may slow down credit growth. For
example, econometric evidence by Shafik and Jalali (1991)[63] rejected the
view that high interest rates are associated with low economic growth in the
industrial countries. The 1980s saw a period of rapid growth in the world
economy that coincided with unprecedentedly high real interest rates. Other
authors[64]
have argued that the level of investment will be higher with increasing real
interest rates, because the resulting greater savings mobilisation eliminates
credit rationing. Higher interest rates may also be associated with rapid
economic growth due to improved resource allocation and more productive
investment. In other words, when interest rates are high, the projects face a
higher threshold of positive net present value (NPV) for obtaining credit. As a
result, only more productive projects will be financed, enhancing trend growth.
For example, when interest rates are high, there should be less demand for
housing loans and more real economy lending. 
Thus, any modelling approach is prone to
challenges and critique, because the results strongly depend on the chosen
methodology and often strong assumptions. Moreover, the models are not capable
of capturing all the expected effects and interactions[65], including
interactions between rules, and are constrained by data limitations. The
results, therefore, need to be interpreted with some caution. The same also
applies to the macroeconomic model applied for the purpose of this study, as
summarised in Box 6.4.1 below and explained in more detail in Annex 5.  
Box 6.4.1: Modelling the macroeconomic costs of
capital requirements, bail-in and resolution tools
The macroeconomic costs of new regulatory requirements
are estimated using a dynamic general equilibrium model QUEST III, developed by
the Commission services. In line with the estimations of benefits (see section
4.2.7 and annex 4), two scenarios are modelled: increasing minimum regulatory
capital requirements from 8 % (baseline) to 10.5 % of risk-weighted assets
(RWA) along with improvements in the quality of capital with (scenario 2) and
without (scenario 1) the additional tools of increased loss absorbency
(bail-in) and resolution funds. The transmission mechanism of the costs to the
real economic is solely through the lending channel. Details are contained in
annex 5.
There are two basic assumptions that underlie the
model. First, if the banks' funding costs increase because of regulation, these
costs are fully passed on to clients (such an assumption only holds true under
perfect competition and is hence a likely overestimation). Secondly, the degree
to which the Modigliani-Miller (MM) theorem holds is important for the impact
of increasing capital requirements on banks’ costs (see section 6.4.2 above).
Under the MM theorem, banks would be indifferent between using debt or equity
to fund their activities, as there is no optimal combination of the two for
firms (i.e. the WACC is invariant to the debt-equity funding mix).  When the MM
theorem holds in full (100 %), an increase in capital funding would be
completely offset by a fall in the equity and debt risk premium and overall
weighted funding costs would not change. Otherwise, the funding costs would
increase and could impact the economic activity through the extent of cost
pass-through to clients. 
In the most conservative approach, costs are estimated
by assuming that MM does not hold (0 % MM offset), i.e. the increase in capital
requirement is fully reflected in the increase of funding costs. This approach
follows the methodology employed in studies by the BCBS (LEI report of 2010 and
MAG 2010 study). Whilst no MM offset is a very strong assumption, there are
several good reasons to believe that the MM does not hold at 100 % in banking,
such as taxes and the existence of implicit subsidies. Therefore, the second
approach follows the Bank of England methodology (Miles et al (2013) and allows
for a 50 % pass-through to bank funding costs (i.e. 50 % MM offset).
The results reported below assume that all banks need
to increase their capital levels by 2.5 percentage points (i.e. from 8 % to
10.5 %), which tends to overestimate the costs. Annex 5 therefore also reports
results (showing lower costs) based on banks' 2012 capital levels (i.e.
allowing for capital buffers) and counting increases in capital from those
levels to meet the new requirement. 
Results in Table 1 show the impact of increasing
capital requirements, measured as the % deviation from the baseline for GDP and
investment. The impact on other variables, including lending rates, loan volumes,
employment and consumption are reported in annex 5. For example, with full cost
pass-through and under the 50 % MM offset, on average, bank lending rates
increase by some 13 bps on average in the long term, whilst the volume of loans
falls by 0.86 %. 
Focusing on the impact on GDP, assuming 50 % MM
offset, increasing capital requirements from 8 % to 10.5 % of RWA has a
negative impact on the level of GDP, which expressed as deviation from the
output trend amounts to 0.13 % of GDP per year in the long term. The costs
increase to 0.27 % under the more extreme assumption of zero MM offset (and
they are equal to nil under the assumption of a full MM offset). 
    
Table 2 reports the joint impact of capital
requirements and the additional BRRD tools of increasing loss absorbency
through bail-in and the introduction of a resolution fund. The long term
deviation from the output trend equals 0.34 % EU GDP per year when 50 % MM
offset is assumed. In the most conservative case, when no MM offset is assumed,
the costs are twice as high (and again zero if the full MM offset were to
apply). As noted above and presented in annex 5, costs are estimated to be
somewhat lower if the modelled adjustment in bank capital reflects banks'
existing capital buffers (and only counts changes from the existing capital
level in 2012 to the new required level).    
The gross cost estimates need to be seen and
interpreted in conjunction with gross benefits presented in section 4.2.7 (Box
4.2.6) to arrive at the net overall impact estimate, bearing in mind however
that the costs and benefits are estimated in quite different models and are
subject to significant modelling uncertainty.
6.5 Impact on
other sources of financing   
Restoring bank balance sheets and improving
banks' resilience is a key objective of the financial regulation agenda.
However, there is also a case for diversifying financing sources to reduce the
economy's dependence on bank lending. This would help strengthen the resilience
of the economy faced with future banking crises and, more generally, contribute
to financing of the EU economy. Concerns have been raised that the reform
programme may be impeding the provision of other sources of finance or
distorting the financial intermediation process in a way that increases the
costs of alternative financing sources. The following focuses on two sets of
alleged adverse effects:  

 The impact of  Solvency II on insurers' investment and asset allocation decisions
     (section 6.5.1);
 The impact of different regulations on
     market liquidity, which affects the financial
     intermediation process and ultimately the cost of raising finance in the
     market (section 6.5.2).

Other potential unintended consequences and
possible new risks of the financial regulation agenda are discussed further in chapter
7. 
While parts of the reform efforts are about
making the financial system more stable and resilient whilst minimising any
undue adverse effects on the financial intermediation process, regulatory
attention is, in fact, proactively promoting alternative sources of financing
for the economy. [66]

6.5.1 The impact of
Solvency II on insurers' investment and asset allocation decisions
Insurance companies are major institutional
investors in Europe. Given the often long-term nature of their liabilities, they
are particularly suited to make long-term investment and hence act as providers
of long-term financing to the economy.[67]
It has been argued that strengthening capital requirements as part of Solvency
II to capture all quantifiable risks, including market risk (which was not
considered in Solvency I), and the introduction of “artificial volatility” due
to market-consistent valuation may distort insurers' investment behaviour and
long-term asset allocation decisions.[68]

The introduction of risk-based capital
requirements entails an incentive to adjust asset allocation in favour of
assets with lower capital charges. For example, according to the standard
formula, charges are higher for equity instruments and, among debt instruments,
for debt with longer durations and lower credit ratings. Also, zero-risk
weights apply to sovereign debt issued in the EEA, which has also been
criticised in relation to bank capital requirements under the CRD IV package
and is a point that requires further analysis, especially in the context of
on-going sovereign debt problems and high public financing requirements.
However, the incentives for insurers to shift assets (e.g. from equity to debt,
from corporate to government bonds, or from short to long durations) is
unlikely to be as pronounced as a simple comparison of risk weights may
suggest.   
Critics often neglect the fact that Solvency
II removes the investment limits currently in place under Solvency I and
national provisions (in the form of restrictions on both the admissibility of
asset classes to cover technical provisions and quantitative limits on the
degree to which certain asset  classes can be held to cover technical
provisions). They are replaced by the "prudent person" principle,
which allows insurers to invest more freely, subject to the insurer properly
diversifying assets and limiting investments to those assets whose risks they
can truly understand and control. Hence, in principle, Solvency II frees up
insurers' asset allocation and makes possible investments that have
previously been constrained. 
The alleged undesirable results on asset
allocation are deduced from the implementation of the standard formula in
Solvency II. However, insurers can also develop internal models that might
mitigate some of the possible effects. 
Importantly, Solvency II aligns capital
requirements with investment risks. Thus, insurers will be incentivised to
weigh up the investment risks with the expected returns on all their assets.
Moreover, Solvency II recognises diversification effects, including on
investment risks, which should incentivise insurers to invest in several
classes of assets. 
As regards the potential disincentive to
invest in bonds of longer maturity, there is a trade-off between the higher
credit risk resulting from investing in long-term corporate bonds and the
mismatch resulting from investing in short-term corporate bonds to cover
long-term liabilities. For high-quality bonds covering long-term liabilities,
the incentive is still to invest in long-dated bonds. The incentive is reversed
for low credit-quality bonds, for which the credit-risk charges outweigh the
charges for a maturity mismatch between assets and liabilities. 
As regards equity investments, Solvency II
calibrations already take into account the role of insurers as long-term equity
investors, and calibration of capital charges for equity investments has
been adjusted. Detailed calibrations have also been conducted for other
asset classes and will be conducted going forward, so as to ensure that the new
regime, once it enters into force in 2016, will not unduly hinder long-term
investments (but also not artificially favour certain investments, especially
if they carry higher risk and deliver uncertain economic and social returns).
Moreover, there is a review clause which will require re-examining
the risk weights under the standard formula. 
Parts of the past literature on potential
adverse effects of Solvency II have been invalidated by the recent adjustments
put forward as part of the long-term guarantees package (see also section 4.5).
These adjustments mitigate the impact of short-term balance sheet volatility
stemming from spread risk and better reflect the long-term investment model of
insurers and their propensity to hold assets to maturity. They lessen in
particular the volatility of own funds for insurers underwriting certain
insurance products (e.g. annuities, other insurance products with long-term
guarantees). 
Importantly, the role of regulation
should not be overemphasised given the many other factors that influence
insurers' asset allocation decisions. This includes for example a repositioning
of investment portfolios in light of the financial and economic crisis. 
As already referred to in section 6.4.5
above, research by Höring (2013) shows that the market risk requirements of
Solvency II's standard formula would not bind for most life insurers. Instead,
rating agency models already tend to require higher capital than what is
required by Solvency II. 
Industry surveys confirm the relative
weight given by insurers to capital charges in determining their asset
allocations, and that major asset reallocations as a result of Solvency II
are not expected. For example, a survey conducted for BlackRock (2012)
shows that less than 10 % of responding EU insurers expected to decrease their
asset allocations to private equity and hedge funds upon the entry into force
of Solvency II. 32 % instead were positive that allocations to alternatives
would increase, in spite of comparatively higher capital charges. In another
survey conducted by ING Investment Management (2013), 49 % of the UK fund managers and financial intermediaries interviewed believed insurers have over the
past 12 months increased their exposure to new asset classes such as
infrastructure. When asked about the next three years, 77 % of those
interviewed said they expect insurers to increase their exposure to these new
asset classes.[69]
Allocation to alternatives has traditionally been low, both due to risk
aversion and limits imposed by pre-Solvency II regulation.  Interest in these
assets from life insurers is generally explained by the search for yield in a
low interest environment, the need to meet liabilities arising from legacy
products with high long-term guarantees as well as insurers' need to match long
duration liabilities. Other studies confirm that a reduction in equities and
alternative assets is not expected despite the higher capital charge they may
incur in Solvency II.[70]
In September 2012, the Commission asked the
European Insurance and Occupational Pensions Authority (EIOPA) to examine
whether the calibration and design of capital requirements necessitates any
adjustment, without jeopardising the prudential effectiveness of the regime,
particularly for investments in infrastructure, SMEs and social businesses
(including securitisation of debt serving these purposes). EIOPA recommended
criteria to define high-quality securitisation and a more favourable treatment
for such instruments.[71]
This is a major step in the wider agenda of fostering sustainable
securitisation markets (see section 7.6). The Commission will take the EIOPA
advice into account when formulating the relevant delegated acts for Solvency
II in the second half of 2014, including possible adjustments to the treatment
of assets classes other than securitisation (infrastructure, SMEs and social
businesses), as set out in the original mandate to EIOPA.
Furthermore, the Omnibus II directive[72]
will introduce measures into Solvency II which are specifically designed to
reinforce existing incentives to match long-term liabilities with long-term
assets and to hold these to maturity (the long-term guarantee package). The
list of assets eligible for the use of the matching adjustment has been
broadened to include key long-term investments such as infrastructure
project bonds.       
6.5.2 The impact of
regulations on market liquidity[73]
Liquid financial markets tend to exhibit a
number of desirable characteristics: [74]
·        
Tightness – i.e.
low transaction costs, such as the difference between buy and sell prices, like
bid-ask spreads in quote-driven markets, as well as implicit costs;
·        
Immediacy – i.e.
the speed with which the orders can be executed and settled, reflecting, among
other things, the efficiency of trading, clearing, and settlement systems;
·        
Depth – i.e. the
existence of a large number of orders, both above and below the price at which
the security trades at any given point of time;
·        
Breadth – i.e.
orders are both numerous and large in volume with minimal impact on prices; and
·        
Resiliency – i.e.
new orders flow quickly to correct order imbalances, which tend to move prices
away from what is warranted by fundamentals.
A natural consequence of the above is that
there is more than one way to measure liquidity, the most prevalent of
which have been: time to execution; trading volume; the number of active
participants; and the bid-ask spread.
Liquid financial markets have traditionally
been thought of as having high trading volumes, narrow bid-ask spreads, and the
ability to trade larger orders without significant price changes. Liquid
financial markets enable investors to buy and sell financial assets as and when
needed and at a fair value. Liquidity provides the opportunity to move in and
out of positions without difficulty. This does not only imply lower costs in
secondary markets where the assets are traded, but also lower costs of issuing
assets and raising external capital in primary markets. Additional benefits of
liquidity include the ability of market participants to liquidate positions as
needed and, particularly in the case of stressed markets, or a market
participant default. Further, liquidity allows market participants to price
contracts accurately and fairly, which allows them to manage risk credit and
market risk effectively. Therefore, liquidity is generally a highly
desirable characteristic of financial markets. In this context, concerns
have been expressed that the EU reforms of financial sector legislation act to
reduce market liquidity, with corresponding costs to the wider economy. 
One of the recent challenges to the
conventional theory and practice, explained also by the crisis experience, is
the idea that market liquidity can be illusory.[75] Such
beliefs can disguise the fragility of the financial system, and induce
investors to place excessive reliance on leverage to fund high-yield growth
activities. This can stretch liquidity in the system beyond its limits, so that
the system is unable to cope when an external shock occurs. Investors facing
large, leveraged losses retreat to safer markets, and markets previously
thought to be deep and resilient can dry up unexpectedly. One consequence of
liquidity illusion is that it may invalidate the conventional measures of
liquidity listed above because in a market suffering from liquidity illusion
these measures will reflect investors’ mistaken perceptions of liquidity. The
true level of liquidity of a market may be very difficult to detect.
Liquidity is likely to be beneficial
only up to a point. The additional benefits
derived, say, from algorithmic trading that exploits price divergences for a
fraction of a second must be minimal compared, say, to the benefits of having
equity and bond markets with reasonable day-to-day liquidity. Moreover, the
position-taking and speculation required to achieve greater liquidity can in
some markets be harmful and produce destabilising effects. Active trading can
be used by intermediaries to extract economic rents, by creating volatility in
the market against which customers then seek to protect themselves and pay for
the provision of market liquidity. In addition, trading on a proprietary basis
may present conflicts of interest between the trader and customers. Thus,
arguments that liquidity is generally desirable and that regulation restricting
liquidity is harmful need to be qualified. Regulation needs to strike the right
balance between the positive and negative effects, and this approach has been
followed in the EU financial regulation agenda. 
Impact of transparency requirements
One of the stated objectives of MiFID II is
to improve the price discovery process and achieve fair and efficient price
discovery, which is expected to have an overall positive impact on liquidity
(see section 4.3.1). However, one area where MiFID II has been criticised the
most for the potential impact on liquidity are the transparency requirements
for non-equities.[76] The other area relates to restrictions of high-frequency trading,
which are discussed separately below. 
Industry concerns have mainly focused on pre-trade
transparency requirements, in particular requirements that all requested
quotes must be firm and once a firm quote is provided to one client, it must be
universally executable for all clients. Critics argue that too much
transparency would have detrimental effects on liquidity as dealers would be
more reluctant to commit capital if their quotes or trades are firm and
displayed in public, so that the market may turn against them. More
specifically, it is argued that dealers need to be able to provide specific
quotes depending on the product, the order size and the settlement risk, so as
to effectively hedge their subsequent risk. Without this information, the
dealer would face uncertainty and would either widen the quote or step away
from the market entirely, impacting on all market participants. Also, it is
argued that transparency compromises the ability of the dealer to hedge the
position as information is leaked to other dealers who may take up contrarian
market positions. Overall, this combination of higher risk and increased
hedging costs is argued to lead to lower yields for investors and push up the
cost for issuers. While a number of studies raise these concerns, there does
not seem to be any empirical evidence to substantiate (or refute) the
significance of these concerns.[77]

As regards post-trade transparency
requirements, the main concern also relates to hedging positions, with
industry asking for delays in reporting (especially on large transactions) to
allow dealers sufficient time to hedge their positions. If not, dealers would
be exposed to the market (e.g. competitors can take contrarian positions),
which may discourage them from providing liquidity, in particular, in relation
to larger transaction of less frequently traded instruments. However, no
negative impact on liquidity has been found in empirical studies. These are
mainly studies that examine the implementation of post-trade transparency
requirements in the USA.[78]
The need to balance transparency and
market liquidity is acknowledged in the MiFID II proposals.
Correspondingly, they were drafted to ensure proportionality in the
transparency requirements to mitigate these risks. In particular, there has
been recognition of the need to properly calibrate transparency requirements
for non-equities. Also, special rules and exemptions (e.g. for large trade
orders) are applied to accommodate and maintain liquidity in non-equity
markets.  
Restrictions on high-frequency
trading (HFT)
HFT or any other type of algorithmic
trading can have beneficial effects on market liquidity.[79]
Correspondingly, any restrictions on HFT would then reduce market liquidity.
However, it can also be argued that the provision of
additional liquidity through HFT is more limited in practice (and ever faster
trading frequencies may result in declining benefits and indeed have adverse
effects[80]),
and that HF traders can take liquidity from, rather than provide it to,
long-term investors, particularly at times when liquidity is already low and
the market is under stress. Data limitations make a final assessment difficult.
Even restrictions on HFT have the
potential to adversely impact liquidity in theory, the HFT proposals in MiFID
II are unlikely to have such impacts. The main
provision is a requirement for HF traders to provide continuous liquidity,
similar to the conditions that apply to market makers. The objective is to
ensure that HF traders provide liquidity at all times, not just when markets
are liquid but also in more stressed market conditions, so as to mitigate
episodes of high uncertainty and volatility. Thus, the provision is in fact
intended to improve liquidity.
Nonetheless, the provision could impose
significant additional risks for HFT if the requirement is interpreted to mean
that, at all times the market is open, the HF trader has to offer to buy and
sell a security across a spread that reflects the usual spread for that
security. This could have the effect of making HFT non-viable and too risky,
potentially resulting in such trading to return to manual trading (with adverse
consequences on trading costs and liquidity). However, any HFT sequence
algorithm is likely to be adjusted such that it will display firm bid and
offers at competitive prices under normal market conditions, and to widen the
spread offered or withdraw from the market under more distressed market
conditions where bid and offers across a narrow spread become too risky (as is
currently allowed for traditional market-makers), such that trades may actually
rarely be executed in those conditions and hence risks for HF traders
minimised. Thus, the rule on continuous liquidity provision for HFT is unlikely
to have an adverse impact on liquidity. At the same time, it may however also
not achieve the desired objective of improving liquidity and reducing
volatility.[81]

Restrictions on short-selling
In December 2013, the Commission adopted a
report on the evaluation of the Short-Selling Regulation,[82] which took
into account technical advice by ESMA.[83]
Overall, the Commission report concluded that the SSR has had some
beneficial effects on volatility, mixed effects on liquidity and led to a
slight decrease in price discovery. The introduction of restrictions on
uncovered short sales in shares and sovereign debt has had the intended impact
of improved settlement discipline. While ESMA's technical advice suggests that
the introduction of the Regulation was followed by a decline in quantities
available for loan on the securities lending market, it also concludes that
this recovered after January 2013. Another analysis by ESMA showed that between
June 2012 and June 2013, the value of equities on loan actually increased by
more than 10 % when adjusting for seasonality[84].

Some concerns were raised by market
participants that increased transparency of short-selling activities
could adversely affect market liquidity. According to these concerns, traders
could seek to counter herding behaviour by trying to limit their short-selling
activities, so that they do not exceed the regulatory thresholds, thereby
harming market liquidity. Although the SSR has set rather high thresholds and
provided for a market-making exemption to address these concerns, ESMA's
analysis of net short positions in shares reported to competent authorities and
disclosed to the public suggests that the data may indicate reluctance from
some market participants to disclose their short positions to the public.
At this stage, the ban on uncovered
sovereign CDS transactions seems to have had no impact on the liquidity of
EU single name CDS, as well as on the related sovereign bonds markets, even
though a decline in activity for sovereign CDS in a few EU countries and
reduced liquidity in European sovereign CDS indices could be noticed. The
Commission noted in its evaluation of the SSR that no Member State has so far
used the possibility granted in the SSR to suspend restrictions on naked
sovereign CDS in the event of an adverse impact on liquidity. In its technical
advice, ESMA suggested that higher legal certainty should be pursued by
clarifying some wording in the legal text (e.g. on the correlation test) and
that some refinements to the detailed provisions could be envisaged:
e.g. the use of sovereign CDS indices for hedging purposes, cross-border
hedging under certain liquidity and correlation circumstances, and group
hedging by a particular and dedicated entity.
Mixed market impacts have been noticed in
relation to the longer-term emergency measures introduced by some EU countries
at the height of the financial crisis. Concerning the possibility to impose
restrictions on short-selling introduced by the SSR, ESMA considers that such
measures are necessary and appropriate. However, no clear conclusion could be
drawn as to their effectiveness on the basis of the few concrete experiences of
short-term bans imposed in case of a significant fall in the price of a
financial instrument. 
According to ZEW (2011), temporary
restrictions on short-selling do not harm market efficiency due to their
transitory nature, but they cannot stop a downward spiral when problems are due
to reasons other than temporary uncertainty. Cliftong and Snape (2008) argue
that constraints on short-selling reduce informational efficiency of the market
by inhibiting downward price discovery, and increase the likelihood of
volatility and discrete price drops. Their empirical analysis shows significant
negative effects on market liquidity of a ban lasting several months.[85]
A study of the European short-sale ban on
financial stocks of August 2011 by Félix et al (2013)[86] finds that the
current format of short sale bans serves the intended purpose, though at a cost.
The bans restrict further selling pressures on selected financial shares, both
in the spot and in the derivatives market. At the same time, the short-selling
ban allows market participants to continue trading in the equity index
derivatives markets. Although a degree of market failure is documented, their
results show that the index option markets continue to function, while
financial sector stability seems to benefit from the bans. During the ban
period, the trading volume of stock put options for the banned stocks declined
due to the reluctance of market makers, as they become more risk averse and as
hedging costs increased. As a consequence, speculators are prevented from
betting on further declines in financial stocks, as the out-of-the-money single
stock put options become too expensive. Thus, the European 2011 short-selling
ban helped curbing synthetic shorting activity in financial stock and reduced
the risk of bank runs. 
In contrast, holders of financial stocks
trying to hedge their positions are no longer able to do so without paying a
higher price. As a result, the short-selling ban transfers wealth from the
hedgers and other liquidity takers to liquidity providers. Moreover, the shift
in investors’ risk aversion provoked by the ban could have acted as a
reinforcing loop of the crisis. While the short-selling ban is effective in
restricting both outright and synthetic shorts (e.g., through options) on
banned stocks, the authors found some evidence of trading migration to the
index option market. Trading volumes in puts on the EuroStoxx50 index reached
an extreme level upon introduction of the short-selling ban. Investors seemed
to switch from single stock puts to index puts because of valuation and
“flight-to-liquidity” incentives. This migration of selling pressures from
financial stocks to European equity indices does not seem to jeopardise the
efficacy of the short sale ban. The selling pressure is diverted from the
financial stocks to a larger share of the stock market, thereby potentially
reducing the destabilising effects in the financial sector such as bank runs
and financial contagion.
Concerning sovereign CDS, some studies such
as Criado et al (2010) provided no conclusive evidence of a link between CDS market
developments and higher sovereign funding costs. However, others such as
Delatte et al (2011) conclude that at least in distressed markets, sovereign
CDS become a bear market instrument to speculate against the deteriorating
conditions of sovereigns. While credit spreads for average firms do not seem to
be affected by the CDS market, CDS spreads for opaque and risky firms exhibit
an increasing effect on funding costs.[87]
The corporate CDS market is more liquid than the underlying one and, therefore,
reacts faster to new information. The deterioration in the informational value
of CDS spreads could impact negatively on the objective to reduce reliance on
credit agency ratings. Furthermore, it may be easy to circumvent the new regime
as traders could short-sell sovereign bonds using options and futures instead.
Survey evidence suggests that the targeted
short-selling ban contained in the Regulation is not widely perceived as having
a detrimental impact on the market. Only 13 % of financial exerts surveyed
by ZEW (2011) viewed the ban as detrimental, compared with 65 % of
respondents who stated that the Regulation would enhance financial stability.
Impact of bank structural (and other)
reforms on market-making and liquidity
One of the functions which banks and
investment banks perform in the market is to trade and thus provide liquidity,
enabling end-investors and other market users to buy and sell at reasonably low
bid-ask spreads. The market-making function is of particular importance in markets that tend to be less liquid and
rely on market makers to act as willing buyers and sellers.
Tighter capital requirements on banks'
trading books provide incentives to reduce trading risk exposures. Any
reduction in trading could reduce liquidity in the market. However, any
reduction in liquidity provision that was, in fact, associated with underpriced
risks and excessive risk-taking by banks may not be a societal cost, but rather
a societal benefit. More generally, as noted above, not all liquidity
serves a useful economic purpose and, from a social impact point of view, it
may be better to forgo liquidity in some cases where this would otherwise come
with excessive risks.
Concerns about liquidity impacts have also
been expressed in relation to bank structural reform, in particular, if
market-making is among the bank activities that can be placed – under certain
circumstances and depending on the supervisory assessment - into a subsidiary
that is separate from the deposit-taking bank. “Liquidity” is often left
undefined, but typically the fear is that bid-ask spreads may increase,
increasing the costs to trade at any scale. Investor options will be reduced,
as trading entities can no longer trade as much and as easily as before. Price
discovery is made more difficult. And price volatility may increase, if
professional position takers no longer spot price divergences from rational
levels and correct them through trading and speculation. However, many
concerns about the liquidity impacts of bank structural reform can be rebutted:[88]

The USA has 80 years of continuous
experience with subsidiarisation of investment banking activities (including
market making, underwriting), as deposit taking affiliates within a Bank
Holding Company are not allowed to do other than “core banking activities”.
There is no evidence to suggest that US bond markets are less liquid than
European ones and have been constrained in their development, on the contrary.
Even in the era when Glass-Steagall Act (the US legislation separating
investment banking from commercial banking) was in place, the US economy has on average been thriving, compared to the current juncture.[89]
Markets need a large number of independent
traders to function properly. Subsidiarisation of market-making deprives
trading entities of access to funds that are artificially cheap because of
implicit subsidies, forcing them to limit their size and the size of their bets
and ensuring fair competition across stand-alone investment banks and
investment banking arms within universal banking groups. These limitations may,
in fact, increase the number of market participants, which may contribute to
making markets more liquid. 
The market liquidity concern neglects the
fact that structural separation merely aims to reduce the implicit subsidies that
distort the proper market functioning. Market prices are distorted when
contaminated with implicit public subsidies. As a result, the banking system
may produce excess liquidity (as is evident from its rapid and unsustainable
expansion in the years leading up to the crisis). Separating market-making from
the deposit entity will reduce excessive risk-taking and artificial balance
sheet expansion. While the funding costs of the trading entity will
increase, it may lower the funding cost for the deposit entity, which is
exposed to less risk under subsidiarisation.
Bid-ask spreads on sovereign bonds of many
EU countries as well as on large corporates were already at negligible levels
before broker-dealer arms of universal banks started to sharply increase their
inventories and market-making activities in the early years 2000. For example,
bid-ask spreads on German Bund paper have not decreased in the run-up to the
crisis, in which large European banks have sharply increased their inventories.

 Chart 6..5.1: Nominal outstanding securities (excl. shares) in the euro area 
 Source: ECB data. 
In any case, the bulk of the securities
inventories do not correspond to sovereign or corporate debt, but rather to
securities issued by financial firms. Only a small fraction (6.5 % at end 2013)
of the outstanding securities in the euro area has been issued by non-financial
private issuers (chart 6.5.1). A similar observation holds for OTC derivatives,
of which only a small fraction have non-financial firms as counterparts. The
bulk of OTC derivatives are intra-financial sector derivatives. In the US, primary dealer corporate bond inventories have surged between 2000 and 2008 and have
collapsed again back to 2002 levels. 
What matters for the economy is the level
of the interest rate, at which corporates and sovereigns can fund themselves,
which is a function of the supply and demand for these securities, and whether
bid-ask spreads are reasonable to allow a normal degree of trading
transactions. The liquidity premium only makes up a negligible fraction of
the interest rate level and reflects the extent to which the security can
be exchanged. Hence, the value added of the ability to purchase and sell a
security 1000 times every minute is economically insignificant. As noted above,
the liquidity concern is built on the presumption that more liquidity is always
and inherently positive, irrespective of its level, which is not the case. 
Financial economics does not have a good
explanation yet on why people trade so much. One explanation is overconfidence,
as in Odean (1999). Recent work presents models in which trading and trading
speed can be excessive (Glode, Green, and Lowery (2012) and Bolton, Santos, and Scheinkman (2012)). In these models, advances in IT do not necessarily improve
the efficiency of financial markets. French (2008) estimates that investors
spend 0.67 % of asset value trying (in vain on average, by definition) to beat
the market.
The market liquidity concern should be put
into perspective. Richardson (2013) notes that the issue of liquidity is
more relevant in times of crisis than in normal times when liquidity is
typically not a pressing concern. Banks have not performed a significant
liquidity role during crisis period,[90]
and central banks have stepped in to assume the role of market maker of last
resort (in covered bond markets, government bond markets) next to their
role as lender of last resort. 
Bid-ask spreads are relatively
negligible compared to the interest rate level. For
example, as shown in charts 6.5.3 and 6.5.4, 10 year Spanish government bond
yields have more than doubled and increased from less than 3.5 % in June 2006
to more than 7.5 % in July 2012. Bid-ask spreads in the period June 2006 to
August 2013 on average are 2bp (0.02 %) and spiked at 12bp (0.12 %) in June
2012. The above suggests that the willingness and ability of (private
sector) market makers to influence the interest rate level is relatively
limited. If anything, their pro-cyclical behaviour and excessive liquidity
provision can sow the seeds of future crises.
 Chart 6.5.2: Yield to maturity of 10-year Spanish government bonds || Chart 6.5.3: Bid-Ask spreads of 10-year Spanish government bonds 
 || 
 Source: Bloomberg data || Source: Bloomberg data 
Moreover, the structural reform as proposed
by the Commission in January 2014 is only aimed at the large banking groups
with significant trading activities. Medium-sized competitors or new entrants
that are not subject to mandatory separation may gain market share from large
banking groups, if artificial competition distortions in favour of too-big-to
fail banking groups are being reduced. Hence, whereas some banking groups may
face increased costs and may no longer serve certain customers, those
activities may be picked up by smaller competitors that do not face structural
separation requirements. Accordingly, customers are not likely to be left
unserved.
Finally, under a subsidiarisation model,
market-making would not be prohibited within a banking group. Depending on the
supervisory assessment, it may just need to be performed by a legally separate
trading entity. The resulting increase in the funding cost for the trading
entity is part of the desired effects of the separation. Market making is a
financially viable activity on its own, as illustrated by the fact that several
important market makers are not taking any deposits. The Commission's reform
proposal only requires the full separation of proprietary trading activities
from deposit-taking entities. Customer-related market making is not
prohibited and only subject to a subsidiarisation requirement, unless the
relevant bank has limited trading activities or can show – to the satisfaction
of its supervisors – that this is not required. 
6.6
Impact on risk transfer and risk management  
In addition to financial intermediation and
facilitating the flow of finance to the economy, the financial system has the
key function of facilitating risk transfer and risk management in the wider
economy. The following examines the potential impact of the reforms with
respect to the risk transfer function, including: 

 Provision of insurance services (life or non-life) which enables households, businesses and
     the public sector to reduce their exposure to risk and purchase protection
     from insurance companies, and 
 Creation of markets in derivatives
     instruments, e.g. in interest rates, foreign
     exchange and commodities, that allow the hedging of risks.  

6.6.1 Impact on insurance
provision
Solvency II is not intended to result in a
general increase in the capitalisation of the EU insurance sector (unlike the
CRD IV package in banking), but to make the capital requirements risk-based.
Indeed, the significant majority of insurance entities are not expected to
raise capital because of Solvency II. This was demonstrated by the fifth
and last quantitative impact study (QIS5)[91]
before the introduction of Solvency II. Based on a sample of 2 520 insurance
companies, QIS5 showed that most of them have sufficient capital (own funds) to
cover the new solvency requirements, and the industry average showed a
comfortable solvency capital ratio (SCR) of 165 % for the participating
institutions. This is in spite of the fact that the aggregate capital surplus
is roughly 25 % lower than under the current regulation.  
Subsequent analysis, conducted by EIOPA as
part of the long-term guarantees assessment, showed that in the baseline
scenario tested, life insurers had an aggregate deficit of EUR 145 billion
relative to the SCR at the end
of 2011, when credit markets were particularly volatile. However, the adjustments
proposed as part of the long-term guarantee package address the artificial
balance sheet volatility that was observed in periods of market stress
under the baseline methodology for the long-term guarantees assessment. 
Nonetheless, there may be effects on some
types of products which see increased capital charges to better reflect the
risks. Life products with guarantees are expected to become more expensive,
with the implication that consumers will be offered the choice of higher cost
guarantees or increased risk-bearing through unit-linked products.[92]
Some insurers may be withdrawing from long-term guarantee products if customers
are not prepared to pay the increased (but risk-reflective) costs of guarantees,
or they may be able to offer products with conditional guarantees, where the
guaranteed return is linked to the market interest rate rather than fixed. 
The increase in the price of guaranteed
products is a reflection of the higher economic costs of providing these products. Policyholders have to either pay for
shifting the risks to insurers or buy a cheaper product, but bear more risk.
These changes are a direct consequence of moving to a more risk-reflective
system. 
6.6.2 Impact on hedging
risks with derivatives[93]
A common criticism of the OTC
derivatives reforms (EMIR) has been the assertion that it would make
hedging idiosyncratic risks more costly. To the extent that EMIR helps correct
the mispricing of risk that occurred prior to the crisis (e.g. in the form of
inappropriate margining practices), its implementation may lead to an
increase in the price of hedging. The precise magnitude of this increase is
unknown, but it is not expected to be excessive. Moreover, the market players
on the demand side may find that the cost of imperfect hedging is smaller than
the pre-crisis cost of perfect hedging due to the low level of competitive
pressures in the bilaterally cleared universe. As a result, they may end up
being better off using an imperfect, but centrally cleared hedge.
Notwithstanding these aspects, efforts have been taken to minimise any
potential negative effects on the economy and to ensure gradual transition to
the new clearing environment. 
For example, pension funds enjoy
specific exemptions from mandatory clearing. Some funds make extensive use
of OTC derivatives to hedge their liabilities against inflation, currency and
interest rate risk. Pension scheme operators have the objective of minimising
their cash positions to maximise the efficiency and long-term returns, holding
higher yielding investments, such as securities. At the same time, CCPs accept
only cash as variation margin. Thus, a move to central clearing could
necessitate pension funds to set aside additional cash reserves. This involves
opportunity costs because of the low level of interest that is currently earned
on cash collateral. 
To reduce the potential negative impact of
the central clearing requirement on retirement income, it has been agreed under
EMIR to exempt pension funds from the central clearing obligation as regards
OTC derivatives contracts that are objectively measurable as contributing to
lower investment risks. In other words, trades that are done for hedging
purposes are exempted for funds that are recognised as an eligible pension type
under EU legislation. This exemption is currently valid for a period of three
years, with a possible extension for another three years. During this period,
OTC derivative contracts entered into by pension funds for hedging purposes will
be subject to reporting and bilateral collateralisation requirements.
In addition, certain exemptions apply for
non-financial counterparties. They are exempt from central clearing as long
as they do not engage in non-hedging activities in the separate OTC derivatives
asset classes that exceed a specific threshold: set at EUR 3 billion for
interest rate, foreign exchange and commodity derivatives’ classes, and EUR 1
billion for credit and equity derivatives. This was done specifically to limit
any potentially adverse consequences on the real economy. Moreover, the more
stringent margining requirements apply to new trades only. 
As regards the macroeconomic impacts of
derivatives reform, the Macroeconomic Assessment Group on Derivatives (MAGD) of
the BCBS estimated that the gross macroeconomic costs of OTC derivatives
regulatory reforms would range between 0.03 % and 0.07 % of annual GDP,
depending on the assumptions relating to the netting benefits. At the same
time, the estimated gross benefits from OTC derivatives reforms are 0.16 % of
annual GDP and hence exceed these costs more than twofold (see also section
4.3.2).
Finally, there have also been concerns
about the introduction of position limits under MiFID II
impacting on the ability of commercial market participants to hedge their
positions. These concerns have been addressed through an exemption from the
position limits regime for ‘bona fide’ hedging by commercial market
participants. Thus, position limits will not apply to positions held by or on
behalf of a non-financial entity and which are objectively measurable as
reducing risks directly related to the commercial activity of that
non-financial entity.
Chapter 7: Addressing new
risks and potential unintended consequences of the Reforms
Concerns have been
expressed that the rules intended to increase the resilience and stability of
the financial system may in fact create new risks elsewhere in the system or
create unintended consequences if unaddressed. This chapter addresses the
following main potential concerns: 
·        
regulatory arbitrage and potential shift of
activities to less regulated sectors (section 7.1); 
·        
risk concentration at the level of market
infrastructures, in particular CCPs (7.2); 
·        
risks in collateral markets (7.3); 
·        
asset encumbrance in financial institutions'
balance sheets (7.4); and
·        
risks of disorderly deleveraging (7.5).  
The chapter also discusses potential
unintended consequences in relation to developments in securitisation markets
(7.6), competition (7.7), EU competitiveness (7.8), the need for consistent
rules at EU and global level (7.9), potential tensions between Banking Union
and the single market (7.10), the complexity of the regulatory system (7.11)
and potential inconsistencies in the legislations (7.12). Overall, these new
risks and potential unintended consequences 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.
7.1 Regulatory arbitrage and shift of activities to
less regulated sectors
Financial institutions may respond to the
financial reforms by changing their behaviour to avoid or mitigate
requirements. There are a number of ways in which industry may respond to
circumvent the rules: through financial engineering (deploying new products to
sidestep regulatory rules); through supervisory arbitrage, by shifting activity
across jurisdictions (i.e. depending on how strictly prudential supervision is
exercised); and by shifting activities to less regulated parts of the financial
system. If done on a large scale, this would render the reforms less effective.
New risks would start building up that would need to be managed and evaluated. 
Regulatory arbitrage through financial
engineering
Financial engineering can be used by
financial institutions or agents to structure activities or products in ways to
"game" the system to avoid the intended effects of the regulatory
reforms and thereby reduce private costs.[94] 
If financial institutions respond to
regulations by engaging in financial engineering to meet the new regulatory
requirements, this can create new risks. For example, in response to higher
liquidity requirements, banks may look to access the liquidity embedded within
asset portfolios held by insurers or fund managers, through so called liquidity
swaps, or collateral upgrade transactions. These trades allow the borrower to
exchange poorer quality assets (e.g. illiquid or less liquid assets or low
credit quality assets) for better quality assets (e.g. liquid or higher credit
quality assets) in return for a fee. In principle, such transactions can have a
role in facilitating temporary transfers of liquid assets to financial
institutions that need them (e.g. banks), whilst at the same time providing the
lending firms (e.g. insurers or fund managers) with secured exposures and
potentially enhanced yield. However, any significant increase in such
activities in response to regulation could create new risks in the system: increased
interconnectedness between banks and insurers and fund managers; possible
increased pro-cyclicality of lending and asset prices (depending on the type
and structure of the collateral arrangements); and concerns about whether using
borrowed assets to meet liquidity requirements offers sufficiently resilient
liquidity benefits in times of stress.[95] Market pressures and the expected liquidity rules have created some
initial demand from banks for liquidity swaps. Similarly, opportunities to
enhance returns on assets also drew interest from insurers. To date, however,
the market remains small.[96] Nonetheless, it is worth watching this development.
Regulators and supervisors face the
challenge of keeping track of new financial products and techniques, which of
course may be developed with good intentions, but which may also allow
financial institutions to circumvent regulations and create new risks to the
system. Ongoing monitoring and review is required to ensure that regulatory
arbitrage does not undermine the effectiveness of regulation.
Regulatory
arbitrage through supervisory arbitrage
Separately, there may be risks of
supervisory arbitrage. This refers to the shifting of certain activities or
positions to other jurisdictions to avoid a situation of relatively more strict
prudential supervision by one set of supervisors compared to another, or to
avoid supervision altogether. 
There is always a tension between rules and
discretion. It would have been possible to completely eliminate such
arbitrage by implementing a large number of strict and uniform rules. However,
this would have then led to significant difficulties in areas where some
discretion is clearly needed. The crisis demonstrated a "tick box approach
to supervision" was inadequate (some banks "produced"
satisfactory indicators shortly before their collapse). It is impossible to
write down a complete (or even adequate) set of binding rules on the financial
health of a bank (or on the substance of the professional competence of
bankers). Policymakers learnt the importance of giving supervisors sufficient
room for subjective discretion in decision-making. There are other examples
where carefully constrained regulatory discretion is clearly desirable, for
example in determining the trigger for bank resolution, where a strict
rule-based trigger could prove counterproductive. At the same time, full
discretion is also not desirable, as it can lead to legal and market
uncertainties and potential divergences in implementation and application of
the rules by different national regulators (see also section 7.9).
Clearly, cooperation between regulators
and supervisors, across borders and across sectors, is an important
prerequisite to any attempt to suppress supervisory arbitrage. The
harmonisation of EU rules, including the single rulebook and the establishment
of the ESAs with their mandate for contributing to supervisory convergence
should help subdue supervisory arbitrage opportunities within the single market.
Furthermore, the establishment of a single supervisor (ECB) as part of the SSM is
a step change for Member States participating in the Banking Union that will
ensure the consistent and objective application of the regulatory framework for
the prudential supervision of banks.
However, opportunities for supervisory
arbitrage may still be apparent as long as the single market for financial
services remains incomplete and national discretion in decision-making
exists. The aim is not necessarily for a full rule book and no discretion. National
supervisors are likely to have more expertise on their specific financial
sectors, and so will always play a fundamental rule. Indeed, the design of the
SSM was calibrated to utilise the local in-depth knowledge of national
regulators. The ECB will focus on the most significant institutions, while
national supervisors will, under the general guidance of the ECB, be in charge
for the day to day supervision of less significant institutions. 
The Commission recognises the need for both
discretion and rules in the reforms, and has tried to strike a balance between
providing clarity and consistency, without choking financial innovation and
impinging on the freedoms on which the EU Treaties are established (e.g. to
locate or conduct business anywhere in the EU).
Potential for risks to be shifted to
less regulated parts of the financial system
The regulatory reforms have aimed to
directly address key failings identified in the financial system as a result of
the financial crisis. The measures have necessarily focused on fixing risks in
specific segments of the financial system. There is a danger that in pursuit of
the reduction of overall systemic risks new risks may be created in other parts
of the system. 
In particular, the regulations in response
to the recent crisis have tended to focus more on the formal banking sector,
rather than the non-bank credit intermediaries (some of which are part of the "shadow
banking" sector). For example, imposing tighter regulatory requirements
on banks may incentivise the migration of some activities out of the banking
sector altogether towards non-bank credit intermediaries. However, this
should not be interpreted as an adverse development per se. Rather, a move of
finance towards non-banks reflects a move away from bank-based towards market-based
finance and thereby helps diversify the funding opportunities for European
businesses. Of course, it can also bring risks, especially if regulators and supervisors
lack information about "shadow banking" activities and have fewer
tools to effectively monitor risk and intervene as required. 
However, this does not so much constitute
an argument against tighter banking regulation. Rather, it highlights the
importance of strong oversight and adequate supervision on all parts of the
financial system and, where required, stronger rules and supervision for
the shadow banking sector. As discussed in section 4.4, work in the area of
shadow banking continues at EU and international level.
7.2 Concentration of risks in central counterparties
Robust financial market infrastructures
make an essential contribution to financial stability by reducing what could
otherwise be a major source of systemic risk. As explained in chapter 4.3, CCPs
will become a critical market infrastructure of the new financial system. As part
of the move to CCP clearing of derivative contracts, counterparty risks will
shift from banks (and other relevant financial entities) to CCPs. It is
therefore important that CCPs do not themselves become a source of systemic
risk.[97]
CCPs were not originally designed as
macro-prudential institutions with a responsibility of improving the safety and
soundness of the broader financial system[98]. However, as the derivatives markets grew, some CCPs have become
sufficiently large and interconnected to be systemically important. This
systemic importance is likely to increase as a result of EMIR mandating the
central clearing of OTC derivatives contracts. The economies of scale (due to
netting and diversification benefits) attached to central clearing favours the use
of a small number of large CCPs. The financial resources of CCPs are not
unlimited. One sufficiently severe shock (or a collection of multiple defaults
of clearing members) could potentially threaten their solvency. Their financial
soundness is therefore essential to ensuring the stability of the entire
financial system.
A CCP default would typically follow
unforeseen losses as a result of simultaneous default of several of its
members. The trigger could be either from a member's insolvency, or its insufficient
liquidity to meet a margin (or delivery) settlement obligation. The subsequent
knock-on effects could be quite far-reaching. ESRB (2013) suggests that the
risk concentration within clearing members themselves would build up due to the
need for indirect access to CCPs. In addition, the large banking groups tend to
exhibit significant overlaps across many CCP memberships. Thus, a significant
cross section of CCPs and their members could be affected by a globally
systemic event. To address the potential contagion risks between CCPs as
a result of interoperability arrangements, EMIR specifically requires CCPs to
identify and manage the risks arising from such arrangements. It also provides
for these arrangements to be assessed and approved by the competent
authorities. 
If the defaulter‘s margin with the CCP is
insufficient to cover its obligation, the CCP would have to call upon other
financial resources, including its equity and default fund and its ability to
call on additional capital contributions by members. If all of these resources
are exhausted as a result of the member default(s), the CCP would default on
its obligations to other members and their clients. Failure of a large CCP
would possibly result in spreading financial contagion, as all major financial
institutions will be interconnected via direct and indirect linkages to CCPs. 
As noted above, a CCP could also default
due to a lack of liquidity. Just like other financial intermediaries, CCPs are
potentially susceptible to ‘runs’ due to a loss of confidence in their
solvency. This could create a liquidity shock for the CCP as it attempts to
return collateral. For instance, in the event of a member default, the CCP is
obligated to make a timely payment to those owed variation margin payments. This
will require the CCP to liquidate the defaulter‘s collateral, and perhaps some
of its own assets. The CCP may also attempt to borrow to meet its obligations.
If such collateral sales and borrowings occur during stressed market conditions
(which is when a large member default is most likely), the CCP may be unable to
raise sufficient funds to meet its obligations in the short time available to
do so.
Indeed, the nature of CCPs makes them most
vulnerable to default in times when their resilience is most needed. The
financial condition of the CCP is weakest at the time its financial obligations
are greatest (i.e. they are susceptible to "wrong-way" risk).[99] 
EMIR explicitly recognises this problem and
requires that margin requirements, haircuts and collateral eligibility all take
wrong-way risk explicitly into account. Wrong-way risk is also to be accounted
for during CCP stress-testing exercises. EMIR also requires CCPs to maintain
sufficient financial resources to protect against its members' default and to
have in place approved default procedures to manage the orderly wind-down of a
defaulting member’s positions. Crucially, the CCP must be able to withstand the
default of two of its largest clearing members. 
However, even in this case the financial
system remains exposed to significant tail risks, as long as there is no
dedicated resolution regime for CCPs. The role that CCPs now play in enhancing
financial stability makes it imperative to design a resolution mechanism to
address the remote possibility of a CCP failure. The cessation of
operations of a CCP would deprive market participants of some very basic
functions, such as trade processing, thereby entailing shutdown of entire
markets with knock-on effects. To prevent such an outcome, a flexible and efficient
resolution mechanism for CCPs is required, and the Commission is already
looking into this problem area as part of its work on non-bank resolution.
This includes an ongoing dialogue with industry and international policymakers.

The central role that CCPs now play in
increasing financial stability raises some concerns linked to the remote
possibility of CCP failure. The cessation of operation of a CCP would deprive
market participants of very basic functions such as trade processing, thereby
entailing shutdown of entire markets, with knock-on effects even on markets not
directly affected. To prevent such an outcome, CCPs require committed resources
that cannot be used to satisfy obligations on derivatives contracts, but which
are sufficient to permit the CCP to continue to undertake its operational (as
opposed to risk-bearing) functions in the event of its inability to perform its
contractual obligations and to allow for the transfer the positions of a
defaulted CCP to solvent counterparties. The Commission announced in its work
programme 2014 that it would table a proposal for a resolution scheme for
non-banks.  Work is under preparation, taking into account developments at
international level.
7.3 Potential risks in collateral markets
The general move to increased
collateralisation of transactions was a logical consequence of the financial
crisis and helped securing some stability in financial intermediation.
Collateral reduces credit risk between market participants and supports
market-based sources of credit to the economy (see Box 7.3.1). It is central to
the functioning of OTC derivatives markets and the funding provided by the
securities financing markets. Since market-based finance needs collateral to
grow sustainably, its availability directly influences the supply of finance to
European households and businesses. 
This section examines the demand and supply
of collateral to address concerns that have been raised about the potential
scarcity of collateral in the system. As explained below, the evidence
available suggests that there is no general shortage of collateral in the
financial system, although some scarcity could emerge, which needs to be
monitored. Rather than shortages in the stock of collateral, there may be
bottlenecks as regards the flow (i.e. collateral “fluidity”). Any such
potential bottlenecks appear to be mainly driven by factors other than
regulation. Upcoming policy initiatives may contribute positively to
alleviating such bottlenecks.
Box 7.3.1: What is collateral and who uses it?
For the purpose of this section, collateral is defined
as a financial asset pledged as security to be forfeited in the event of a
default. For example, a house typically serves as collateral for the bank
mortgage loan used for its purchase. Collateral is held by one contracting
party (the collateral holder) to provide cover against counterparty credit risk
exposure taken in respect of another party (the collateral giver). In other
words, the collateral serves to mitigate loss in case of a counterparty default,
alleviating the problems related to both asymmetric information and moral
hazard faced by the collateral holder.
Historically, collateral has mainly been used in the
context of secured lending, repurchase agreements (repo) and exchange-listed
derivatives. During the 1990s, the practice of secured OTC trading had become
well established in foreign exchange (FX) margin trading and it was adapted for
use with virtually all OTC derivative products. In 2012, in excess of USD 2.5
trillion (85 % of which in cash) were employed to secure OTC derivative
counterparties. Finally, many central bank money market operations are also
secured with collateral.
Assets considered to be ‘safe’ generally exhibit: (i)
low credit and market risks; (ii) high market liquidity; (iii) limited
inflation risks; (iv) low exchange rate risks; and (v) limited idiosyncratic
risks. Whilst cash is often used as collateral, many other types of collateral
exist, such as fixed income bonds (sovereign/corporate) and covered bonds;
securitisation programmes and commercial paper; metals and commodities;
equities and funds; and credit claims.
High-quality and liquid collateral plays a critical
role in a wide range of financial transactions. Its steady income streams and
ability to preserve portfolio values are key considerations in investors’
portfolio decisions. As such, it is widely embedded in portfolio mandates and
often acts as performance benchmarks. Yields on government bonds are reference
rates for the pricing, hedging, and valuation of risky assets. While, in
principle, any type of asset could be used as collateral in private repo
transactions, liquid assets with high credit quality are preferred and
therefore associated with lower secured funding costs. The bilateral repo
market is structured around global dealer banks that, in part, reuse the
received collateral to meet demand by other financial institutions and play a
key role in liquidity provision. 
The key collateral providers include hedge funds,
broker-dealers and custodian banks. Collateral holders, in turn, count amongst
them a wide range of market participants, including: central clearing
counterparties (CCPs); banking institutions and central banks; and central
securities depositories (CSDs); insurance companies, asset managers and pension
funds; as well as prime-brokers and general clearing members.
The demand for collateral
The importance of collateral has increased
significantly since the start of the financial crisis, which is
mainly related to the shift in risk appetite of market participants and reduced
trust in the financial system. Demand for collateral was boosted by the decline
in unsecured money markets after the default of Lehman Brothers in September
2008. Before 2008, monetary and financial institutions were willing to lend to each
other substantial amounts of money without any form of collateral, as mutual
trust was high. Once the crisis hit, however, this mutual trust started to
decline and financial institutions became more risk averse, especially when
doubtful about their counterparties’ financial health.[100] This caused transactions to shift towards the secured money market.
As a result, market participants nowadays need more liquid high-quality assets
for collateral purposes than in the past to attract funding in the private
money markets.
The demand for high-quality liquid assets
that can be used as collateral will increase further due to a number of
regulatory reforms. In particular, the OTC derivatives reforms (EMIR) are
expected to significantly increase the demand for high-quality assets,
primarily through CCP initial margin requirements. Both parties to a centrally
cleared derivatives transaction are subject to these requirements. A two-way
margining regime with initial margin is also contained in the standards for
bilaterally managed transactions, although this is likely to be subject to
thresholds. The initial margin will have to be in the form of cash or
high-quality assets and may be held in segregated accounts, which will
facilitate monitoring and reduce the possibilities for rehypothecation. Several
studies have assessed the impact of derivatives reforms on the demand for high-quality
assets, suggesting that initial margin requirements for centrally cleared
derivatives could add another EUR 0.1 to EUR 0.6 trillion at global level under
normal market conditions.[101] 
Although collateral segregation is not
mandatory, it has implications for collateral availability, since
segregated collateral cannot be re-used. The practice of collateral re-use,
also known as rehypothecation, involves the re-pledging/re-delivery, sale,
investment, or other contractually-permitted use of collateral received by a
party. Securities lending activities and repos are prime examples of collateral
rehypothecation. Institutional investors, such as pension funds, insurance
companies and investment funds, lend out securities to offset custodians’ fees
and generate additional income on their portfolio holdings. In the same way,
securities lending may also be employed by institutional investors to raise
cash for meeting variation margin payments for derivatives trades requiring
central clearing. 
The liquidity rules for banks set out in
the CRD IV package are also expected to have an
effect on the demand for safe (liquid) assets. The ECB has concluded that a
possible bank strategy to increase their LCR would be for them to rely more on
central bank funding by posting non-high-quality liquid assets as collateral.[102] Based on a sample of 357 banks from 21 countries, representing
about two-third of the European banking sector by total assets, EBA (2013)[103] estimates that, at the end of 2012, the LCR stood on average at 115
%, whilst the gross liquidity shortfall amounted to EUR 264 billion across all
the banks (see also section 4.2). The estimated gross shortfall amounts to 0.8
% of the banks’ total assets and represents just 1or 2 % of the EU high-quality
liquid assets markets. Importantly, the EBA study also estimates that more than
80 % of the banks are already LCR-compliant for 2015, taking account of the
gradual phasing-in of the rules until 2018. EBA (2013) also concludes that the
2013 recalibration has led to a significant softening of the LCR regulation. 
Collateral
supply
The total supply of high-quality liquid
assets is expected to continue to outsize demand.
ESMA (2014) recently estimated that although the flow of supply is slowing
compared to 2012 (increase of EUR 701 billion), it is expected to increase
further by EUR 464 billion in 2013 and a EUR 376 billion in 2014 due to
additional issuance from EU sovereigns with high ratings, whereas the supply of
quasi high-quality collateral decreased by EUR 41 billion in 2013.[104] No absolute shortage of collateral assets is expected, even if
collateral is becoming scarcer. Estimates suggest that there is a large
enough stock of collateral in the system to satisfy the demand stemming
from market and regulatory changes.[105] 
The most comprehensive study so far, drawn
up by the Committee on the Global Financial System (CGFS, 2013) of the BIS, suggests
that liquidity regulation and OTC margin requirements might ultimately boost
demand for high-quality collateral by some USD 4 trillion over several years.
That figure is much smaller than measures of global supply. The supply of AAA-
and AA-rated government bonds, for example, has risen by over USD 11 trillion
since 2007; the stock of non-cash collateral eligible for derivatives
transactions is some USD 50 trillion; and the major central banks have
transformed more than USD 4 trillion of collateral (some high quality, some
less so) into the most liquid asset of all (central bank reserves) through
their quantitative easing programmes.[106] 
However, a separate issue is whether enough
high quality collateral will always be readily available in place and time
where it is needed. 
Addressing potential collateral
scarcity and lack of collateral fluidity
Private sector adjustments can ease the
availability of collateral within a market. Any collateral shortages that occur
will be reflected in price adjustments for any given level of high-quality
asset supply. These price adjustments, in turn, induce market participants to
raise the supply of such assets. Potential adjustments include broader
eligibility criteria for collateral assets in private transactions, more
efficient entity-level collateral management and increased collateral reuse and
collateral transformation. 
A scarcity of high-quality liquid assets
generally prompts endogenous private sector responses, such as the observed higher retention rates of securitisations and
covered bonds on bank balance sheets. Banks could expand their securities
(collateral) lending activities to those institutions with a shortage of
high-quality liquid assets. If banks themselves are short, they may turn to
other financial market institutions, such as insurance companies and fund
managers. Collateral transformation services and other forms of collateralised
financing, including collateral swaps, can be also used to increase effective
supply of high-quality liquid assets. In this arrangement, custodians or
institutional investors provide such assets from their balance sheets through
securities lending-type transactions to clients in exchange for lower-quality
collateral (plus a fee). 
While mitigating collateral scarcity, such
collateral upgrade transactions or other endogenous private sector responses can
come with associated costs and risks, such as greater interconnectedness in the
financial system (see also section 7.1 above). More collateral transformation
activity can lead to greater complexity in the system and greater maturity and
funding risks (as collateral lending tends to be of shorter maturity than the
transactions they are used for). They may also add to financial system opacity
(as these transactions are bilateral in nature), as well as increase
operational, funding and rollover risks. Any new collateral assets produced by
private sector solutions may not prove to be as qualitatively liquid
during periods of stress (as occurred during the recent crisis, when market
confidence in the underlying assets of some securitisations collapsed and the
entire securitisation market became illiquid, see also section 7.6). 
When the price of high-quality assets
rises, financial institutions also have incentives to use these assets more
efficiently. Institutions that accept a range of collateral with fixed
criteria are likely to be offered the cheapest eligible assets – known as the ‘cheapest
to deliver’ approach where the best quality assets are used in market
transactions to reduce the related risk premia.[107] In practice, this means that especially central banks, via their
market operations, will be confronted with a decreasing quality of collateral
in times of market stress.
 Chart 7.3.1: Eurosystem collateral (% of total) 
 Source: ECB Notes: Collateral values are based on end of month averages over each time period after valuation and haircuts. Detailed breakdown of non-marketable assets is only available as of 2013. 
Central banks can relax collateral
constraints in the market by broadening the assets
accepted as collateral. By broadening collateral acceptance when market
participants require more or better collateral, central banks can have an
important role in dampening the financial cycle. This has happened in the euro
area, as is visible from chart 7.3.1. The share of non-marketable assets in
Eurosystem refinancing operations increased from 4 % of the total in 2006 to
26.5 % in 2012. Sovereign bonds represent only a small fraction of the
collateral delivered to the Eurosystem. Non-marketable credit claims and
covered bonds both exceed their share, with asset-backed securities and
unsecured bank bonds being of comparable magnitude.
There are other possible public (and
private) sector responses to improve collateral fluidity, with a strong role to
play for central banks. As an example, the impending Target2 Securities
(T2S) initiative should unlock European collateral flows (see Box 7.3.2). 
Another enhancement that should improve
collateral fluidity is the abolishment of the repatriation requirement in the
Eurosystem’s Correspondent Central Banking Model (CCBM), expected in 2014.[108] The removal of this requirement will facilitate the use of a
combination between CCBM and cross-border securities transfer between two
settlement systems. It will also facilitate tri-party collateral management
services on a cross-border basis via CCBM and will enable the use of
euro-denominated collateral issued in non-euro area countries. 
Overall, collateral markets need to be
closely monitored and the emergence of any new risks promptly analysed. Markets are already adjusting to possible tensions between
collateral demand and supply. Extended phasing-in periods granted in the
relevant regulations will give market participants time to adjust and ease the
pressures on collateral markets resulting from regulations. In addition, if
needed, central banks can relax (and already have relaxed) eligibility rules on
collateral – by absorbing lower quality securities to free up better ones to
the market. There is a need for ongoing review and for considering whether
additional policy levers may be helpful going forward.
Box 7.3.2: TARGET2 Securities (T2S)
T2S aims at creating a single securities settlement
engine in Europe, eliminating differences between domestic and cross-border
settlement. It is the Eurosystem’s main contribution towards the creation of an
integrated post- trade market infrastructure in the EU. T2S will provide CSDs
with a centralised service for delivery-versus-payment (DvP) settlement of
securities transactions in central bank money at low and standardised cost,
irrespective of whether transactions are settled nationally or across borders.
DvP settlement will reduce counterparty risk, whilst the use of central bank
money will eliminate settlement agent risk. T2S, in conjunction with the CSDR,
will also introduce harmonised rules and standards to domestic and cross-border
transactions.
T2S is conceived as a multicurrency system that will
extend beyond the euro area, enabling other central banks to connect with their
currencies. T2S will integrate into a single IT platform both market
participants’ securities accounts and their dedicated central bank cash
accounts held with the respective national central bank. It will also
effectively provide a single collateral pool and incorporate several features
that aim at helping banks to optimise their liquidity and collateral
management. Migration to T2S is expected to be completed by February 2017.
Today, investors with diversified portfolios hold
their securities, typically through custodians, with different national CSDs
(Chart 1). This is because the collateral lies within those CSDs. The cross-CSD
settlement, involving an investor holding securities with a single CSD which
then acts as an investor CSD in other markets, is inefficient and costly.
Although there has been some pooling of securities amongst international CSDs
(ICSDs) and global custodians, the amounts are limited and settlement can only
take place in commercial bank money, not central bank money. As a result of
this fragmented environment, banks usually need to hold significant excess
collateral, because they cannot reuse surplus collateral if they have a long
position in a settlement system. At the same time, they need to maintain a
precautionary buffer of collateral and liquidity for days when they will be
short in this market.
T2S will abolish this need for market participants to
hold multiple buffers of collateral and liquidity when settling in several
European markets (Chart 2). T2S will make it possible for banks to have a
single buffer for the entirety of their European business. A single pool of
assets and liquidity will automatically net short and long positions in various
markets, thus generating significant collateral savings. Banks and
intermediaries will be able to manage their collateral much more efficiently,
optimise their funding costs and avoid failed deliveries.
In addition, T2S will put into mainstream a market
feature that is so far available only in a very few European countries: namely,
the central bank auto-collateralisation mechanism, which allows the buyer of
securities to use central bank eligible debt securities as collateral to obtain
central bank intraday credit to pay for the securities being bought (auto-collateralisation
on flow). It will also be possible for the buyer to use an earmarked stock of
securities as collateral to obtain central bank intraday credit to buy assets,
which may not be central bank eligible collateral (so-called client collateralisation).
The auto-collateralisation feature in T2S will
significantly reduce the need for pre-funding of cash accounts, both for
daytime settlement and, in particular, for night-time settlement. Furthermore,
because the securities being bought can be used immediately as collateral, it
will release for alternative use a large amount of collateral on stock that is
normally needed as a buffer.
7.4 Asset encumbrance 
A related area of concern is the encumbrance of assets in banks'
balance sheets. As noted in section 7.3, banks have
increasingly resorted to secured funding in the wake of the financial crisis
and as unsecured funding has become more expensive and generally scarce, while
investors have increasingly preferred secured assets in order to mitigate
heightened counterparty credit risk.[109] An increase in secured funding implies an increase in banks' assets
that are "encumbered" – i.e. pledged with priority to investors in
the banks' secured debt.[110] The encumbered assets therefore are not available to unsecured creditors
in the event of a bank's insolvency, as they are structurally subordinated to
secured creditors. Derivatives also lead to asset encumbrance, as collateral is
posted to meet initial and variation margins to limit counterparty risk. 
Prudential rules may add to the incidence
of asset encumbrance. For example, secured funding in
the form of covered bonds is given a favourable treatment in the calculation of
banks' capital requirements for covered bonds and for exposures in covered
bonds. Covered bonds will also become more attractive for meeting the liquidity
rules under the CRD IV package, and such bonds receive favourable treatment
under Solvency II. Combined with the increased collateral requirements of the
OTC derivative reforms, this could result in greater asset encumbrance of
banks' balance sheets. A further source of increased asset encumbrance is the
provision of central bank liquidity on a secured basis, where banks pledge
collateral to access the liquidity facilities.
There is only limited publicly available
data on the level of asset encumbrance of banks. The
ESRB has calculated that the median asset encumbrance of 28 large European
banks (measured as the ratio of encumbered assets to total assets, with repos
netted against reverse repos) increased from 7 % in 2007 to 27 % by 2011,
although the degree of asset encumbrance varies very widely, even within Europe, between countries and between institutions. The Committee of Global Financial
Supervisors (CGFS, 2013) estimates the median asset encumbrance ratio for a
sample of 60 large European banks to be 28.5 %.
While much of the rise in secured funding
and collateralisation is likely to come from the aftermath of the financial
crisis and not from prudential regulation, increased levels of asset
encumbrance raise policy concerns for a number of reasons.[111] In particular, increased asset encumbrance
can generate conflicts with the objectives of bail-in and depositor preference
if fewer unsecured liabilities are available to bail in at the point of bank
failure. It may also put more pressure on the potential liabilities of DGS
funds, constrain access to unsecured funding, and lead to pro-cyclicality. 
Asset encumbrance reduces the assets
available to the liquidator in the event of a default of a bank and therefore
the recovery rate of unsecured bank creditors. Even if depositors (and the DGS)
are given a preferential status in insolvency proceedings compared to unsecured
creditors, high asset encumbrance reduces the assets available to satisfy their
claims against the failed bank. The risk to unsecured investors of increased
asset encumbrance may make long-term unsecured debt more expensive for banks to
issue, which may limit the quantity of these assets available for bail-ins
under the new recovery and resolution regime (BRRD) and, in the extreme, may
expose taxpayers to the cost of rescuing failing banks.
Assets available to meet claims of
unsecured creditors can decline quickly, particularly under stressed market
conditions. In addition, the lack of hard data on asset encumbrance may
reinforce the uncertainty among unsecured debt investors. Increasing issuance
of secured debt can also impede access to unsecured funding. As the investment
risk for unsecured creditors rises with the level of asset encumbrance, they
may demand higher interest rate payments. As could be observed recently, a rise
in the cost of unsecured debt reinforces banks' reliance on secured funding,
thereby raising asset encumbrance further. Beyond a certain threshold level of
asset encumbrance, and in the absence of other risk mitigation tools, banks may
find it increasingly difficult to retain access to unsecured funding markets.[112]
Asset encumbrance therefore warrants
close monitoring. In addition, there is a need for
greater transparency on asset encumbrance, also to ensure that unsecured
creditors can more accurately assess the risk posed to their recovery rate by
asset encumbrance.[113] Furthermore, any increase in asset encumbrance raises residual
risks for DGS. Whereas EU eligible deposits will enjoy seniority over unsecured
debt, as per BRRD (see section 4.2), they could still remain vulnerable in case
of an insufficient unsecured debt buffer. To this effect, the BRRD mandates the
resolution authorities to require banks to hold a specific amount of own funds
and subordinated and senior liabilities subject to the bail-in tool, with the
explicit goal of avoiding that the latter is rendered ineffective. Besides,
banks and prudential supervisors perform regular stress tests that evaluate
encumbrance levels in periods of market stress. 
Current asset encumbrance levels can be
expected to fall somewhat going forward, as
and when the economic and financial environment in the EU improves and
stability in the financial system is restored. For unsecured debt to regain its
status in bank funding markets, confidence and trust in the banking system as a
whole and in individual institutions will have to be strengthened first. The
current asset quality review exercise by the ECB is expected to provide a solid
contribution towards this goal.[114] Moreover, as the financial regulatory reforms take effect and banks
become more resilient, their credit worthiness is enhanced, which is likely to
give more comfort to unsecured creditors. 
Against the background of recent episodes
of contingent convertible bond issues, there does not seem to be evidence that
the new bail-in regime could be at fault in the lack of revival in the unsecured
debt markets. Even if the reversal to pre-crisis levels of unsecured issuance
are unlikely (and would be undesirable if the debt continued to be underpriced
in the market) and there is a structurally higher demand for secured lending
going forward, unsecured debt markets can be expected to pick up again as risk
aversion abates and the price of secured funding relative to unsecured funding
rises. The eventual unwinding of the ECB balance sheet could also be expected
to contribute to the latter phenomenon. 
7.5 Disorderly bank deleveraging
Whilst the financial crisis has
emphasised the need for the EU banking system to deleverage, it is important to
recognise that this process could entail risks if it occurs in a disorderly
manner.[115] As already noted in section 6.4, bank deleveraging is a necessary
process to correct the excess leverage built up pre-crisis and to put the
banking sector back on a more stable footing. Banks have various options in
which to deleverage, and this process does not necessarily have to hamper
lending to the economy. However, a relatively fast and disorderly process of
deleveraging ("bad" deleveraging) runs the risk of damaging economic
activity.
Sharp cut backs in bank lending within a
short period of time can harm the flow of credit to businesses, in particular
SMEs due to their dependence on banking lending as a main source of finance. It
can also harm the flow of credit for the financing of international trade,
considering that European banks are a major supplier of such credit on a global
scale. However, while sharp or disorderly deleveraging would significantly
restrict bank lending (and can currently not be observed in Europe), a slow and
unconvincing process of deleveraging may undermine market confidence and hinder
the return to financial stability.
Policymakers need to tread a fine line
between encouraging balance sheet repair at the financial institution level,
whilst minimising the potential implications of disorderly deleveraging of the
banking system as a whole at the macro-economic level. Caruana (2012) provides
an overview of the challenges facing policymakers in a balance sheet recession.
Historically, prompt and thorough balance sheet repair has proved to be the
best way to restore post-crisis growth and stability. This is the lesson of the
Nordic banking crisis in the early 1990s, and also the lessons from Japan's experience. The main challenge for policymakers is to prevent a balance sheet
recession leading to protracted weakness. Policymakers need to devise policies
that ease the required balance sheet adjustments without setting off
destabilising dynamics.[116]
The IMF GFSR (2013) assessed the dilemma of
the need to deleverage against the current macroeconomic situation in the
European economy. It noted that if policy challenges are properly managed, and
if reforms are implemented as promised, the transition towards greater
financial stability should prove smooth and provide a more robust platform for
financial sector activity and economic growth. However, the IMF also cautioned
that a failure to implement the reforms necessary to address the problems
identified in the crisis could trigger profound spill-overs across regions and
potentially derail the smooth transition to greater stability. 
In the EU, bank deleveraging (and in
particular the direct causation from financial regulations) has not obviously
constrained credit. While credit is falling during
an economic downturn and it is difficult to disentangle the supply and demand
effects, demand factors seem to have played a major role (see also section 6.4).
Additionally, the issuance of debt securities has partly compensated for the
decline in bank lending in aggregate terms, although this type of financing is
not available for all non-financial companies in the same way. 
Nevertheless, the European Commission's
2013 Autumn forecast[117] provided some warnings. It noted that although bank funding
conditions have generally improved, access to longer-term funding at
sustainable cost remains a challenge for several small euro-area banks, in
particular in Member States that remain under intense market scrutiny due to
lingering concerns about fiscal sustainability. Moreover, banks that find it
difficult to improve their capital position (for example by retaining earnings
or raising capital on financial markets) may still be reluctant to extend
credit to the private sector. Banks have also tended to focus their deleveraging
efforts on cross-border activity and to ring-fence their domestic business.
The EU financial regulation agenda has been
mindful of the risk of disorderly deleveraging. As set out in Chapter 6, longer
phasing-in periods have been adopted to allow the necessary deleveraging
process and strengthening of bank balance sheets to be a smooth process that
does not hamper the economic recovery. The process of bank deleveraging is
subject to ongoing monitoring, e.g. at EU level by the EBA.
7.6 Developments in securitisation markets
Concerns have been raised that prudential
regulation may be hindering securitisation activities and thereby impede a
potentially important source of finance to the economy. The sharp decline in
securitisation following the crisis cannot be attributed to regulatory reforms.
On the contrary, tighter regulation was needed to address the failures in the
market. A separate question is whether and what policy measures can be taken to
facilitate the recovery of sustainable and safe securitisation markets with a
view to unlocking additional funding sources for the economy.  
Some of the “originate to distribute”
models, which were in particularly present in the US markets, have proved to be
clearly inadequate to ensure sound and stable securitisation markets and
contributed to the subprime crisis.[118] The weaknesses of these models have been identified early on and
addressed through EU financial reforms. Risk retention (“skin-in-the-game”)
requirements have been in place in the EU banking sector since 2011 and have
been widened to all financial sectors. In addition, disclosure obligations have been reinforced to allow
investors to develop a thorough understanding of the instruments in which they
invest.
However, since 2008, no substantial
recovery of these markets has been observed, and activity remains quite
limited. Since the start of the crisis, there has been a sharp fall in the
issuance of securitised products in the EU. Chart 7.6.1 illustrates that
the peak of annual issuance of securitised products was reached in Q1 of 2009
with almost EUR 800 billion. In Q3 of 2013 it had dropped to 2002 levels again
of EUR 170 billion. Roughly 70 % to 75 % of the issuance is retained on the
balance sheet or used for repo, whereas the remainder is placed with investors.[119]
 Chart 7.6.1: European securitisation issuance 2000-13 (EUR m) 
 Notes: Left panel shows annual issuance of securitised products in Europe; right panel shows breakdown of issuance by retention. Source: AFME, as processed by the Commission Services. 
In the current economic environment in Europe, securitisation could constitute an important instrument to finance the economy and
help economic recovery, provided that appropriate safeguards are in place.[120] Stakeholders and public authorities have
actively supported the need to foster the recovery of safe and sustainable
securitisation markets in Europe. The use of securitisation to facilitate SME
financing has received particular attention in this regard (see Box 7.6.1). The
Commission is following this development with interest, as already indicated in
its Green Paper on long-term financing, published in March 2013.[121]
Box 7.6.1: Developing SME finance through
securitisation
The development of
financing SMEs through securitisation brings unique challenges – separate from
those related to the reforms - that need to be addressed first before the
market can develop. There are specific asset-class characteristics which had
prevented the market for securitising SME loans from really taking off even
when almost all other types of loans and receivables (e.g. auto leases, student
loans, and credit cards) were being securitised in size. The granularity of the
underlying asset pool is crucial to the tranching exercise, and relatively
chunkier SME loans entail higher idiosyncratic risk which can result in quick
credit enhancement depletion and senior tranches being hit after just a small
number of individual defaults. The average tenor of SME loans tends to be
around 4-5 years in most jurisdictions (if not shorter), which compared to
around 20-25 years for mortgages could make them a less desirable investment
for investors such as pensions funds and insurance companies with long-dated
liabilities to match against. For these reasons, aside from any recent
regulatory hurdles, there are other challenges to the growth in the SME
securitisation market.
At this stage, it is not
clear whether the reforms are having a particular impact on SME loan based
securitisations. There does not appear to be any significant evidence yet to
suggest that either the CRD IV package or Solvency II reforms have directly
hampered SME financing through securitisation. With respect to Solvency II, the
duration mismatch issue of SME loans are likely to make them less attractive to
insurance companies in any event, irrespective of Solvency II changes. Furthermore,
insurance companies are not the only players on the "buy side" in
these markets. Market insights suggest insurance companies now only hold about
15 % of the European RMBS market (a market which is likely to provide less of a
maturity mismatch for insurance companies than SME securitised loans), so any future
market is unlikely to be only dependent on insurance companies. 
As regards regulation, the prudential
framework for banks is a risk-based system whereby the more risky an asset the
more capital the bank needs to hold against it (see Chapter 4.2 for more
detail). In some cases the reform agenda may have penalised higher quality and
safer securitised products compared to other similar forms of financing.[122] Although there seems to be a widespread acceptance for a required
increase in capital requirements on securitised products, there is a more open
debate amongst stakeholders about the appropriate level of capital. The BCBS is currently carrying out a substantial
review of these measures, along with an impact assessment, in order to address
some of the shortcomings revealed by the crisis and enhance the risk
sensitivity of capital requirements. In this debate, it should also be kept in
mind that the European banking sector traditionally refinances a significant
amount of their residential assets thanks to covered bonds which benefit from a
more favourable treatment under the CRD IV package.
This can provide an alternative option for banks wanting to fund through
secured financing, but may not help efforts to diversify sources of financing
in the EU.
In terms of the impact of reforms on the
"buy side", prudential requirements for insurance companies (within
Solvency II) also play a role. Industry representatives have been arguing that
the calibration for standardised risk-weights on securitised products is too
high, especially when compared to other assets. This could in turn make it less
attractive for insurance companies to buy securitised products, relative to other
investments, as they would be required to hold more capital against it under
Solvency II. However, the calibration of securitisation is being reviewed in
the Solvency II framework based on the latest technical advice from EIOPA from
December 2013. [123]
Whilst some reforms may have hampered
securitisation markets, others have supported them, including for example the
risk retention requirements or those enhancing transparency. In the EU,
measures have been taken to ensure that the interests
of the persons initiating securitisation transactions are firmly aligned with
those of the end-investors. This evolution is essential to restore investors’
confidence. Credit institutions are now obliged to check that the originator or
sponsor institution of a transaction has an economic interest equivalent to at
least 5 % of the securitised assets.[124] Requirements similar to those set out in bank capital regulation
are laid down for insurance companies (Solvency II), alternative investment
fund managers (AIFMD) and UCITS. The European regulatory framework is in line
with the recommendations issued on 16 November 2012 by the International
Organization of Securities Commissions (IOSCO).[125]
Other reform measures are reducing
information difficulties, through greater levels of transparency. The CRA
regulations will notably require the issuer, the originator and the sponsor of
a structured finance instrument established in the EU to jointly publish
detailed information on all structured finance instruments on the website set
up by ESMA. The main objectives are to enable investors to make informed
assessments and to reduce their dependence on credit ratings. In addition, other
initiatives led by the ECB and Bank of England on collateral and labelling
initiatives taken by industry also aim to allow supervisors to better monitor
risks and enable investors to better analyse risks. 
The Commission set out in its recent Communication
on long-term financing a number of actions to progress with securitisations
going forward.[126] For example, one way to foster the development of sustainable securitisation
markets could be to develop an operational distinction between
"high-quality" and "other" securitisation markets, as long
as this is prudentially sound. This may help to alleviate stigma on these
products and constitute a first step before considering a potential
differential prudential treatment for safer instruments. In response to a request from the Commission, an approach
identifying “high quality” securitisations has been advocated in the insurance
sector by EIOPA in December 2013.[127] A detailed list of criteria has been proposed related to i)
structural features, ii) underlying assets and related collateral
characteristics, iii) listing and transparency features and iv) underwriting
processes. 
With respect to the banking sector, the
Commission asked the EBA for advice, inter alia, to assess the appropriateness
of ensuring a preferential treatment for "high-quality"
securitisations. In addition, the Commission's proposal on bank structural
reform differentiates between "sound, simple and transparent" and
"other" types of securitisations. Supervisors would have to review
trading activities to be separated in trading entities, but core credit
institutions would still be allowed to invest in or sponsor sound, simple and
transparent types of securitisation.
At international level, a new working group
has been established by IOSCO and BCBS. The group's mandate includes the need
to develop criteria that identify and assist in the development of simple,
transparent and high-quality securitisation structures, with a view to
promoting diverse and reliable sources of market-based finance. Finally, the
Commission will also work with standard setters to develop and implement
international standards especially on rules on risk retention, high quality
standardisation and transparency to ensure consistency and avoid regulatory
arbitrage.
7.7 Impact on competition
As set out in chapter 4.8, the financial
regulation agenda helps improve the competitive functioning of the market in
different ways: e.g. by opening access to market infrastructures; promoting entry
to other markets; facilitating market exit with new resolution regimes;
reducing implicit subsidies; and reducing information asymmetries. However,
there could also be unintended effects from the reforms that limit competition.
Firstly, there is a risk that the rules
will increase barriers to entry for market entrants. Regulations tend to pose a
disproportionate burden on smaller players in the market and new entrants,
which can make it harder for them to compete with more established players. However,
as noted in chapter 4.8, the reform agenda seeks to reduce this effect by
introducing waivers or exemptions from rules for smaller institutions in the
market or, conversely, imposing additional requirements on the largest
institutions.
Secondly, the rules may incentivise firms
to focus more on core activities, encouraging them to sell-off non-core
businesses, which in turn may reduce the number of providers for some financial
services. As the cost of doing business becomes more expensive, it may be in
the interest of financial institutions to either leave the relevant market or
sell off parts of the business in which the relevant institutions are less
profitable – focusing instead only on their "core" business. Other
market incumbents may then take on the additional business. Firms could become
increasingly specialised – which can be good for efficiency - but also larger, which
could lead to less competition. For example, the structural bank reform
proposals would ban the activity of propriety trading for deposit-taking banks.
Any bank with a propriety trading desk will have to either close down or sell
off its propriety trading desk. A large established investment firm may want to
buy these operations to increase the scale of its operations. Structural
separation could trigger some financial institutions to specialise their
functions, rather than engage in a diversity of operations. On the other hand,
structural reform may enhance competition by requiring the large banks to sell
off (or subsidiarise) certain trading activities. This in turn may open the
market to other providers, encouraging a diversity of institutions.
Another example relates to financial market
infrastructures. Here, there also tend to be significant economies of scale, so
that consolidation can enhance market efficiency. A number of infrastructure
providers have recently merged, or expressed interests in mergers to realise
these benefits. In addition to possible financial stability risks, the
authorities will need to watch the implications for competition and potential risks
of abuses of dominant positions of firms in the market. In markets with
players, the risks of abusive practices (e.g. excessive pricing) can often be
higher. As set out in chapter 4.8, the access provisions contained in the
relevant legislations (MiFID II, EMIR and CSDR) seek to enhance competition
along the trading chain. Also, at EU level, the Commission is watching these
developments closely, preventing mergers where needed.[128]
More generally, there is a risk that
scalability leads to financial institutions becoming more concentrated within
given markets. [129] Increased concentration of financial institutions can impact on
competition in at least two ways: first, by potentially increasing the market
power of existing firms and second, it can entrench the advantages that systemically
important financial institutions gain from being 'too-big-to-fail'. The EU
state aid regime, as well as the resolution framework with tougher bail-in
rules and structural bank reform, will stand against this tension.
Some have argued that there may be a
trade-off between competition and stability, that regulation aimed at enhancing
financial stability may hinder competition, and that increased competition may
in fact increase the risk and cost of financial crisis.[130] However, neither economic theory nor the evidence suggest that
measures to improve financial stability need to hamper competition.[131] The instances where competition is likely to be bad for financial
stability are when the incentives of financial intermediaries are not aligned
with the public interest and this leads to excessive risk-taking. This is what
regulatory intervention aims to correct. Restrictions to competition would not
address the underlying problems of excessive risk-taking. Rather, they could have
a negative effect on efficiency without improving the resilience of financial
institutions.
Instead, the challenge is to design a
regulatory framework that improves financial intermediaries' risk-taking
incentives and thereby allows financial stability to be achieved without
compromising on competition and resulting efficiency benefits. As explained in
chapter 4.8, the financial reform agenda includes measures that aim at
enhancing financial stability while at the same time improving the competitive
functioning of the market.
An indicator to watch is the diversity of
financial agents in the financial system. It has been argued that the new rules
tend to incentivise banks to become smaller and more similar, and that banks
will be encouraged to focus on certain types of activities rather than others.
Smaller banks can be easier to resolve, and simpler products are easier for
consumers and investors to understand in terms of levels of risk. However,
caution needs to be taken with making the system too homogenous.  Diversity in
the financial sector is important for a number of reasons. In the limit, when
all firms are the same, they take the same risks, and would then all take the
same defensive actions when the risks materialise. This creates systemic risk
to the financial system. The EU financial regulation agenda has therefore been
mindful of the diversity objective.
Contrary to the claim that regulatory
reform is reducing diversity, it should be noted that the pre-crisis system had
in fact become more homogenous. As explained by Haldane and May (2011) "in
the run-up to the crisis and in the pursuit of diversification, banks’ balance
sheets and risk management systems became increasingly homogenous. For example,
banks became increasingly reliant on wholesale funding on the liabilities side
of the balance sheet; in structured credit on the assets side of their balance
sheet; and managed the resulting risks using the same value-at-risk models.
This desire for diversification was individually rational from a risk
perspective. But it came at the expense of lower diversity across the system as
whole, thereby increasing systemic risk. Homogeneity bred fragility." 
Finally, there may be a risk that the
reform efforts to improve disclosure of information and increase the level of
transparency in financial services could have unintended consequences on
competition. There are some segments of financial markets that are operated by
only a small number of market participants. In markets where there are a limited
number of market players that are engaging with each other on a very frequent
basis, there might be a risk of greater transparency leading to more collusive
practices. If these market participants have full disclosure of the other
market participants' positions and prices, it may be easier (and more tempting)
to attempt to collude, possibly in the same manner as happened in the recent
LIBOR/EURIBOR market manipulation scandal and the alleged manipulation of
foreign exchange and commodity markets (section 4.7.1). Anti-trust authorities
will need to continue to monitor these markets carefully. 
7.8 Impact on EU competitiveness
Financial services are an important
industry in the EU, providing for jobs, GDP and exports. The financial services sector provides 6.5m jobs and has been
estimated to account for EUR 636 billion or 5.5 % of total EU GDP (charts 7.8.1
and 7.8.2). Related professional services employ an additional 4.7m people (chart
7.8.3). The EU is a leading exporter of financial services with extra-EU
exports of EUR 77.3 billion accounting for about a quarter of financial
services exports worldwide (chart 7.8.4). Thus, it is an important industry of
the EU economy for growth and jobs. 
 Chart 7.8.1: Gross value added (GVA) of financial services in % of EU GDP, 2000-2013 || Chart 7.8.2: Financial services % share of GVA, 2013 
 || 
 Notes: GVA is the standard way of measuring, within the National Accounts, the contribution of a sector to output in the economy. 2013 data are based on preliminary estimates. Source: Commission Services || Notes: Based on GVA at basic prices. Data are based on preliminary estimates. Source: Eurostat 
 Chart 7.8.3: Employment in financial services, 2012 by Member State (million) || Chart 7.8.4: Exports of financial services, 2012 (EUR billon) 
 || 
 Notes: Related professional services include legal services, accounting and management consulting activities associated with financial services. Source: Eurostat || Source: Eurostat, UNCTADS 
The EU should be the market of choice for
investors, depositors and insurance policyholders world-wide. In addition to
creating jobs and income, there can be other advantages of remaining a central
player in the global financial system. For example, the access to a global
capital market helps to reduce the cost of financial services for EU firms. It
can also promote greater levels of free trade in goods and services, and help
reinforce other EU industries (e.g. manufacturing and high-tech service
businesses) to compete globally. In this way, the EU can help re-build the
integrated and open global financial system to stimulate sustainable economic
growth going forward. 
However, while having an internationally
competitive EU financial services industry is a valid policy objective, given
the recent crisis experience, this cannot override the objectives of
re-building a stable, responsible, and efficient EU financial system. In fact,
what matters is not so much the competitiveness of the EU financial sector but
the competitiveness of the EU economy.
The global nature of financial services
and markets makes it important for the EU to ensure and promote coherence with
regulation in other jurisdictions (section 7.9).
There can be costs to the EU in terms of competitiveness (compared to the rest
of the world) and financial stability if the implementation of the financial
regulatory reforms diverges across jurisdictions. Following the crisis,
governments and regulators came together to work on a harmonised response. The
international standard setters, such as the FSB, the BCBS or the International
Organisation of Securities Commissions (IOSCO), have been working to set out
common international principles and standards. Member jurisdictions have
committed to follow those that have already been agreed. Yet these are non-binding,
and jurisdictions are left to interpret and transpose these principles
independently. This leaves room for divergence in application, and possible
costs and risks for the EU if other jurisdictions do not move in tandem. If Europe moves either too quickly or decides to take "tougher" measures (i.e.
"gold plating"), there could be costs to the competitive position of
EU financial services. However, if reforms are implemented too slowly or are
much weaker, then the EU financial system remains prone to instability risks.
7.9 Consistency of rules within the EU and Globally
Given the financial integration in the EU
as well as the global nature of many financial services and markets, there is a
need for consistent implementation of regulatory reforms both in the EU and
globally. Inconsistent implementation will carry risks of rendering the reforms
less effective and impose additional costs (e.g. on regulated firms that need
to comply with different and potentially overlapping requirements).
Need for consistent implementation of
rules in the EU
As explained in chapter 4.6, policy action
at the EU level was needed to drive convergence of regulations and supervisory
practice, for example, through the development of a single rule book, the
creation of the ESAs and the move to Banking Union. 
Although well underway, the EU financial
regulation agenda is dependent upon Member States ensuring faithful
implementation of EU legislation, through timely and comprehensive
transposition as well as appropriate monitoring and enforcement by the relevant
authorities. In order to address system-wide threats to financial stability, it
is important that such actions are coordinated and consistently implemented among
all relevant national and European authorities. There is also a need to have
robust procedural frameworks with sufficient procedural guarantees to ensure
consistent and effective implementation and enforcement of the new
legislations.
The Commission is working hard to identify
and address barriers where they exist to help complete the single market for
financial services and make it work better for all citizens of the EU. For example, the Single Market Act (SMA) I
and II highlight key areas of action to stimulate the economy and further
develop the single market (see section 4.6.4). Furthermore, the March 2014 Communication
on long-term financing[132] of the economy suggests a number of actions covering a broad scope
(capital markets, SMEs, private savings, cross-cutting issues such as the
accounting framework and insolvency law) in order to foster the supply of
long-term financing and to improve and diversify the system of financial
intermediation for long-term investment in Europe.
Need for
consistent implementation of rules at global
If globally agreed rules (by the G20) are
not implemented in a consistent manner, this creates tensions with the goals of
achieving global financial market liberalisation while maintaining financial
stability.
A process in which each jurisdiction
implements its own legislation, with extra-territorial implications, creates scope
for duplication and inconsistencies, which result in increased risks and costs.
It creates considerable uncertainties for many
global financial institutions and a deadweight cost for the economy. Such
circumstances may occur due to an imprecision or even an absence of
international rules in a given policy area. It may also be driven by technical
inconsistencies between extra-territorial rules in different jurisdictions. Box
7.9.1 illustrates the need for globally consistent rules with respect to
reforms of the inherently global OTC derivatives markets. Stakeholders have
raised other examples, including on data protection, accounting principles, and
trade reporting.[133] The Commission is working closely with third countries to build
efficient exchanges of information; to assess risks and evaluate market
practices; and to ensure that a consistent regulatory and supervisory framework
emerges between the EU and third countries.
Box 7.9.1: Illustration
of the need for international cooperation: the case of EMIR
The large share of
cross-border activity in many OTC derivatives markets means that coordinated
implementation of global regulatory reform is crucial for all stakeholders.
Uniform international principles covering OTC reform areas almost
comprehensively have either been completed or are under development by the
regulatory community. However, due to political, legal and market
idiosyncrasies in individual jurisdictions, differences have emerged between
the substance and timing of implementing rules in different jurisdictions. This
can lead to regulatory conflicts, inconsistencies, duplication and gaps. 
These issues are
exacerbated by regulatory frameworks which seek to apply extraterritorially to
market participants and infrastructures in foreign jurisdictions, as multiple
differing rules may apply to the same entities or transactions. This can cause
a range of issues from increased compliance costs to the inability for firms to
execute cross-border transactions. For example:
1. Internationally
active central counterparties (CCPs) may need to comply with multiple regimes
Internationally active
CCPs are essential for ensuring that counterparties to cross-border
transactions can satisfy their respective mandatory clearing obligations in
line with G20 commitments. However, some jurisdictions require foreign CCPs
providing services locally to comply with domestic requirements. This results
in internationally active CCPs having to comply with multiple differing
regimes, which can cause operational complexity and increased costs, ultimately
making international activity less attractive.
2. Firms transacting
cross-border may be subject to incompatible transaction requirements
Some jurisdictions
require all domestic market participants to comply with domestic requirements
in respect of transaction requirements such as reporting, clearing and risk
management. Where cross-border counterparties are each obliged to comply with
their own domestic requirements in respect of a single transaction, inconsistencies
and conflicts can result in dual compliance. The consequences of this may be
double reporting, which distorts the data available to regulators, or increased
compliance burdens, which increases the costs of entering into cross-border
transactions.
To
the extent that cross-border activity is ultimately inhibited by these issues,
market and liquidity fragmentation will occur. In the absence of harmonisation,
conflicts, inconsistencies, duplication and gaps can be minimised by providing
for deference to foreign rules.
EMIR
(see also section 4.3.2) provides the possibility to recognise the rules and
infrastructure of third countries by way of adopting an implementing act
determining 'equivalence'. Third country CCPs and trade repositories can provide
services to EU market participants, provided they are subject to domestic rules
which achieve the same overall regulatory objectives as EMIR. 
EMIR
further provides a mechanism for firms to choose to comply with the rules of
third countries with respect to transaction requirements, provided those rules
achieve the same overall regulatory objectives as EMIR. This means that an EU
firm can comply with the rules of its third country counterparty rather than EU
rules.
These
mechanisms therefore enable cross-border activity to continue without the
application of multiple rules, whilst ensuring that regulatory objectives are
still achieved. 
The G20 and FSB have played a key role in
agreeing the global reform framework and standards since the start of the financial
crisis. It is important that in its implementation of those agreed standards,
the EU works effectively with other jurisdictions to reduce the opportunity for
regulatory fragmentation and arbitrage.
Jurisdictions have been working on
cross-border agreements. The Commission has set up equivalence procedures (of
third-country regimes) in many areas of reforms (see box 7.9.1 for an example).
G20 finance ministers and central bank governors are taking steps to ensure
global consistency of rules. Further work is being done by the international
standard setters to assess compliance against the agreed international
standards across jurisdictions (Box 7.9.2).
The work of international standard setters can
be complemented by more granular bilateral agreements on regulatory cooperation
with some jurisdictions. By creating accountable and transparent frameworks for
bilateral cooperation, regulators and supervisors would then endeavour to
implement international standards in a coherent manner. An outcomes-based
assessment of the rules of the other jurisdiction would lead to mutual reliance
and remove unnecessary barriers, while safeguarding financial stability. 
Box 7.9.2: International work on consistency of implementation of
global financial reforms
The lessons of the recent financial crisis underscored
the need for full, timely and consistent implementation of the standards across
the globe. International standard setters have set out a work agenda to assess
the progress and consistency of rules across jurisdictions.
Implementation covers the period from the development
of an international standard or policy through its adoption via changes in laws
and regulations at national/regional levels to actual practice by market
participants and oversight/enforcement by national authorities. International
monitoring of this process, in all its phases, helps to ensure complete and
consistent implementation across jurisdictions and the effectiveness of the
standard or policy in achieving its desired results, and demonstrates accountability
by providing information on implementation progress to the public.
At the request of the G20, the Financial Stability
Board (FSB) has been monitoring progress in the development and implementation
of the G20 recommendations for financial sector policy reforms since the
Washington Summit in November 2008. The FSB coordinates with the relevant
standard-setting bodies (SSBs) on substantial policy development work in a
number of key areas, also creating the Coordination Framework for
Implementation Monitoring (CFIM) to strengthen the coordination and
effectiveness of this monitoring.  CFIM promotes effective and prioritised
monitoring by facilitating ongoing consultation and collaboration between the
FSB and SSBs as well as by allocating their scarce resources efficiently based
on comparative advantage. It also sets out where the primary responsibility for
monitoring resides with a specific SSB.
For example, on bank prudential regulation (the Basel
III measures), the Basel Committee on Banking Supervision (BCBS) has primary
responsibility. As a result, the BCBS has established the Regulatory
Consistency Assessment Programme (RCAP) to assess and report on the consistency
of implementation of the rules on capital, liquidity, leverage and systemically
important banks (see also section 4.2).  The programme consists of two distinct
but complementary workstreams to monitor the timely adoption of Basel III
standards, and to assess the consistency and completeness of the adopted
standards and the significance of any deviations in the regulatory framework.
Various other mechanisms are in place for monitoring
the implementation of international financial standards and policies and for
reviewing their effectiveness. They include the IMF-World Bank Financial Sector
Assessment Programs (FSAP) and Reports on the Observance of Standards and Codes
(ROSC) assessments; FSB thematic and country peer reviews and progress reports;
and monitoring and review processes carried out by the SSBs.
Notes: For more information see the FSB and BCBS
websites
7.10 Potential Tensions between banking union and the single
market
While the move towards Banking Union is an
important development to complement EMU (see section 4.6.3), concerns have been
raised that Banking Union may create a "two tier" system between euro
area (and other Member States participating in the Banking Union, which is open
to all Member States if they wish to take part) and those Member States that
are not participating.[134] 
However, a number of important
safeguards have been provided to help protect the interests of the single
market in financial services when creating the Banking Union. First and
foremost, the Banking Union is based on the single rule book, which applies
across the EU and not just to Banking Union members.  
In addition, as concerns the relationship
between participating and non-participating Member States, the home/host
supervisor coordination procedures and colleges of supervisors will continue to
exist as they do today, as far as coordination with supervisors in non-euro
area Member States is concerned. Non-euro area Member States will hence retain
all their existing powers and prerogatives, but the Banking Union will reduce
the scope of coordination failures between national supervisors (as there will be
coordination between only one authority (the ECB) instead of a multitude of
authorities) and remove the tendency to blend prudential supervision with the
protection of national interest. The ECB as a European institution will work in
the interest of the whole EU and not only the Euro area. There will also be a
memorandum of understanding between the ECB and the competent authorities of
non-participating Member States on the way they will cooperate in performing their
supervisory tasks.
Furthermore, the EBA will play an integral
part in protecting and further developing the single market for banking. It
will also have to ensure that the interests of the wider single market are
protected. In order to ensure that the EBA can perform these tasks, some
targeted amendments to the EBA founding regulation have been introduced in the
context of establishing the SSM. 
In particular, with the creation of the SSM
for euro area members (and those other members that would wish to join), there
could have been a concern that these members could form a block to
systematically outvote the non-participating members on the EBA's Board of
Supervisors, which is the main decision-making body of the authority, leading
to a situation that might rather serve the interest of the euro area than the wider
European interest. This concern was addressed through the creation of a double
majority voting system. Now, when EBA decides, for instance, on binding
technical standards, a majority of both euro area and non-Euro area countries
need to agree for them to come into force. Also, some
powers of the EBA were strengthened (e.g. access to information, stress tests,
and rights of the EBA to request a meeting of supervisory colleges). Furthermore, the ECB will be subject to the same procedure of
binding mediation by the EBA as any other supervisory authority.
In addition, a
"non-discrimination" clause has been inserted into the SSM
regulation, stating that "no action, proposal, or policy of the ECB shall,
directly, or indirectly, discriminate against any Member State or group of
Member States as a venue for the provision of banking or financial services in
any currency." This clause recognises that non-participating members of
the Banking Union should still be able to play a role in euro-denominated
banking services, in line with the principles of a single market.
Similar safeguards to protect the interest
of Member States not participating in the Banking Union are valid for the SRM. Again,
the first layer protection will be the application of the same EU-wide rulebook
of prudential requirements, which will continue to apply to all Member States. In
this way, the EU wide single rulebook will prevent differences of treatment
among banks across the whole EU. Moreover, to ensure an objective and fair resolution
process, any discrimination by all actors within the SRM against banks, their
depositors, creditors, or shareholders on grounds of nationality or place of
business is forbidden. Also, pursuant to the principle of cooperation, the
Single Resolution Board will cooperate with the resolution authorities of
non-participating Member States at different stages of the recovery and
resolution process: for the drafting of group recovery and resolution plans;
for the assessment of such plans; for addressing or removing impediments to
resolvability in case of groups; and for taking concrete resolution decisions
for the group.
Overall, therefore, the Banking Union has
been created in a manner that will support the interests of the single market. 
7.11 Complexity of
regulation
Primary legislation and the detailed
rule-making that it triggers together amount to several thousands of pages.
Regulatory and supervisory resources have increased significantly over the
years, and so have the compliance costs of regulated entities. Financial
regulation is complex, and the reforms will further increase this complexity,
with related costs.[135] There are more than 400 pages of legal texts for firms, regulators
and proactive market participants to trawl through counting only the CRD IV
package.
The complexity of regulation is, at
least in part, a reflection of the complexity of financial institutions, the
products and services they offer, and the financial system as a whole. It also is the result of a process of regulatory reforms that
responds to new risks in the system and that adds or modifies rules as the
system evolves and new risks emerge. In addition, the complexity reflects a
desire for regulatory and legal certainty, which generally calls for
rule-making at a very detailed level.
Schneiberg and Bartley (2010), Harford
(2013), Haynes (2012) and others explain the difficulties for policymakers,
regulators and supervisors in managing such complex systems. Schneiberg and
Bartley explain that regulation faces problems of uncertainty that go beyond
"getting the rules right". Complex systems are characterised by
extensive interdependence and relations among elements that are poorly
understood, non-linear, variable, and idiosyncratic. Under these conditions,
many interactions will remain hidden, and oversight can yield false alarms and
warning systems that may be ignored or rationalised away. Harford argues that
regulators and regulated must learn about rapidly changing properties of
financial products and markets and to adjust rules in light of their
discoveries.
Haldane and Madouros (2012) and others have
well presented the case against complexity of regulation, in particular in the
context of the Basel III capital adequacy framework, which is transposed into
EU law by the CRD IV package. Haldane and Madouros argue that complex rules
often have high costs of information collection and processing; rely on
"over-fitted" models that yield unreliable predictions; and can
induce defensive behaviour by causing people to manage the rules. They conclude
that "modern finance is complex, perhaps too complex. Regulation of
modern finance is complex, almost certainly too complex. That configuration
spells trouble. […] Because complexity generates uncertainty, not risk, it
requires a regulatory response grounded in simplicity, not complexity."
Among other policy lessons, they argue in favour of the leverage ratio as a
simple backstop to risk-based capital ratios determined by banks' internal
models; a move to more simplified bank balance sheets; and a less rules-focused
and more judgment-based approach to supervision.
While adding to the overall complexity of
financial regulation, the EU financial regulation agenda also seeks to
reduce complexity and related costs in several ways: by harmonising rules
and developing a single rulebook to avoid duplication or inconsistent
application of rules across the EU, which presents significant simplification
for cross-border financial institutions; by developing the reform agenda in
line with the G20 commitments and working towards greater coherence and
convergence of international regulatory frameworks; and by adhering to the
principle of proportionality in the form of exemptions (e.g. for small
institutions) and targeted regulation to those institutions (e.g. systemically
important or 'too big-to-fail' institutions) or activities that pose the
greatest risk. 
In addition, the EU is supporting ongoing
work by the Basel Committee to introduce the leverage ratio as a backstop to
the risk-based capital framework for banks. Requirements for banks to draw up
recovery and resolution plans under the BRRD may also provide incentives for
institutions to review the complexity of their organisational structures and
simplify business models. Moreover, proposals to reform banking structures are
aimed at simplifying bank balance sheets and imposing quantitative restrictions
on what deposit-taking banks can and cannot do. 
Review clauses have been included in the
bulk of the EU proposed or adopted legislation (see annex 3), and there is
scope for wider review in future ex-post evaluations of the effectiveness and
transparency of the financial reforms. Complexity can be a key aspect of these
reviews, including its impact on the effectiveness and ease of supervision.
However, the more general question is not just about whether financial
regulation is too complex, but also about the complexity of the financial
system and what can or should be done to reduce this complexity.
7.12 Potential conflicts and inconsistencies in the regulatory
framework
The financial and economic crisis made
necessary a series of urgent reforms and thus precipitated a large number of
interlinked reform proposals which normally would have been proposed over a
longer time period. The need to respond swiftly to the crisis and restore
confidence posed significant challenges for the legislative process and
ensuring that the reforms are well-crafted and consulted with stakeholders and that
they considered all possible effects, including the interaction effects between
different reforms. The ongoing international reform efforts, led by the G20 and
FSB, and the EU commitments arising under those, further influence the
Commission’s freedom when drafting legislative proposals and make it more
difficult to adapt the timeline for proposals. 
The Commission (as well as its
co-legislators) made best efforts to ensure the coordination of the proposals
and to avoid overlaps and inconsistencies that could affect the rights of the
entities affected by the legislative measures.
Nonetheless, given the number of necessary
reforms and the complexity of the task, technical inconsistencies and other
mistakes in the legislative proposals are inevitable. Some have been identified
already and corrected, but new ones may only be revealed going forward. Even if
the initial proposals are based on a consistent approach, challenges may arise
from the legislative process, where inconsistencies can emerge as a result of
negotiations, and thereafter during the implementation phase.
The Economic and Monetary Affairs Committee
of the European Parliament held a public consultation in 2013 on the coherence
of EU financial services legislation.[136]  Responding stakeholders identified a range of specific areas where
they perceive to be overlaps and inconsistencies both in existing legislation
and in legislation being negotiated. Similar issues have also been raised in
various industry submissions and available studies.
Overlaps and
duplications: Given the sheer volume of
legislation, there may be specific cases where regulation overlaps, creating
the risk of duplicating requirements. There may be specific cases where a given
market participant is required to meet similar obligations resulting from
different pieces of legislation, or where different legislation appears to
pursue the same objectives. However, it should be stressed that overlapping
requirements do not necessarily mean contradictory requirements, and do not
necessarily impose an unjustified burden in terms of cost and resource
requirement of the entities that are concerned by the legislative measures. 
Also, while
overlaps are to be avoided wherever possible, seemingly overlapping regulation
may in fact be complementary and enhance the effectiveness of the other
reforms. As already noted, an example is structural bank reform. While some
industry stakeholders argue that such reforms are redundant and do not deliver
benefits over and above what is achieved by higher capital, resolution
mechanisms and the other bank reforms in place, structural reform can deliver
important complementary benefits (see sections 4.2 and 5.2).
In the area of
financial reporting, firms often have to comply with a different set of
accounting rules for financial statements (i.e. local accounting standards,
IFRS, accounting rules for tax purposes, etc.). This creates a burden for the
relevant firms. 
Inconsistencies: Concerns have been expressed about inconsistencies in regulations
or the risk thereof. Some of these concerns are of detailed technical or legal
nature, and their economic significance appears limited. Others have been
addressed, e.g. as part of negotiations. 
It has been
argued that there could be a potential inconsistency between the requirements
applying to financial instruments under MiFID II and those applicable to insurance-based
investment products under IMD II. The Commission proposal on IMD II aimed at
reducing the regulatory divergences by mirroring as far as possible the MiFID
II requirements on selling (see section 4.7.2). Related concerns have also been
raised about the Prospectus Directive (covering securities issuance) and the recently
agreed PRIIPS Regulation (covering retail structured products), as both have a
common purpose to provide the most salient information to potential investors.
It has also been
argued that there are inconsistencies in the rules on remuneration, e.g. in the
CRD IV package, MiFID II and other legislations, which can all differ but apply
simultaneously to some investment firms. However, the remuneration rules in
MiFID II and the CRD IV package are designed in a complementary way. The CRD rules
on remuneration cover mainly those "members of staff whose professional
activities have a material impact on the institution's risk profile",
whereas MiFID II rules on remuneration are designed to address concerns raised
by the remuneration of client-facing and sales force staff and persons
overseeing them. Their remuneration, if not properly designed, may give wrong
incentives to act unfairly and not in the best interest of the client, thereby creating
conflicts of interest.
Both EMIR
(Article 7 and 8) and MiFIR (Article 28 and 29) contain provisions granting
trading venues access to a CCP and vice versa, but with different scopes: EMIR
just applies to OTC derivatives, whereas MiFIR extends the scope to other
financial instruments. In most respects the provisions are aligned, and MiFIR has
amended certain aspects of EMIR where necessary to ensure alignment.  
The interactions
between rules are often complex, also reflecting the complexity of the
financial system and the regulatory framework. The initial
"fire-fighting" mode in response to the crisis added to the
challenges. Thus, inconsistencies were bound to arise and, where significant, should
be (and have been) remedied when identified. The risk of these inconsistencies
must be considered acceptable in relation to the objective pursued.
Inconsistencies
often emerge as a result of inconsistent implementation of legislation within
the EU. However, compared to the pre-crisis period, the legislative reforms
rely more heavily on maximum harmonisation and move towards the adoption of a
single rulebook in financial services. This reduces the scope for national
interpretations and adding national requirements (gold-plating), which in turn
reduces the risk of inconsistencies arising from the implementation of rules. A
separate but related issue is the need for consistent rule-making at
international level, as already discussed in section 4.9 above.
Sequencing: The nature of the financial and economic crisis unfolding led to the
incremental discovery of gaps in legislation, e.g. in the field of short
selling, credit rating agencies and shadow banking. The order of such
legislation is not always a choice but a consequence of developing insight into
the failures of the financial system. The recent benchmark manipulation
scandals are a clear example where action needed to be taken urgently when the
problems came to light, irrespective of the fact that the initiative was not
initially planned. 
Sequencing challenges
apply also at international level where, as noted above, efforts are being made
to ensure global consistency and coordination. The concern here is about the EU
front-running legislations that are still being consulted upon at a global
level. The front-running of proposals may result in differently-defined
requirements, different implementation dates and different implementations,
which are undesirable in the international context even if the rules are
necessary at EU level.
Uncertainty
and delays: Concerns and criticisms in some cases
stem not so much from inconsistencies in the rules, but from the uncertainty
about the timing and final form of the legislative measures and their
implementation. Delays in the adoption and implementation of proposed measures
also create uncertainty and add costs. The most prominent example is Solvency
II. Since the agreement of the Directive in 2008, insurance companies have been
preparing for an implementation, which still has not happened, and incurred
significant costs in the process that have increased as a result of the delays.
On other occasions, an over-reliance on delegated and implementing acts,
including technical standards, can sometimes lengthen the process. While often inevitable
given the nature of the legislative process, uncertainty and delays are
undesirable.
To conclude, financial regulation is a very
complex task where policymakers face numerous challenges. This applied in
particular to developing the policy response to the financial and economic
crisis, where a large number of measures had to be taken in a short period of
time to address the failures and restore financial stability and confidence. As
the implementation of the reforms beds down, it will be important to closely
monitor the overall effectiveness and impact of the new regime. Review
provisions are included in all major legislation and will provide an
opportunity to report on any issues arising and to consider any measure
necessary to adapt, complete or improve the regime 
Where adverse consequences of the reforms
have been identified, corrections to initial proposals have already been made
(e.g. the treatment of trade finance in the CRD IV package, the long-term
guarantee package in Solvency II). Also, where regulation entered uncharted
territory, observation periods have been applied before finalising the rules or
deciding on the need for intervention (e.g. the NSFR and the leverage ratio in
the new capital adequacy framework for banks). In addition, the gradual phasing
in of other provisions limits adverse impacts during the transition phase and
allows adjustment as appropriate (while being mindful that too much flexibility
creates uncertainty, which is also undesirable). 
The financial reform agenda is not a
one-off exercise with a static set of measures. Financial regulation needs to
evolve and adapt over time. While the reforms address the problems revealed by
the recent crisis, the risk of future crises cannot be regulated away. The
rules adopted to deal with the causes of this crisis may not be adequate to
deal with problems that may arise in the future. New risks will emerge, also as
a result of changing markets, technological developments and financial
innovation. The Commission will remain vigilant and proactive, monitoring
financial innovations and identifying new risks and vulnerabilities as they
emerge.
[1] See for example Boot and Ratnovski (2012).
[2]                “The ratio of risk-weighted assets to total
assets differs significantly between banks. It is remarkable that the banks
with the highest amount of trading assets, notional derivatives, etc. (i.e.
banks that are least "traditional") tend to have the lowest ratio.”
Report of the High-level expert group on bank structural reform (2012). 
[3]               “[…] for a sample of 16 large EU banks, the
capital requirements for market risks vary between close to 0 % to just over 2
% of the total value of trading assets, the average being close to 1 %.”
Report of the HLEG, p. 48. This explains why some measures have been taken,
e.g. the use of stressed VaR as part of Basel II.5’s revisions to the market
risk framework.
[4]               See European Banking Authority (2013) and BCBS
(2013).  
[5] Structural reforms could also complement Banking Union. Banking Union is meant to reduce the inappropriate links between sovereigns and their banks.
However, by shifting the risk to the supranational level, implicit subsidies
and the corresponding problems of moral hazard, aggressive balance sheet
expansion, and competition distortions become even more prominent. As a result,
Member States may be reluctant to mutualise (future) risks through Banking
Union, in the absence of structural reform and credible orderly resolution
mechanisms. Targeting the safety net to those core banking activities that
deserve subsidisation and protection because they address a market failure
reduces the scope of the public safety net.
[6]               See e.g. Moody’s (2013) assessment of the BRRD: “Taken
at face value, the draft is credit-negative for senior unsecured creditors of
the roughly two-thirds of EU banks whose ratings incorporate some level of
systemic support uplift. It is unlikely we would remove all systemic support
from every EU bank’s rating in the foreseeable future, but a change to our
assumptions would imply lower ratings for some or all banks. However, there are
a number of important areas in which we need greater clarity before we can take
a definitive view on the implications for EU bank ratings. For example, to be
able to assess the Directive’s impact we would ideally want to understand […]
the plans for broader structural changes in the EU banking industry”
[7] See the impact assessment of the proposal
for a regulation on MMFs, SWD(2013)
315 final.
[8] Potential negative interactions between bank reforms and Solvency
II for insurers are separately discussed in chapter 6.
[9] See ZEW (2011), study for EP.
[10] FICOD I also revises the rules for the identification of
conglomerates, introduces a transparency requirement for the legal and
operational structures of groups, and brings alternative investment fund
managers within the scope of supplementary supervision in the same way as asset
management companies. The revision also gives the ESAs powers to draft
regulatory technical standards and the European Commission to adopt them.
[11] COM(2010) 716 final
[12] See BIS (2010). 
[13] COM(2013) 207 final.
[14] For example, a recent study by EY discussed this and seven other
big themes that are predicted to drive bank business models as far out as 2030,
none of which directly relate to regulation. See EY (2013). 
[15] Joint Committee report of the European supervisory authorities on
risks and vulnerabilities in the EU financial system, March 2014
[16] Moreover, the taxable portion of such litigation costs represents a
direct social cost on top of the harm that was subject to the litigation itself,
where such litigation costs are tax deductible. Fines should have an element of
punishment and a deterrent character, which is undermined by tax deductibility.
Hence, tax deductibility of cartel fines imposed by the Commission is
considered contrary to EU law. But even if fines themselves may not be tax
deductible, legal fees most certainly are.
[17] Notably, the pending regulatory investigation in foreign exchange
manipulation is not included. Analysts estimate that Deutsche Bank, UBS, RBS,
Barclays and HSBC will together have to set aside EUR 8.5 billion to EUR 10.6
billion for litigation costs (including fines and penalties) in 2014 and 2015,
in addition to the EUR 16.4 billion already provisioned up to the end of 2013. 
[18] See impact assessment, SEC(2010) 1058/2
[19] See impact assessment, SEC(2011) 1226 final
[20] See impact assessment, SEC(2011) 1217 final
[21] See impact assessment, SWD(2013) 336 final
[22] See impact assessment, SWD(2012) 198 final
[23] See KPMG (2013, 2014).
[24] See Elliot et al. (2012).  
[25] On average, large euro area banks’ cost-to-income ratios remain
elevated compared with their pre-crisis levels, and even showed an increase
between 2010 and 2012. However, for the euro banking sector as a whole, the
median cost-to-income ratio period 2008-2012 declined from 70 % to 62 %. During
2012, euro area banks’ cost-to-income ratios remained stable, on average, as
banks’ cost-cutting efforts were insufficient to offset lower revenues. See ECB
(2013) for more details. 
[26] Bonuses in the banking industry typically make up more than a
substantial portion of an employee's pay, sometimes more than 75 percent of the
total (as fixed salary can be relatively low). See SEC(2010) 671.
[27] See for example PwC (2013).
[28] See Alessandri and Haldane (2009).
[29] The discussion focuses on the impact of the rules on those key
economic functions for which the main negative impacts have been noted in the
current policy debate. The discussion therefore does not cover the impact on
the payment function nor on the function of "pricing of risks/creation of
markets" (although, broadly speaking, the "creation of markets"
is discussed in the context of the impact of rules on hedging through
derivatives markets).  
[30] Japan is usually referred to as an example of the negative
consequences of forbearance. See Caballero et al (2008).
[31] Although not part of the financial regulation agenda, it should be
noted that in order to address the corporate debt overhang problem the European
Commission has issued a Recommendation for a new approach to business failure
and insolvency, setting out best practice principles to enable the early
restructuring of viable enterprises and to allow bankrupt entrepreneurs to have
a second chance (C(2014) 1500). 
[32] See analysis of the interaction between weak banks and weak corporates
in IMF Global Financial Stability Report 2013. 
[33] See for example Admati et al (2013), Haldane (2011), Miles et al
(2011), Tarullo (2008) and Vickers (2012). Similar points were made prior to
the crisis by Harrison (2004) and Brealey (2006), who also conclude that there
are no compelling arguments supporting the claim that bank equity has a social
cost. Turner (2010) and Goodhart (2010) have argued that a significant increase
in equity requirements is the most important step regulators should take at
this point. See also a letter signed by 20 academics - “Healthy Banking System
is the Goal, Not Profitable Banks,” Financial Times, November 9, 2010. Among
the signatories are J. Cochrane, E. Fama, C. Goodhart, S. Ross, and W. Sharpe.
The text and links to other commentary are available at
http://www.gsb.stanford.edu/news/research/admatiopen.html.
[34] According to the Modigliani-Miller (MM) theorem, which is one of
the core principles of modern corporate finance, there is no such thing as an
optimal level of equity (capital) because the value of a firm is independent of
its capital structure. The value of a firm is determined by its investments and
operational activities (i.e. asset side of the balance sheet), not the
proportion of debt to equity (i.e. liability side of the balance sheet). Thus,
the overall funding cost of a bank is also determined by the risks on the asset
side of its balance sheet independently of the way it structures its
liabilities.
[35] See Miller (1995). 
[36] Debt is exposed to this phenomenon to a much smaller extent,
because it is insensitive to any variations in banks’ future performance except
for default, provided debt is held to maturity. The specific financial
performance matters a lot to shareholders though.
[37] See Elliott (2009). 
[38] The conclusion also holds with other specifications and is
confirmed by other research.
[39] The authors find a negative response of bank loans to an increase
in bank capital only at levels of the capital-to-asset ratio of 35 % (ratios
far outside the range of values observed in the sample period or proposed in
the current regulatory debates).
[40] See, for instance, Thakor, (2013). Further studies are listed in
section 6.4.6 and annex 1.
[41] See IMF (2012) Global Financial Stability Report.
[42] The report follows a requirement in the CRD IV package, which tasks
the EBA with advising on the impact of the LCR, on the business and risk
profile of institutions established in the Union, on the stability of financial
markets, on the economy and on the stability of the supply of bank lending
[43] Diversified business models tend to be more adapted to the LCR than
specialized banks. The share of non-compliant banks is relatively high for auto
and consumer credit banks (83 %), pass-through financing banks (53 %), and
private banking (45 %). EBA (2013) proposed specific derogations for certain
specialised business models under stringent and objective conditions.
[44] It is relevant to point out that the baseline EBA data analysis
assumes that any government and central bank unconventional liquidity support
is not withdrawn. A separate analysis of the withdrawal of government support
on the LCR has been included through.  
[45] Moreover, the events surrounding the call for financial assistance
by Cyprus, together with the response given by EU institutions, worked to
reaffirm such beliefs.
[46] See Standard & Poor's (2014). Several EU countries have already
anticipated the BRRD in their legislation.
[47] However, the overall impact will be limited, since some 60 % of the
covered bonds at stake already enjoy an AAA rating. See discussion in Natixis,
Covered Bond Market Weekly 10, 12/03/2014.
[48] “Santander set to lead wave of coco sales”, Financial Times,
5 March 2014.
[49] “UK’s Nationwide poised to issue coco bond”, Financial Times,
3 March 2014.
[50] “Barclays bond a key test for cocos market”, Financial Times,
22 November 2012.
[51] The following is based on analysis prepared by the risk
sub-committee of the Joint Committee of European Supervisory Authorities 
[52] For example, banks can lend to insurers, insurers may have deposits
in banks, and banks and insurers may engage in financial transactions
(insurance linked securities, securities lending, liquidity swaps, etc) to
transfer and manage risks. However, these interlinkages do not appear to be
significantly affected by the interrelation of the prudential frameworks. 
[53] Investment may also be in equity. However, the total amount of
insurers invested in equity is significantly lower. Also, the general
conclusions about a limited impact of Solvency II on asset allocation also hold
for equity. Current trends in insurers' equity investments appear to be driven
by the current economic environment and low interest rates and not capital
requirements. As regards banks' equity investments in insurers, the holdings are
not significant, and the CRD IV package does not introduce any material changes
to capital charges for market risk in equities. 
[54] The reasoning is that, in the application of the standard formula
of Solvency II, there is an increase in capital requirements as the maturity of
the debt increases and as the credit quality deteriorates. It is therefore
concluded that this may lead insurers to hold relatively fewer long-term bonds,
especially low quality bonds, at a time when banks need to issue more.
[55] See for example Fitch (2011) and Oliver Wyman and Morgan Stanley
(2010). 
[56] See JP Morgan (2012). 
[57] A unit-linked insurance plan is a product offered by insurance
companies that gives investors the benefits of both insurance and investment
under a single integrated plan. Hence, the insurance company buys units in an
investment fund. The number of units attributed to a specific policyholder
depends on the amount invested and the price of the units at the time of the
investment. One can choose from a range of different funds to suit one’s
attitude to risk. These include low-risk deposit-type funds, medium-risk funds
and higher-risk funds that are mostly invested in the stock market. Almost all
unit-linked plans involve some degree of capital risk. 
[58] See Elliot et al (2012), for a full critique.
[59] The study also reports the impacts for Japan (8bp) and the USA (28bp). 
[60] See Slovik and Cournede (2011). 
[61] See BCBS (2010). Note when changes in RWA while meeting NSFR
requirements are assumed, the costs for the Euro area sum up at 0.16 % (see
Table 9 in the study). 
[62] See Elliot et al (2012) op.cit. for a full critique and Table 1 in
this report. 
[63] Shafik N., Jalali, J., "Are High Real Interest Rates Bad for
World Economic Growth?”, Working Paper Series 669, World Bank, May 1991.
[64] E.g. see McKinnon, R.I. (1973), „Money and capital in economic
development”, Washington DC, Brookings Institution, and Shaw, E.S. (1973),
Financial deepening in economic development”, Oxford University Press.
[65] For example, none of the study considers the interaction of the
bank reforms with Solvency II. The interaction with the insurance sector would
be extremely complex to model.
[66] See the measures set out in the Communication on long-term
financing the European economy (COM(2014) 168 final),
summarised in section 4.8.
[67] See the Green Paper on long-term financing of the European economy,
COM/2013/0150 final
[68] See for example Insurance Europe (2013). 
[69] www.ingim.com/EU/News/News/IWP_072400

[70] See for example Committee on the Global Financial System (2011). 
[71] See
https://eiopa.europa.eu/fileadmin/tx_dam/files/consultations/consultationpapers/EIOPA-13-163/2013-12-19_LTI_Report.pdf
[72] A directive proposed in 2011 (COM 2011/0008) to adapt Solvency II
to the new framework for implementing measures introduced by the Lisbon Treaty
and to the creation of EIOPA
[73] This section mainly focuses on market liquidity, which is generally
referred to as the ability to buy or sell an asset at short notice with little
impact on its price. This is different from what was discussed in section 6.4.3
in relation to banks' funding liquidity, which describes the ability to raise
cash either by borrowing or via the sale of an asset. Market liquidity does of
course influence funding liquidity.
[74] See Sarr and Lybek (2002).
[75] This can occur when market participants mistakenly perceive that
financial conditions and specifically, the liquidity of an asset, portfolio,
market or even the economic system as a whole, is more robust than it is in
reality. See Nesvetailova (2008) for a more detailed discussion.
[76] MiFID I only mandated transparency for shares admitted on a
regulated market. 
[77] See for example, TABB (2012). 
[78] See MiFID II impact assessment prepared by the Commission Services.
[79] See Box 4.3.1. 
[80] Budish et al (2013). 
[81]             The other relevant proposals (e.g. on minimum tick
size, minimum latency periods and minimum execution orders) are also unlikely
to have an adverse effect on liquidity. See for example study prepared for the
UK Government Office for Science (2012).
[82] COM(2013) 885 final
[83] “ESMA’s technical advice on the evaluation of the Regulation (EU)
236/2012 of the European Parliament and of the Council on short-selling and
certain aspects of credit default swaps”, Final Report, ESMA/2013/614, 3 June
2013.
[84] See ESMA (2013). 
[85] E.g. see Cliftong and Snape (2008) and Boehmer et al (2008).
[86] See Félix et al (2013). 
[87] See e.g. Ashcraft and Santos (2009). 
[88] See also the Commission Services' impact assessment on structural
reform.
[89]Zingales (2012): “The third reason why I came to support
Glass-Steagall was because I realised it was not simply a coincidence that we
witnessed a prospering of securities markets and the blossoming of new ones
(options and futures markets) while Glass-Steagall was in place, but since its
repeal have seen a demise of public equity markets and an explosion of opaque
over-the-counter ones. […]With the repeal of Glass-Steagall, investment banks
exploded in size and so did their market power. As a result, the new financial
instruments (such as credit default swaps) developed in an opaque
over-the-counter market populated by a few powerful dealers, rather than in a
well regulated and transparent public market.”
[90] More generally, voluntary market making may not occur when it is
most needed, i.e. during troubled market conditions. Even dedicated market
makers are typically only allowed to post quotes during 90 % of the trading
period and of course they may decide to breach their contractual obligations if
they deem that fulfilling them would threaten their solvency.
[91]  EIOPA Report on the fifth Quantitative Impact Study (QIS5) for
Solvency II, 14th March 2011.
[92] Contracts offered by insurance undertakings where no guarantees are
provided (i.e. where the market risk is borne by policyholders – e.g.
unit-linked products) are not factored into the calculation of the solvency
capital requirement.
[93] In addition to the impact of the rules described here, as already
alluded to in section 6.5.2, restrictions on short-selling may have an impact
on hedging costs, whereby a short-selling ban acts as a wealth transfer from
liquidity takers to its providers. As suggested by ESMA, some refinements can
still be implemented to lessen this impact.
[94] For example, under the old capital rules, firms could avoid taking
a deduction (from their capital requirement) for “material holdings” in other
financials, by making the investment indirectly.  This issue was spotted and
addressed in the recent revisions of the capital requirements within the CRD IV
package, which captures both direct and indirect holdings in other financials
(under the rules for non-significant and significant investments). Whilst this
example was spotted and addressed, there may be others that the regulators are
yet to see as the market innovates to adjust to the new rules.
[95] See Joint Committee of the ESAs (2013). 
[96] Based on a 2012 EIOPA study of 112 responding institutions, the
overall size of the collateral upgrade transaction market is low, but varies
much across the EU. In the survey, the notional value was about 3 % of total
balance sheet assets.
[97] Much of the discussion in this section can be extended to other
systemically important market infrastructrures.
[98] See Pirrong (2011).
[99] Wrong-way risk tends to be largest for the most senior component
of payment ‘waterfalls’ and highly rated counterparties. Entities with these
characteristics rarely fail, but their failure tends to occur concurrently with
large asset price movements, thereby exacerbating market crises. Given that
CCPs have attributes that make them vulnerable to wrong-way risk, this is a
major concern.
[100] See for example Levels and Capel (2012). 
[101] A BIS study by Heller and Vause (2012)
concluded that initial margin requirements of G14 dealers would amount only to
a small proportion of their unencumbered assets, even if CCPs cleared all of
their IRS or CDS positions. At the same time, BIS estimates of initial margin
requirements for central clearing of non-dealer IRS and CDS positions were considerably
greater, mainly reflecting the presumption that the degree of hedged positions
is typically much lower in the portfolio of an end user of derivatives. BIS
found that total initial margins would demand globally between USD 0.3 trillion
and USD 1.2 trillion, depending on the assumed volatilities. A study by the
BCBS and IOSCO estimated the total initial margin required to collateralise
exposures from non-centrally cleared trades to be around EUR 0.7trillion
(http://www.bis.org/publ/bcbs242.pdf). The CGFS (2013) estimates that the
structural demand for HQA and other collateral assets could increase by
combined EUR 1.3 trillion globally on account of initial margin requirements
for bilaterally cleared OTC derivatives (EUR 0.7 trillion) and for centrally
cleared derivatives (EUR 0.6 trillion). This additional collateral demand would
be gradually phased in over a four-year period starting in 2015. Importantly,
the margin requirements under EMIR apply to new trades only. 
[102] See ECB (2013). ECB. Liquidity regulation and monetary policy
implementation, Monthly Bulletin, April 2013.
[103] EBA (2013). Report on impact assessment for liquidity measures
under Article 509(1) of the CRR, European Banking Authority, 20 December 2013.
[104] See ESMA (2014), ESMA
Report on Trends, Risks and Vulnerabilities, No. 1, 2014. Sovereign bonds
issued by countries with a credit rating of BBB- or above serve as the proxy
for high-quality collateral, whereas corporate and covered bonds rated AA- or
above are used to estimate quasi high-quality collateral. The annual sovereign
debt estimates for 2013 and 2014 are based on AMECO general government debt
forecasts, whilst net issuance of quasi high-quality collateral is assumed to
remain stable in 2014.
[105] See also Levels and Capel (2012) who conclude that there is
unlikely to be any collateral scarcity in absolute terms (total supply in 2012
of EUR 8.3 trillion-EUR 9.8 trillion, total demand of EUR 4.5 trillion), but
that high-quality liquid assets are becoming scarcer (comparing the forecasted
increases in collateral demand (EUR 1.8 trillion) and collateral supply (EUR 0.7
trillion - EUR 0.9 trillion). Increased collateral scarcity will create
pressure on the prices of high-quality assets, especially when considering that
many institutional investors now hold large portfolios of high-quality liquid
assets on their balance sheet and that banks will demand more of those. 
[106] See Hauser (2014).
[107] It is also worth noting that the cheapest to deliver collateral in
a low interest rate environment is often cash.
[108] Eurosystem counterparties and participants in the Eurosystem’s
Target2 real-time gross settlement system can only obtain credit from their
home central bank. CCBM enables them to use eligible marketable assets issued
(i.e. registered or deposited) in other euro area countries as collateral. In
line with the repatriation requirement in CCBM operations, assets have to be
moved from the investor securities settlement systems to those of the issuer.
[109] Long‑term secured funding is typically in the form of collateralised
mortgage debt. Two types of instruments are common. The first type consists of
covered bonds, which remain on the issuing bank balance sheet and add to asset
encumbrance. The second type relates to RMBS, which are generally off‑balance sheet instruments. RMBS affect encumbrance only to the
extent that issuing banks provide implicit or explicit guarantees, or retain
the RMBS on their own balance sheet. For short term secured funding, repurchase
arrangements (repos) are the most common instruments. These instruments play an
important role in secured funding markets, including central bank liquidity
provision. Repo positions are often offset through reverse repos, reducing the
net contribution to asset encumbrance levels.
[110] The CRD IV package states that an asset is considered encumbered if
it has been pledged or if it is subject to any form of arrangement to secure,
collateralise or credit enhance any transaction from which it cannot be freely
withdrawn. 
[111] See Houben (2013) and Committee of Global Financial Supervisors
(2013) for further explanations of asset encumbrance and its potential
consequences.
[112] However, when asset encumbrance increases, unsecured creditors should
in principle demand a higher rate of return, so if prices for secured and
unsecured financing are able to adjust, there is no reason why it should come
to the point of no demand from unsecured creditors. They would simply accept
the higher risk for higher returns.
[113] While the general regulatory response has been to enhance the
monitoring of asset encumbrance and impose requirements on banks to be more
transparent in their reporting, some countries impose prudential limits on the
issuance of covered bonds in order to contain asset encumbrance. For example,
as summarised in Houben (2013), countries such as Australia, Canada and
Singapore apply strict ceilings for the amount of covered funding or covered
bonds'; in the Netherlands, Norway and the United Kingdom a case‑by‑case approach is used that sets threshold values for covered bond
issues per institution.
[114] https://www.ecb.europa.eu/pub/pdf/other/notecomprehensiveassessment201310en.pdf

[115] For an assessment of deleveraging and other potential risks in the
European banking system, see also EBA (2013).
[116] Co-ordinated policy initiatives can help to ease this problem. For
example, the Vienna initiative has helped ease risks of disorderly deleveraging
in central, eastern and south-eastern Europe. See also section 6.4.1.
[117]
http://ec.europa.eu/economy_finance/publications/european_economy/2013/pdf/ee7_en.pdf
[118] It is worth noting that the performance of
US securitised products during the crisis was considerably different to that in
the EU, where much lower actual (and expected) losses have appeared.  For
example, see: Standard & Poor’s, “Transition
Study: Less Than 1.5% Of European Structured Finance Has Defaulted Since
Mid-2007”, 11 June 2013. Moody’s Investors Service, “Structured Finance Rating
Transitions: 1983-2013”, 7 June 2013. Fitch Ratings, “The Credit Crisis Four
Years On … Structured Finance Research Compendium”, June 2012, “EMEA Structured
Finance Losses”, August 2011.
[119] The total outstanding amount has peaked at EUR 2.25 trillion in
2009, but has dropped to somewhat more than EUR 1.5 trillion in 2013 (Q3). RMBS
make up 60 % of outstanding securitised notes.
[120] There are a few studies on the impact of securitisation on credit
market conditions and credit availability. For example, NERA (2009) study shows
that a 10 % increase in securitisation rate can result in: a reduction of 15
bps in mortgage yield spreads; a decrease in yield spreads for car loans of
between 22 to 64 bps; and a decrease in yield spreads for credit card loans of
between 8 to 54 bps.
[121] COM/2013/0150 final.
[122] See Mersch (2013), IOSCO (2012), and Joint Paper by the ECB
and Bank of England (2014).   
[123] The advice includes a differentiated treatment for
"high-quality" and other securitisations and significantly reduced
risk factors for the high-quality category (see below).
[124]            The requirement applies since the entry into force of
CRD II at the end of 2010. See Directive 2009/111/EC of the European Parliament
and of the Council of 16 September 2009 amending Directives 2006/48/EC,
2006/49/EC and 2007/64/EC as regards banks affiliated to central institutions,
certain own funds items, large exposures, supervisory arrangements, and crisis
management (OJ L 302 17.11.2009 p.97)
[125] See http://www.iosco.org/library/pubdocs/pdf/IOSCOPD394.pdf.
[126] See communication on long-term financing of the European economy,
COM(2014) 168 final
[127]http://eiopa.europa.eu/fileadmin/tx_dam/files/publications/reports/EIOPA_Technical_Report_on_Standard_Formula_Design_and_Calibration_for_certain_Long-Term_Investments__2_.pdf
[128] This was the case in the proposed merger between Deutsche Börse and
NYSE Euronext. The analysis indicated that the merged entity would have held 90
% of the share in worldwide market for European financial derivatives traded on
exchanges.  It was therefore concluded that the proposed merger would have
eliminated global competition and created a quasi-monopoly in a number of asset
classes, leading to significant harm to derivatives users and the European
economy as a whole.  Commission decision - http://ec.europa.eu/competition/mergers/cases/decisions/m6166_20120201_20610_2711467_EN.pdf
[129] A more detailed assessment of the competition of financial markets
is beyond the scope of this report.  However, it may be useful to have more
market investigations in the future to ensure the legislation is having its
intended effect.
[130] The traditional argument (see Keeley (1990)) goes that increased
competition may reduce profits and hence reduce bank resilience, and it may
spur incentives for excessive risk-taking because foregone future profits in
case of failure are lower. 
[131] See OECD (2010) and Carletti and Hartmann (2002), 
[132] COM(2014) 168 final 
[133] See, for example, "The Danger of Divergence: Transatlantic
Financial Reform and the G20 Agenda" by The Atlantic Council, co-chaired
by Sharon Bowles, Chair of European Parliament's Economic and Monetary Affairs
Committee, and US Senator Christopher Murphy.
[134] See also Enria (2013). 
[135] The increase in costs could affect the freedom to conduct a
business enshrined in article 16 of the Charter of fundamental rights and
limitations have thus had to be conceived in strict compliance with the
requirement of legality and proportionality, as provided for in article 52.1 of
the charter.
[136] http://www.europarl.europa.eu/committees/en/econ/subject-files.html?id=20130314CDT63219

TABLE OF CONTENTS
TABLE OF
CONTENTS. 2
List of
abbreviations. 3
Bibliography.. 7
Annex 1: Review
of existing Studies. 20
Annex 2:
Summary of proposed and adopted legislations. 29
Annex 3:
Overview of Review reports required in key legislations  35
Annex 4:
Quantitative modelling of benefits. 37
Annex 5:
Quantitative modelling of costs. 64
List of
abbreviations
ABCP                          Asset-Backed
Commercial Paper
ABS                             Asset-Backed
Securities
AIF                              Alternative
Investment Funds
AIFMD                                    Alternative
Investment Funds Managers Directive 
ATM                           Automated
Teller Machine
BCBS                          Basel Committee on Banking Supervision
BIS                              Bank for
International Settlements
BRIC                          Brazil, Russia, India and China
BRRD                         Banking Recovery
and Resolution Directive
CCP                            Central Counterparty
CDO                           Collateralised
Debt Obligation
CDS                            Credit Default
Swap
CESEE                        Central, Eastern
and South Eastern Europe
CFTC                          Commodity
Futures Trading Commission
CGFS                          Committee on
the Global Financial System
CME                           Chicago Mercantile Exchange
CNAV                                    Constant
Net Asset Value
CNMV                        Comisión Nacional
  del Mercado de Valores
CRA                            Credit Rating
Agency
CRD                            Capital
Requirements Directive
CRR                            Capital
Requirements Regulation
CRR/CRD IV               Capital
Requirements Regulation and Capital Requirements Directive IV ("CRD IV
package")
CSD                            Central
Securities Depository
CSDR                                     Central
Securities Depositories Regulation
DGS                            Deposit
Guarantee Scheme
DGSD                         Deposit
Guarantee Scheme Directive
EURIBOR                  Euro Interbank
Offered Rate 
EBA                            European
Banking Authority 
ECB                            European
Central Bank
EFRAG                       European
Financial Reporting Advisory Group
EIOPA                        European
Insurance and Occupational Pensions Authority
ELA                            Emergency
Lending Assistance
EMIR                          European Market
Infrastructure Regulation
EMS                            European Monetary System    
EMU                           Economic and
Monetary Union
ESA                            European
Supervisory Authority
ESBC                          European System
of Central Banks
ESFS                           European
System of Financial Supervision
ESIS                            European
Standardised Information Sheet
ESM                            European
Stability Mechanism
ESMA                         European
Securities and Markets Authority
ESRB                          European
Systemic Risk Board
EP                               European
Parliament
EuLTIFs                      European
Long-Term Investment Funds
EuSEFs                       European Social
Entrepreneurship Funds
EuVECAs                   European Venture
Capital Funds
EUR                            Euro
FCA                            Financial
Conduct Authority
FDI                             Foreign
Direct Investment
FDIC                           Federal
Deposit Insurance Corporation
FHFA                          Federal Housing
Finance Agency
FRAs                           Forward Rate
Agreements
FSA                             Financial
Services Authority
FSAP                          Financial
Sector Assessment Program
FSB                             Financial
Stability Board
FX                               Foreign
Exchange
GDP                            Gross Domestic
Product
G-SIB                         Global
Systemically Important Bank
HFT                             High
Frequency Trading
HLEG                         High Level
Expert Group
HQA                           High Quality
Assets
HQLA                         High-Quality
Liquid Assets
IAS                             International
Accounting Standards
IASB                           International
Accounting Standards Board
IBORs                         Interbank
Offered Rates
ICS                              Investor
Compensation Scheme
IFRS                           International
Financial Reporting Standards
IMD                            Insurance
Mediation Directive
IMF                             International
Monetary Fund
ISDA                          International
Swaps and Derivatives Association
KID                             Key
Information Document
LAC                            Loss Absorbing
Capacity
LCR                            Liquidity
Coverage Ratio
LIBOR                        London Interbank Offered Rate
LTRO                          Long-Term
Refinancing Operations
MAD                           Market Abuse
Directive
MAG                           Macroeconomic
Assessment Group
MAGD                        Macroeconomic
Assessment Group on Derivatives
MAR                           Market Abuse
Regulation
MAR/CSMAD           Market Abuse Regulation
and Directive on Criminal Sanctions
MBS                            Mortgage-Backed
Securities
MCD                           Mortgage Credit
Derivative
MFI                             Monetary
Financial Institution
MiFID                         Markets in
Financial Instruments Directive
MiFIR                         Markets in
Financial Instruments Regulation
MMF                           Money Market
Fund
MPO                           Monetary Policy
Operation
MoU                            Memorandum of
Understanding
MS                              Member State 
MTF                            Multilateral
Trading Facilities
NAV                           Net Asset Value
NFC                            Non-Financial
Corporation
NFPS                          Non-Financial
Private Sector
NPL                            Non-Performing
Loans
NSFR                          Net Stable
Funding Ratio
NYSE                         New York Stock Exchange
OECD                                     Organisation
for Economic Co-operation and Development
OTC                            Over-the-Counter
OTF                             Organised
Trading Facility
PRIIPs                                    Packaged
Retail and Insurance-based Investment Products
PAD                            Payment
Accounts Directive
PSD                             Payment
Services Directive
RCAP                         Regulatory
Consistency Assessment Programme
RMBS                         Residential
Mortgage-Backed Security
RoE                             Return-on-Equity
ROSC                         Reports on the
Observance of Standards and Codes
RWA                           Risk-Weighted
Assets
SFT                             Securities
Financing Transaction
SIV                             Structured
Investment Vehicle
SMA                           Single
Market Act
SME                            Small
and Medium Enterprise
SRF                             Single
Resolution Fund
SRM                            Single
Resolution Mechanism
SSM                            Single
Supervisory Mechanism
SSR                             Short-selling
Regulation
T2S                              Target 2
Securities
TBTF                           Too Big To
Fail
TIBOR                        Tokyo Interbank Offered Rate
UCITS                        Units in
Collective Investment Undertakings
USD                            US dollar
WACC                        Weighted Average
Cost Of Capital
VaR                             Value-at-Risk
VNAV                                    Variable
Net Asset Value 
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Annex 1: Review of
existing Studies 
This annex presents a
literature review of the main quantitative impact studies on banking sector
reform. It reviews those studies prepared by industry, public authorities and
academics. While it only covers banking sector reform, focusing in particular
on the Basel III reforms, a wider set of literature has been reviewed for the
main report.  The other (non-banking sector) studies are also referred to,
where appropriate, within the relevant sections of the main report and listed
in the bibliography. 
Studies commissioned or
carried out by the industry focus mainly on the private costs of regulation,
such as costs on banks' profitability, loan volume and pricing. Few of them go
further to translate these banking sector specific impacts into the wider
effects on the economy as a whole. The public authority studies tend to focus
more on social costs, often struggling to fully estimate the benefits. This is
a reflection of the difficulties in quantifying (or even just measuring), the
benefits of several fundamental measures[1], such as those to increase transparency.  At
present, it seems many benefits cannot be appropriately quantified, even by the
most state of the art models. 
In general, industry
estimates tend to be more pessimistic than those undertaken by public
institutions, in terms of the potential decline in the volume of lending and
the short- and long-term decline in GDP. This is mainly due to the different economic assumptions,
regulatory scenarios, forecasting methods and modelling techniques used. Many
industry studies were estimated at a time when regulatory changes were still
under discussion and not yet finalised.  Most industry studies preserved their
initial assumption of a swift implementation of all proposed changes under
Basel III, despite the final agreement in Basel and its transposition in CRD IV
providing for gradual implementation over a longer transitional period. It may
therefore not be surprising that there is a wide range of results between industry
and public authority studies.
Industry studies
The Institute of International Finance (IIF)[2] published a report on the cumulative impact of Basel III
in September 2011. This report focuses on the transitional effects in the
short- and medium term.  It estimates the negative impact of new regulation in
terms of credit and GDP dynamics. An econometric model (NiGEM), developed by
the UK National Institute of Economic and Social Research, was used to estimate
the impact on the economic activity. The IIF estimates a yearly GDP drop of 0.6
% from the trend for the Euro area over a period of five years (0.7 % in
average for all countries included in the study) when measures are implemented
in 2015. This drop is primarily triggered by an allegedly sharp decline in the
growth of credit supply (up to 4 % in 2020 for the Euro area). According to the
IIF, Basel III measures make credit not only more scarce, but also more
expensive. Lending rates are projected to increase by 328bp for the period
2012-2019. The IIF study claims that there is a significant risk that the Euro
area banking sector will not be able to fully meet the new liquidity
requirements (LCR and NSFR). The IIF results are high compared to those from
public institutions. An important assumption which may overstate costs is
that increases in safety margins
are only due to regulatory changes and not driven by market-adjustments.
Moreover, the IIF focuses on only transitional costs and not long term effects
in contrast to public institution's studies which also take the long-term
effects into account. 
PricewaterhouseCoopers coordinated a project (Project Oak) in 2010
undertaken by the six largest UK banks and the British Bankers Association
(BBA) to estimate the impact of Basel III and associated reforms in the UK. The study claims that the UK banks have moved much more quickly than the resulting
Basel III framework envisages. The estimated economic cost of reforms over a 20
year timeframe ranges between £600 billion and £1.5 trillion (using a
multi-equation structural model with separate credit variables). This
translates to roughly between 24 % and 104 % of the 2010 GDP. Comparing these
economic costs to the simulated benefit of having the risk of a crisis
occurring every 20 years, where the cost of a crisis represents 30 % of GDP,
gives an indicative economic benefit for the reforms of £200 billion in present
value terms.  
Other private firms, such
as McKinsey and JP Morgan, estimate the impact only on bank fundamentals
and credit volume and pricing. They base macroeconomic impacts on projections
derived from accounting identities and past bank data. The McKinsey and JP
Morgan primarily look at the impact on the banking sector return-on-equity
(RoE).  They foresee a sharp decline, from 15 % to 9.7 % by 2012 (McKinsey) or
from 13.3 % to 5.4 % in 2011 (JP Morgan), if the banking sector fully
internalises the costs of the reform. The studies claim that at these reduced
rates of profitability the banking sector would not be able to attract new
capital.   They assert this is
primarily due to higher capital and liquidity requirements and the business
model changes being mandated for the derivatives business.
KPMG (2013a, 2103b) has conducted studies on the
impact of the new regulation on the banking sector for Belgium and Netherland for the time period 2013 to 2016. These quantitative assessments
derive from accounting identities and concentrate on private costs.  They look
at the effects of regulation on banks' balance sheets and income statements for
the following measures: CRD IV/Basel III, crisis management and bank resolution
(incl. bail-in), deposit guarantee scheme (DGS) and the financial transaction
tax (FTT). Special measures in each country, such as the financial stability
contribution for the Belgium banks, are also included. In the baseline
scenario, in which banks do not take any additional measures to comply with the
new regulatory requirements, the estimates show large falls in bank
profitability, and an expectation that they would still not be able to reach
the regulatory targets by 2016.  The studies suggest that in order to reach the
targets, a mix of measures (e.g. structural net costs reduction of 10 %,
re-pricing of debt and loans, extra fee business and a liquidity transformation
of assets), is necessary - the costs of which would be around EUR 4.4 billion
for the Belgian and EUR 3.3 billion for the Dutch banking sectors respectively.
KPMG (2013c) also conducts a more qualitative study on the regulatory costs for
German banks from 2010 to 2015. This study is based on a sampled survey of 20
German banks forming up to 60 % of the total assets in the German banking
sector. The direct costs of regulation for the sample banks are about EUR 2.3
billion for 2010-2012 and EUR 2.9 billion for 2013-2015. These costs include
not only the CRD IV package, but also EMIR and other regulatory measures.
Studies by public authorities and academics
The Basel Committee on Banking
Supervision (BCBS) has coordinated work on estimation of the impact
of Basel III among public institutions worldwide in 2009/2010. The Basel
Committee established a Macroeconomic Assessment Group (MAG) to draft a
unified impact report based on the estimation approaches taken by public
entities in each country. The interim report issued in June 2010 draws on the
preliminary results of several quantitative assessments prepared by central
banks and regulators in 13 countries[3]
plus the IMF, the ECB and the European Commission Services. The final MAG
report was published in December 2010 and reflects the regulatory proposals as
agreed by the Basel Committee in September 2010 by the group of Governors and
Heads of Supervision (GHOS). 
The MAG study focuses only on the
transitional costs of stronger capital requirements. The estimates consider the
macroeconomic response during an eight-year implementation period for a gradual
increase in target capital ratios, so that both the quantity and quality
expectations of new capital requirements are met. Overall, the MAG’s estimates
suggest a modest impact on aggregate output in the transition towards higher
capital standards. Based on the unweighted median estimate across 97
simulations, the MAG estimated that increasing the target ratio of tangible
common equity (TCE) to RWA, in order to meet the agreed minimum requirements
and the capital conservation buffer, would result in a maximum decline in GDP
of 0.22 % relative to baseline forecasts after 8 and ¾ years. Note that these
results apply to any kind of increase of TCE. They do not discriminate by type
of increased requirement, e.g. higher regulatory minima buffers, changes to the
definitions of capital or risk-weighted assets, or voluntary decisions by banks
to increase their capital buffers.  The regulatory impact of increased TCE on
the volume and the costs of lending in the interim MAG report is also less
severe than projected by the industry (e.g. IIF). The median lending volume
declines by a maximum 1.9 % for capital changes (TCE rising by one percentage
point) and 3.2 % for liquidity changes (a 25 % increase in the liquid-to-total
assets ratio) according to the MAG interim results. The median increase in
lending spreads under the MAG scenario was 17 bps due to changes in capital
requirements and 14 bps due to liquidity requirements.
A later MAG study in 2011 estimated
the impact of higher capital requirements on global systemic important
institutions (G-SIBs) by scaling the impact of raising capital requirements
on the banking system as a whole by the share of G-SIBs in domestic financial
systems. The study finds that higher capital requirements on G-SIBs have only a
moderate effect on economic activity. It estimates that
raising the capital requirements for the top 30 potential G-SIBs by one
percentage point over eight years, would lead to a reduction in GDP of 0.06 %
below trend which would then be followed by a subsequent recovery, i.e. it will
bounce back to the trend. The primary driver of this macroeconomic impact is an
increase in lending spreads of 5bp–6bp from the
build-up of capital buffers.
The work of the MAG on short-term effects
of higher capital requirements was complemented by an assessment initiated by
the Basel Committee on the long-term economic impact (LEI) of the
proposed capital and liquidity reforms[4]. The LEI report,
published in August 2010, concludes that the potential benefits of the bank
regulatory reforms are large and outweigh the perceived costs.  The regulatory
benefits are expressed through a reduction in the probability of a crisis
multiplied by potential losses once it occurs. The costs are expressed as
steady state output losses, mainly related to higher lending rates, resulting
from a higher overall cost of capital. The LEI report presents the potential
costs/benefits as a median of estimations from thirteen different studies. Key 
assumptions are within this report are: a full
pass-through of capital and funding costs to loan rates; no reduction in
operating expenses; no increase in non-interest sources of income; no credit
rationing; no changes in the cost of capital and debt arising from higher
capital and liquidity ratios; a possible reduction in the liquidity
requirements arising from compliance with the capital requirements; a 15
percent return-on-equity (ROE) that firms need to meet all the time; and a 100
bps yield difference between illiquid and liquid assets and long and short
liabilities. 
The report treats the macroeconomic costs
of financial crises as either temporary, in which case the economy returns to
its growth path, or permanent, where the economy eventually resumes its
pre-crisis growth rate but remains on a lower growth path compared to a no
crisis situation. The potential losses associated with banking crises range
between 19 % (when only temporary effects are assumed) and 158 % (when large
permanent effects are assumed) of the pre-crisis GDP levels. Assuming moderate
permanent effect of a financial crisis, the potential costs would sum up to
around 63 % of the pre-crisis GDP. 
The probability of a financial crisis is
derived through two different approaches: (1) reduced-form econometric models
based on historical data; and (2) structural (credit risk type) models based on
portfolio theory.  The second approach resembles the methodology used in the
Commission's SYMBOL estimations (see Annex 4). Based on these two approaches
and assuming moderate permanent effects of a crisis, then the expected annual
benefits of increasing only capital requirements by two percentage points from
7 % to 9 % of RWA would be around 1.62 % of the pre-crisis GDP.  When in addition the NSFR is fully met, the annual expected benefits
can add up to 1.82 % of the pre-crisis GDP. 
The estimation of
macroeconomic costs is normally based on various DSGE (Dynamic Stochastic
General Equilibrium) type models, which is similar to the QUEST model used to
estimate the costs for this report (see Annex 5). It is estimated that
increasing capital requirements from 7 % to 9 % of RWA
would reduce the long-run steady-state level of GDP by 0.18 % annually (and by
0.26 % when the NSFR is also met).[5]
While these numbers represent a median of various different studies from
different countries, the numbers for the Euro Area are similar. The net-benefits for the Euro Area sum up to 1.56 % of the
pre-crisis GDP. More generally, the LEI reports positive net benefits for a
broad range of minimum regulatory capital ratios imposed, even in scenarios
when the financial crisis has only temporary effects.
The European Parliament published an
impact assessment on the different measures within the CRD IV package in June 2011.
This assessment evaluates the potential effects of the
new capital requirements on the cost of capital and thereby on interest rates
through three scenarios: (1) fixed return on equity and bank debt interest
rates, (2) complete/incomplete pass-through of increased bank financing costs
to bank customers, (3) Modigliani-Miller (MM) perspective on bank financing,
assuming that bank financing costs does not change (100 % MM). In the first scenario bank funding rates are assumed to be
constant due to the gradual implementation of reforms. The weighted average
cost of capital (WACC) is calculated based on the changes in the shares of
equity and debt in bank funding. A one percentage point increase in the capital
requirements and the liquidity requirements will increase the WACC by 11.5
basis points. In the second scenario the report does not provide a conclusive
finding on whether bank cost of funding will be fully transferred to customers.
The increase in WACC will lead to a different response in the costs of credit
depending on the credit demand elasticities. In the third scenario the study
concludes that the WACC increase will be modest.  The report by the European
Parliament estimates the costs of CRD IV measures on economic output and
growth. It finds a one percentage point increase in the capital requirement and
the liquidity requirement will lead to a decrease in the GDP growth rate of
0.33 percentage points in the short run.  This is breaks down into a decline in
the GDP growth rate of 0.18 percentage points due to the increase in the
capital requirement and 0.15 percentage points due to the increase in the
liquidity requirements[6].

The Organization for Economic
Cooperation and Development (OECD) provided estimates of the macroeconomic
impact of the new Tier 1 and common equity standards in early 2011.  OECD uses
a simple banking model, where the transmission mechanism is the lending
channel. This model assumes the increased costs of funding are directly passed
through as an increase in the price (interest rates) of loans. Adjustments on
operational costs are not considered. The bank discretionary buffer, which in
practice a bank might decide to reduce in a new environment of higher capital
requirements, is also kept constant. These assumptions tend to overstate the
costs. To meet the capital requirements by 2019, the
estimations show that the banks' lending spreads would increase by 54bp for the
Euro area and about 50bp for the advanced economies (OECD 2011). The increase
in lending rates would translate in 1.14 % decrease in GDP level for the Euro
area and 0.73 % for the advanced economies after five years (OECD 2011).
In May 2012, the UK Financial Services
Authority (FSA) published an empirical study on the impact of changes in
prudential standards on economic activity. The total cost of the policy package
was estimated at £4.9 billion or 0.38 % of yearly GDP and includes measures
related to the FSA's capital requirement regime, CRD III, Basel III minimum
requirements, capital conservation and countercyclical buffer, systemic
institutions surcharge and the new liquidity coverage ratio. The key finding of
this study is that short-run reductions in GDP are more than offset in the
longer term as crises become rarer. This is in addition to the increase in financial
stability related benefits to public welfare. The study finds the overall net
impact on GDP to be positive, with a net benefit estimated to be £11.9 billion
annually (or ranging between £4- 66 billion per year within a 90 % confidence
interval).
In September 2012, the International
Monetary Fund (IMF) published a working paper "Assessing the Cost of
Financial Regulation" which assessed the costs of financial regulation in
terms of an increased credit spread. The relatively low economic costs found in
this study strongly suggest that the benefits will outweigh the costs of
regulatory reforms in the long-term. 
The IMF caution the approach taken in some
other studies (e.g. IIF) that assume all increases in safety margins are due to
regulatory changes, which may exaggerate the total cost of reforms. The IMF uses a relative simple model to estimate the increase in
credit spreads required to accommodate the various reforms (capital and
liquidity requirements, derivatives reforms). IMF assumes that credit providers
need to charge for the combination of the cost of allocated capital, the cost
of other funding, credit losses, administrative costs, and other miscellaneous
factors. Cost estimates are provided for capital and liquidity requirements,
derivative reforms, and the effects of higher taxes and fees. 
The cumulative impact estimates break down
as follows: a 19bp increase in cost of capital; 4bp increase in LCR; 10bp
increase in NSFR; 6bp increase due to taxes; and 1bp due to derivative reforms[7];
all of which will be offset by a 9bp decrease in return on equity (ROE) and 2bp
spread adjustment for overlaps. The total gross effect on the credit spread is
an increase of 29bp. When other actions are taken into account, for example,
expense cuts of 5 % and other aggregate adjustments for Europe, the credit
spread additionally decreases by 8bp and 5bp respectively.  Taking these
together, the IMF estimates a total net increase in the credit spread of 17bp.
Sensitivity analysis performed on the cost
estimates indicate that reasonable changes in the assumptions would not alter
the conclusions dramatically. The results are broadly in line with previous
studies, including the official BIS assessment of Base III (BCBS (2010), MAG
(2010) and the OECD analysis by Slovik and Cournéde (2010).
In its approach, the IMF extends the
methodologies of the public authority studies which lead to substantially lower
net economic costs. The increase in the credit spreads are roughly a third to a
half of those found in the BIS and OECD studies. The major difference stems
from the fact that the IMF assumes greater impact from market forces on the
safety margins, and as a result less regulatory effect. Industry actions
through the end of 2010 suggest that these market reactions would have occurred
even if no regulatory changes were contemplated. Another major difference from
the previous public authority studies relates to the effect on credit prices
and availability. However, the IMF recognises some limitations to its own
analysis, including that: transition costs were not examined; a number of
regulatory reforms were not modelled; subjective judgement was used in
developing some estimates; the overall modelling approach is relatively
simplistic; and that the regulatory implementation is assumed to be efficient
and sensible.
In its consultation paper from August 2013
"Strengthening capital standards: implementing CRD
IV", the Bank of England (BoE) estimated
the impact of higher capital requirements coming from the CRD IV package for
the period 2010 to 2021. The sample used for estimations includes 10 UK firms representing 64 % and 70 % of the UK banking sector in terms of total assets and lending
activity. The BoE clearly states that the estimated numbers should only be
indicative, as it is not possible to disaggregate the
benefits of the CRD IV package in isolation from other measures taken in
response to the crisis that affect deposit-takers’ capital ratios. However, the
measured benefits of actions taken since the crisis to raise capital ratios are
estimated to be in excess of the assessed costs. Therefore, the BoE considers
the CRD IV package to be net beneficial to the UK economy. Macroeconomic costs (using the NiGEM model) of higher capital
requirements are estimated to be around £ 4.5 billion/year, while the benefits
resulting from reducing the probability of a crisis are about £ 15.5/year. 
Note that these estimates underlie significant model and data uncertainty,
which is demonstrated by their variability for different confidence intervals
(e.g. for the 95 % confidence interval the net-benefits
lie between a range of £ -2 billion and £23 billion /
year).
For the UK economy, there have been
additional studies on the impact of higher capital and liquidity requirements. Barrell
et al. (2009) estimates using the NiGEM model that one percentage point
rise in the target level of the capital adequacy ratio and in the liquidity
ratio is found to reduce equilibrium output by around 0.08 per cent in the UK.
Barrell et al. (2009) also provide a cost-benefit analysis of increased capital
and liquidity standards. A three percentage point increase in the capital and
liquidity ratios will produce long term net benefits that are worth 7 % of 2009
UK GDP. 
In a working paper published by the Bank of
England, Miles et al. (2011) link the capital asset pricing model (CAPM)
and the MM theorem by showing that in the absence of systemic risk on bank debt
the risk premium on bank equity should decline linearly with leverage. The
authors find that the MM offset is about 45 % for UK banks. Miles et al. use a
constant elasticity of substitution production function to assess the impact of
higher capital requirements. If the UK banks are required to halve their
leverage this translates into a long run decline in GDP of 0.15 %, or a fall of
the present value of all future output by about 6 % of GDP. 
References:
Bank
of England (2013): "Strengthening capital standards: implementing CRD
IV", August 2013, CP5/13.
Basel Committee on Banking Supervision, (BCBS – LEI Group, 2010).
"An assessment of the long-term economic impact
of the stronger capital and liquidity requirements", August 2010.
_____, BCBS – MAG
Group, (2010a). "Assessing the macroeconomic impact of the transition to
stronger capital and liquidity requirements", December 2010.
_____, BCBS - Basel III, (December 2010b). " Assessing the
macroeconomic impact of the transition to stronger capital and liquidity
requirements", December 2010.
_____, BCBS – MAG
Group, (2011). "Assessing the macroeconomic impact of higher loss
absorbency for global systemically important banks", October 2011.
Barrell Ray, E. Philip
Davis, Tatiana Fic, Dawn Holland, Simon Kirby, Iana Liadze (2009).
"Optimal regulation of bank capital and liquidity: how to calibrate new
international standards". FSA Occasional Paper Series, No. 38.
European Parliament,
(2011). "CRD IV – Impact Assessment of the Different Measures within the
Capital Requirements Directive IV", June 2011.
______ (2011).
"Assessment of the Cumulative Impact of Various Regulatory Initiatives on
the European Banking Sector", August 2011.
Financial
Stability Board (2013): "A Narrative Progress Report on Financial
Reform", Report of the Financial Stability Board to G20 Leaders, August
2013.
Financial
Supervisory Authority (2012): Measuring the impact of prudential policy on the
macroeconomy: A practical application to Basel III and other responses to the
financial crisis, Occasional Paper Series 42, May 2012.
International
Monetary Fund (2010). "Impact of Regulatory Reforms on Large and Complex
Financial Institutions", November 2010, IMF Staff Position Note. 
_____,
(2012). "The Cumulative Impact on the Global Economy of Changes in the
Financial Regulatory Framework". Assessing the cost of financial
regulation", September 2012, IMF Working Paper 
Institute of International Finance (2010). "Interim Report on the Cumulative
Impact on the Global Economy of Proposed Changes in the Banking Regulatory
Framework". 
_____,
(2011a). "The Cumulative Impact on the Global Economy of Changes in the Financial
Regulatory Framework". 
J.P. Morgan (2010).
"Global Banks – Too Big to Fail?"  February 2010
_____, (2010). "European Bank Bail-In Survey", October
2010
KPMG
(2012): "The cumulative impact of regulation. An impact analysis of
accumulation of regulations on the Duch banking sector", September 2012.
KPMG
(2013): "The cumulative impact of regulation. An impact analysis of the
accumulation of regulations on the Belgian banking sector", June 2013.
Miles D., Jing Yang and Gilberto Marcheggiano
(2011). "Optimal bank capital". Bank of England Discussion Paper n.
31.
McKinsey&Company
(2010). "Basel III and European Banking: Its impact, how banks might
respond, and the challenges of implementation". November 2010
Annex 2: Summary of proposed and adopted legislations 
The following lists the main
measures of the financial reform agenda, categorised into three groups: 
–       
Response to the financial crisis—the measures
that constitute the direct response to the financial crisis, as also agreed at
international level as part of the G20 commitments;
–       
Banking
 Union—the measures to improve the operation of the economic and monetary union
in the euro area by creating a Banking Union; and
–       
Other
measures—the wider, additional measures taken to establish a stable, responsible
and efficient financial sector that serves the real economy and contributes to
economic growth. 
Response to financial crisis
 Date of COM proposal || Short title || Status || Link to website 
 Apr 2009 || Hedge Funds & Private Equity (“AIFMD”) || Completed   || http://ec.europa.eu/internal_market/investment/alternative_investments/index_en.htm 
 Jul 2009   || Remuneration & prudential requirements for banks (“CRD III”) || Completed   || http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm   
 Sep 2010 || Derivatives (“EMIR”) || Completed   || http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm   
 Jul 2010   || Deposit Guarantee Schemes || Political agreement reached; pending final vote || http://ec.europa.eu/internal_market/bank/guarantee/index_en.htm   
 Nov 2008 June 2010 Nov 2011 || Credit Rating Agencies || Completed || http://ec.europa.eu/internal_market/rating-agencies/index_en.htm   
 Jul 2011 || Single Rule Book of prudential requirements for banks: capital, liquidity & leverage + stricter rules on remuneration and improved tax transparency (“CRD IV package”) || Completed || http://ec.europa.eu/internal_market/bank/regcapital/index_en.htm   
 Oct 2011 || Enhanced framework for securities (“MiFID II”) || Political agreement reached; pending final formal adoption || http://ec.europa.eu/internal_market/securities/isd/mifid/index_en.htm   
 Oct 2011 || Enhanced framework to prevent market abuse (“MAD/R”) || Political agreement reached; pending final formal adoption || http://ec.europa.eu/internal_market/securities/abuse/index_en.htm   
 Jun 2012 || Prevention, management & resolution of bank crises (“BRRD”) || Political agreement reached; pending final vote || http://ec.europa.eu/internal_market/bank/crisis_management/index_en.htm#maincontentSec4     
 Sep 2013 || Shadow banking, including Money Market Funds || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/finances/shadow-banking/index_en.htm   
 2014 || Prevention, management & resolution of financial institutions other than banks || Proposal to be presented by COM ||   
Banking Union
 Date of COM proposal || Short title || Status || Link to website 
 Sep 2012 || Single Supervisory Mechanism || Completed || http://ec.europa.eu/internal_market/finances/banking-union/index_en.htm 
 Jul 2013 || Single Resolution Mechanism || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/finances/banking-union/index_en.htm   
Other measures to
enhance a stable, responsible and efficient financial sector
 Date of COM proposal || Short title || Status ||   
 July 2007 || Risk-based prudential and solvency rules for insurers (“Solvency II”) || Completed || http://ec.europa.eu/internal_market/insurance/solvency/latest/archive_en.htm   
 Sep 2009 || Establishment of the European Supervisory Authorities (for banking, capital markets, insurance and pensions) & the European Systemic Risk Board regulations || Completed || http://ec.europa.eu/internal_market/finances/committees/index_en.htm   
 Sep 2009 || Proposal for a review of the Prospectus Directive || Completed || http://ec.europa.eu/internal_market/securities/prospectus/index_en.htm 
 July 2010   || Investor Compensation Schemes || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/securities/isd/investor/index_en.htm   
 Aug 2010 || Strengthened supervision of financial conglomerates (FICOD I) || Completed || http://ec.europa.eu/internal_market/financial-conglomerates/supervision/index_en.htm#maincontentSec2   
 Sep 2010 || Short-Selling & Credit Default Swaps || Completed || http://ec.europa.eu/internal_market/securities/short_selling/index_en.htm   
 Dec 2010 || Creation of the Single Euro Payments Area (“SEPA”) || Completed || http://ec.europa.eu/internal_market/payments/sepa/index_en.htm   
 Jan 2011 || New European supervisory framework for insurers (“Omnibus II”)   || Political agreement reached; pending final vote || http://ec.europa.eu/internal_market/insurance/solvency/latest/index_en.htm   
 Feb 2011 || Interconnection of business registers facilitating cross-border access to information about EU companies || Completed || http://ec.europa.eu/internal_market/company/business_registers/index_en.htm   
 Mar 2011 || Responsible lending (mortgage credit directive, MCD) || Completed || http://ec.europa.eu/internal_market/finservices-retail/credit/mortgage/index_en.htm   
 Oct 2011 || Simplification of accounting || Completed || http://ec.europa.eu/internal_market/accounting/sme_accounting/review_directives/index_en.htm   
 Oct 2011 || Enhanced transparency rules || Completed || http://ec.europa.eu/internal_market/accounting/non-financial_reporting/index_en.htm   
 Nov 2011 || Enhanced framework for audit sector || Political agreement reached; approved by Parliament and endorsed in Coreper in April 2014 || http://ec.europa.eu/internal_market/auditing/reform/index_en.htm   
 Dec 2011 || Creation of European Venture Capital Funds (EuVECAs) || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/investment/venture_capital/index_en.htm   
 Dec2011 || Creation of European Social Entrepreneurship Funds (EuSEFs) || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/investment/social_investment_funds/index_en.htm   
 Mar 2012 || Central Securities Depositaries   || Political agreement reached; pending final vote || http://ec.europa.eu/internal_market/financial-markets/central_securities_depositories/index_en.htm   
 Jul 2012 || Improved investor information for packaged retail and insurance-based investment products (“PRIIPS”) || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/finservices-retail/investment_products/index_en.htm   
 Jul 2012 || Strengthened rules on the sale of insurance products (“IMD II”) || Political agreement reached, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/insurance/consumer/mediation/index_en.htm   
 Jul 2012 || Safer rules for retail investment funds (“UCITS”) || Political agreement reached; pending final vote || http://ec.europa.eu/internal_market/investment/ucits-directive/index_en.htm   
 Feb 2013 || Strengthened regime on anti-money laundering || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/company/financial-crime/index_en.htm   
 Apr 2013 || Non-financial reporting for companies || Political agreement reached; pending final vote || http://ec.europa.eu/internal_market/accounting/non-financial_reporting/index_en.htm   
 May 2013 || Access to basic bank account / transparency of fees / switching of bank accounts || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/finservices-retail/inclusion/index_en.htm   
 Jun 2013 || Creation of European long-term investment funds (EuLTIFs) || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/investment/long-term/index_en.htm#maincontentSec2   
 Jul 2013 || New rules for innovative payment services (cards, internet & mobile payments) & the interbank fees paid on card transactions (“multilateral interchange fees”) || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/payments/framework/index_en.htm#psd2   
 Sep 2013 || Regulation of Financial Benchmarks || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/securities/benchmarks/index_en.htm   
 Jan 2014 || Structural reform of banks || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/bank/structural-reform/index_en.htm   
 Jan 2014   || Securities financing transactions regulation || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/finances/shadow-banking/index_en.htm   
 2014 || Revised rules for occupational pension funds (“IORP”) || Proposal presented by COM, but not yet adopted by the co-legislators || http://ec.europa.eu/internal_market/pensions/directive/index_en.htm     
 2014 || “Say on Pay” & increasing long-term shareholder commitment || Proposal to be presented by COM ||   
Annex 3: Overview
of Review reports required in key legislations 
The reform measures include comprehensive
review clauses on the application and impact of the respective measures two to
five years after entry into force or application of the legislative act. This
annex lists the different reports required under the legislations. It is not
exhaustive and only covers a selection of reports to be produced under some of
the key legislative measures during 2014 and 2016.[8] Other legislative
measures also contain review clauses.  
 Basic legal text || Topic(s) || Deadline 
 CRR Regulation (EU) No 575/2013 || Liquidity (Art. 8) || 01/01/14 
 CRR Regulation (EU) No 575/2013 || Cyclicality of capital requirements (Art. 502) || Bi-annually 
 CRA Regulation Regulation (EU) No 462/2013 || Appropriateness of the development of a European creditworthiness assessment for sovereign debt (Art. 39b) || 31/12/14 
 EMIR Regulation (EU) No 648/2012 || Progress made by CCPs in developing technical solutions for the transfer by pension scheme arrangements of non-cash collateral as variation margins (Art. 85) || 01/08/14 
 CRR Regulation (EU) No 575/2013 || Covered bonds (Art. 502, 503), long-term financing (505), level of application (508), transferred credit risk (512, 513), large exposures (517), own funds (519) || 31/12/14 
 CRR Regulation (EU) No 575/2013 || Temporary stricter prudential requirements (Art. 459) || At least on an annual basis 
 CRD Directive 2013/36/EU || Disclosure (Art. 89), Pillar 2 (161), Central bank funding support measures (161) || 31/12/14 
 CRR Regulation (EU) No 575/2013 || Lending to SMEs (Art. 501) || Within 36 months after entry into force 
 CRD Directive 2013/36/EU || Benchmarking of internal models (Art. 78) || 01/04/15 
 CRD Directive 2013/36/EU || Country by country reporting (Article 89) || 31/12/14 
 CRD Directive 2013/36/EU || Diversity (Art.161) || 31/12/16 
 CRA Regulation Regulation (EU) No 462/2013 || Report in respect of the delegated powers in the CRA Regulation (Art. 38a) || At the latest 6 months before 1/6/15 
 MiFID II (political agreement, pending final formal adoption) || Assessment of the treatment of Central Banks and of the BIS (Art. 1(4g)) || 01/06/2015 
 EMIR Regulation (EU) No 648/2012 || Application of EMIR (Art. 85), systemic importance of the transactions of non-financial firms in OTC derivatives contracts || 18/08/15; 17/08/15 
 EMIR Regulation (EU) No 648/2012 || Risk and cost implications of interoperability arrangement || Annual report 
 CRD Directive 2013/36/EU || Systemic risk (Art. 132) || 31/12/15 
 CRR Regulation (EU) No 575/2013 || Large exposures to shadow banking entities (Art. 395), investment firms (498, 508), large exposures (507), long-term investments (516), own funds (518) || 31/12/15 
 SSM (Council Regulation (EU) No 1024/2013) incl. amendment to EBA regulation  (Regulation (EU) No 1022/2013)   || Application of SSM Regulation; impact on internal market, governance arrangements in SSM and EBA (Art. 2 of Regulation No 1022/2013, Art. 32 of the SSM Regulation) || 31/12/15 
 CRA Regulation Regulation (EU) No 462/2013 || Report on steps taken to delete references to ratings and on alternative credit risk assessment tools || 31/12/15 
 CRA Regulation Regulation (EU) No 462/2013 || Report assessing disclosure on Structured finance instruments, conflicts of interest, rotation, remuneration, competition, contractual over-reliance on ratings, financial stability (Art. 39) || 01/01/16 
 BRRD (political agreement, pending final vote) || Preventive recapitalizations (Art. 27) || 01/01/16 
 MiFID II (political agreement, pending final formal adoption) || Assessment of the need for temporary exclusion of exchange traded derivatives from the scope of Article 28 and 29 (Art. 43(8)) || 30/06/2016 
 CRR Regulation (EU) No 575/2013 || SMEs (501) || 28/06/16 
 CRD Directive 2013/36/EU || Remuneration (Art. 161) || 30/06/16 
 CRD Directive 2013/36/EU || Systemic risk (Art. 89, 132), governance (161) || 31/12/16 
 CRR Regulation (EU) No 575/2013 || Covered bonds (503), own funds (504), leverage ratio (511), counterparty credit risk (514, 515), extension of Basel I floor (500) || 31/12/16; 01/01/17 
 CRA Regulation Regulation (EU) No 462/2013 || Appropriateness and feasibility of a European CRA dedicated to assessing the creditworthiness of MS sovereign debt and/or a European credit rating foundation for all other credit ratings (Art. 39b) || 31/12/16 
Annex 4: Quantitative modelling of benefits
This annex has been prepared by the Joint
Research Centre (JRC) of the European Commission (EC). It presents some
estimations of potential benefits for public finances and macroeconomic
benefits of implementing the Capital Requirement Directive IV (CRD IV) package
and the Bank Recovery and Resolution Directive (BRRD) proposal. The methodology
used in this section is the same in the BRRD impact assessment published in
June 2012.[9] 
The benefits of the new bank regulatory
framework for public finances are measured as a decrease in the potential costs
for public finances in the case of bank defaults when the above reforms are in
place. More precisely, the costs are the losses of
distressed banks as well as recapitalisation needs (i.e. capital injections solvent
banks need to replace depleted capital in order to remain viable) beyond those
covered by the available tools set up in the EU legislation (CRD IV package and
BRRD).[10] These losses and recapitalisation needs were mostly covered by
State aid during the recent financial crisis started. Results are calculated as
an aggregate for the entire European Union 27 (EU 27)[11]. 
Macroeconomic benefits of introducing the
CRD IV package and the BRRD arise from the fact that individual banks'
increased capital and safety net tools determine a reduction in the probability
of a systemic crisis (Systemic PD henceforth). This implies that
expected costs of a crisis are reduced compared to a situation where CRD IV and
BRRD are not in place.
The CRD IV package and BRRD are two pieces
of EU legislation which aim to reduce the probability of future crises and also
to set up tools which call shareholders and creditors to pay costs of a crisis
in case of need. More specifically, the CRD IV package[12] is a package that entered into force in July 2013 which transposes
into EU legislation the new global standards on bank capital (the Basel III
agreement). The new CRD IV rules "tackle some of the vulnerabilities shown
by the banking institutions during the crisis, in particular the insufficient
quantity and quality of capital, resulting in the need for unprecedented
support from national authorities. More specifically, Basel III rules raise
both the quality and quantity of the regulatory capital base and enhance the
way Risk Weighted Assets (RWA) are computed. The BRRD Proposal, published by
the EC in July 2012 and for which an agreement among the EU decision-making
institutions was reached in December 2013, ensures that banks’ shareholders and
creditors pay their share of costs in case of need (via the bail-in tool) and
it sets up pre-funded national Resolution Funds (RF) to be used in case bail-in
is not sufficient. Moreover, it sets the rules clarifying the role of deposit
guarantee schemes (DGS) in the resolution process.
Results in this annex are obtained using
the SYMBOL model (Systemic Model of Banking Originated Losses), a simulation
engine developed by the JRC, the Directorate General Internal Market and
Services, academia, and experts on banking regulation (see De Lisa et al., 2011).
Using selected balance sheet data as inputs and the loss distribution function
of the Basel Foundation Internal Rating Based (FIRB) approach, it simulates
losses within a banking system.[13] The SYMBOL model is also employed to estimate the Systemic PDs
of occurrence of a systemic crisis for the macroeconomic benefits analysis.
The model can be run under alternative
“counterfactual” specifications for the amount of Minimum Capital Requirement
(MCR) and for the resolution tools in place, enabling to assess the effects of
introducing the CRD IV package and BRRD. In particular, we simulate the effects
of moving from a baseline scenario reflecting the situation at the inception of
the crisis to alternative ones with improved capital (CRD IV implementation) and
bail-in/resolution funds (BRRD introduction). 
Benefits for public finances are measured
by comparing residual losses (i.e. losses not covered by provisions, capital
and safety net tools) in the baseline with those obtained under the alternative
"reform" scenarios. Macroeconomic benefits are measured as the
avoided expected shortfalls in GDP due to the decrease of the frequency of
systemic crises (i.e. reduction of the Systemic PD). In this
report a systemic banking crisis is defined as a situation where the amount of
covered deposits[14] held in distressed banks (i.e. defaulted or undercapitalized)
exceed a specified threshold, beyond which authorities would find it impossible
to avoid the crisis from spreading into the real economy.
This annex is organized as follows. The
next section outlines the SYMBOL model. The data and the regulatory scenarios
are subsequently described. The following sections present estimated benefits
for public finances and the macroeconomic benefits in terms of avoided costs.
The last section concludes. Three appendices give more detail on technical
aspects. Appendix 1 describes the preliminary steps for setting up the SYMBOL
model. Appendix 2 gives details on the dataset employed. Appendix 3 gives
technical details on the estimation of the cost of crisis employed in this
annex.
SYMBOL
SYMBOL simulates the distribution of losses in excess of banks’
capital within a banking system (usually a country) by aggregating individual
banks' losses. Individual banks' losses are generated via Monte Carlo simulation using the Basel FIRB loss
distribution function. This function is based on the Vasicek model (see
Vasicek, 2002), which in broad terms extends the Merton model (see Merton,
1974) to a portfolio of borrowers.[15] Simulated losses are based on an estimate of the average default
probability of the portfolio of assets of any individual bank, which is derived
from data on banks' MCR and Total Assets (TA).
For the purpose of the present exercise,
each SYMBOL simulation ends when 100,000 runs with at least one default are
obtained. The large number of runs ensures a sufficient degree of stability in
the tail of the loss distributions. As a consequence, the model runs for a few
millions of iterations for small countries and hundreds of thousands iterations
for medium or large countries.
The model includes also a module for
simulating direct contagion between banks, via the interbank lending market. In
this case, additional losses due to a contagion mechanism are added on top of
the losses generated via Monte Carlo simulation, potentially leading to further
bank defaults (see also Step 4 below). The contagion module can be turned off
or on depending on the scope of the analysis and details of the simulated
scenario.
In addition to bank capital, the model can
take into account the existence of a safety net for bank recovery and
resolution, where bail-in, DGS, and RF intervene to cover losses exceeding bank
capital before they can hit public finances.
Estimations are based on the following
assumptions: 

 SYMBOL approximates all risks as if they
     were credit risk; no other risk categories (e.g. market, liquidity or
     counterparty risks) are explicitly considered.
 SYMBOL implicitly assumes that the FIRB
     formula adequately represents (credit) risks that banks are exposed to.
 Banks in the system are correlated with
     the same factor (see Step 2 below);
 All events happen at the same time, i.e.
     there is no sequencing in the simulated events, except when contagion
     between banks is considered. 
 The only contagion channel is the
     interbank lending market. SYMBOL assumes that each bank is linked with all
     others and uses a criterion of proportionality to distribute additional
     contagion losses: the amount of losses distributed to each bank is
     determined by the share of its creditor exposure in the interbank market
     (for more details and references see also the description of SYMBOL steps
     below). 

We continue this section detailing
steps/assumptions of SYMBOL and the way safety net tools are introduced into
the framework.
Steps of SYMBOL
·        
STEP 1:
Estimation of the Implied Obligors’ Probability of Default (IOPD) of the
portfolio of each individual bank.
      The model estimates the average IOPD of the portfolio of each
individual bank using its total MCR[16] declared in the balance sheet by numerical inversion of the Basel
FIRB formula for credit risk. Individual bank data needed to estimate the IOPD
are banks' RWA and TA, which can be derived from the balance sheet data. All
other parameters are set to their regulatory default values. Appendix 1 gives
additional technical details on the FIRB formula for the interested reader.
·        
STEP 2:
Simulation of correlated losses for the banks in the system.  
      Given the estimated average IOPD, SYMBOL assumes that
correlated losses hitting banks can be simulated via Monte Carlo using the same
FIRB formula and imposing a correlation structure among banks (with a
correlation set to R=50 %). This correlation exists either as a
consequence of the banks’ common exposure to the same borrower or, more
generally, to a particular common influence of the business cycle[17]. In each simulation run j, losses for bank i are
simulated as:
      where N is the normal distribution function, N−1(α
i,j) are correlated normal random shocks, and  IOPDi is
the average implied obligors’ probability of default estimated for each bank in
Step 1. LGD is the Loss Given Default, set as in Basel regulation to 45
%.
·        
STEP 3:
Determination of the default event.
      Given the matrix of correlated losses,
SYMBOL determines which banks fail. As illustrated in Figure 1, a bank default
happens when simulated obligor portfolio losses exceed the sum of the expected
losses (EL) and the total actual capital (K) given by the sum of its MCR plus
the bank’s excess capital, if any :
      The green-shaded area in Figure 1 represents the region where
losses are covered by provisions and total capital, while the red-shaded one
shows when banks default under the above definition. It should be noted that
the probability density function of losses for an individual bank is skewed to
the right, i.e. there is a very small probability of extremely large losses and
a high probability of losses that are closer to the average/expected loss. The
Basel Value at Risk (VaR) corresponds to a confidence level of 0.1 %, i.e. the
MCR covers losses from the obligors’ portfolio with probability 99.9 %. This
percentile falls in the green-shaded area as banks generally hold an excess
capital buffer on top of the MCR. 
      Data needed for determining the default event for each bank is
its level of total capital. 
Figure 1: Individual bank loss probability
density function
·        
STEP 4
(Optional): Contagion mechanism.
      SYMBOL can include a direct contagion
mechanism since the default of one bank can compromise the solvency of its
creditor banks, thus triggering a domino effect in the banking system. SYMBOL
focuses on the role of the interbank lending market in causing contagion. In
fact, the failure of a bank is assumed to drive additional losses on the others
equal to 40 % of the amounts of its total interbank debts.
      As bank-to-bank interbank lending positions are not publicly
available, an approximation is needed to build the whole matrix of interbank
linkages. It is assumed that the more a bank is exposed in the interbank market
as a whole, the more it will suffer from a default in the system. In
particular, contagion losses are apportioned to all other banks proportionally
to their interbank loans. A default driven by contagion occurs whenever these
additional contagion losses and losses generated via Monte Carlo exceed the
bank’s available capital. This contagion mechanism stops when no additional
bank defaults.
      The magnitude of contagion effects depends on the two
assumptions made: first the 40 % interbank debits that are passed on as losses
to creditor banks in case of failure, and, second, the criterion of
proportionality used to distribute these losses across banks. [18]
A loss of 40 % of the interbank exposure is consistent with the upper bound of
economic research on this issue, see e.g. James, 1991, Mistrulli, 2007 and
Upper and Worms, 2004. A sensitivity test has been developed in Zedda et al.,
2012 in order to test whether variations in the structure of the interbank
positions systematically change the magnitude of contagion. The test shows that
increasing the concentration of interbank linkages does not relevantly affect
the results. 
      Data needed to simulate contagion is the amount of interbank
debts and credits for each individual bank.
·        
STEP 5:
Aggregated distribution of losses for the whole system.
      Aggregate losses are obtained by summing losses in excess of
capital plus potential recapitalisation needs of all distressed banks in the
system (i.e. both failed and undercapitalised banks) in each simulation run.
In order to
compute losses hitting public finances, we consider the amount of funds
necessary to recapitalize all banks to an 8 % level of RWA. This is done
because of two main reasons: first, this is the level of minimum capitalization
under which a bank is considered viable under Basel rules and the minimum level
to which banks were recapitalized by public interventions in the past crisis;
second, even if under the newly agreed provisions that allow the European
Stability Mechanism (ESM) to directly recapitalize banks which have capital
ratios between 4.5 % and 8 %,[19] this funding will still be coming from public sources.
On the other
hand, in order to estimate macroeconomic benefits and to be conservative in the
estimation of benefits, we consider a recapitalisation to 4.5 % of the RWA of
each bank. This is based on the assumptions that banks below this level, if not
bailed out, would not be able to access any source of new capital and should
thus be considered as equivalent to a defaulted bank in terms of systemic
consequences. Similarly, banks which are above this level could possibly issue
new equity on the markets and, in the worst case, resort to ESM direct
recapitalization. It also has to be noted that considering only banks which are
severely undercapitalised as having systemic consequences implies a more
conservative estimate of the benefits because the probability of a systemic
crisis is lower than in the 8 % recapitalization case.[20]
In addition, the
model estimates the distribution of covered deposits held in distressed banks
(i.e. defaulted and/or needing recapitalisation). This distribution is used to
measure the probability of a systemic crisis. This is defined as a crisis where
the total of covered deposits held by banks in distress exceed a certain
threshold, assumed to be equal to 3 % of the GDP.[21],[22]
Implementation of safety net tools
Safety net tools modelled in SYMBOL include
bail-in, RF and DGS. These tools are assumed to intervene to cover simulated
losses and recapitalization needs, hence protecting public finances. The tools’
order of intervention, reflecting the position agreed by the European
Parliament, the Council and the EC in December 2013 (see European Parliament
and Council, 2013), is sketched in Figure 2. Under the bail-in tool, a minimum
amount of losses, equal to 8 % of total liabilities
plus own funds (here measured by total assets) needs to
be covered by shareholders and unsecured creditors (first two boxes in Figure
2) before other tools can intervene. Then, only in exceptional circumstances
the RF can contribute to the resolution (Article 38 of the text agreed) in order to exclude or partially exclude an eligible liability or
class of eligible liabilities, absorbing losses up to 5
% of the total assets of the failing bank (third box Figure 2). The total size of
RF ex-ante funds equals 1 % of the country-level amount of covered deposits
(Article 93). After this, the order of intervention of the remaining tools is
subject to the discretion of the resolution authority. For instance the
additional bail-in tool could be used (i.e. all other unsecured creditors, if
available, could be written down) and/or the residual RF could be called to
cover losses above 5 % total liabilities (including own
funds) after all unsecured, non-preferred liabilities, other than eligible
deposits, have been written down or converted in full
(Article 38(3cab)). Eligible deposits (above EUR 100 td) and/or the DGS could
also intervene as the last tools (Article 98(a)).[23]
Figure 2: Order of intervention of the safety
net tools.
Only the first three tools (grey boxes in
Figure 2) are considered in this modelling exercise, due to the following
reasons: 

 There is discretionary decision given to
     the resolution authority to call additional RF intervention above the cap
     of 5 % of TA (see in Fig. 2 the dotted boxes).
 The amount of additional unsecured debt
     above the minimum required to comply with the 8 % threshold is not
     available on a bank-by-bank level and it is likely that the current level
     of unsecured funding will change due to the implementation of the bail-in
     tool. 

Though not directly considered in the
exercise, the additional tools in the dashed boxes of Figure 2 will in practice
contribute to further reduce losses. In terms of implementation, in the BRRD
scenario it is imposed that all banks hold an amount of capital and
bail-in-able liabilities which is needed to trigger the RF intervention, equal
to 8 % of total assets.[24] RF is also assumed to absorb losses up to the 5 % of total assets
maximum. Moreover, the model assumes that the BRRD tools are, by themselves,
sufficient to ensure the orderly resolution of banks and prevent contagion in
the system. In practice, to the extent that structural reform is deemed
necessary to facilitate orderly resolution for the large banks, the modelled
BRRD impacts partly reflect structural reform benefits.
Data
Unconsolidated balance sheet data
The main data source for SYMBOL simulations
is Bankscope, a proprietary database of banks’ financial statements produced by
Bureau van Djik. The dataset covers a quite large sample of banks in 27 EU
countries (about 3,000 banks). The data used is as end of 2012. European
Central Bank (ECB) data on aggregated banks’ total assets per country (see
Appendix 2) are used as the statistical population, in order to calculate the
sample coverage ratio. This is defined as the share of aggregated total assets
in the sample of banks compared to ECB aggregated total assets per country.
To maximize the sample size, robust
imputation procedures of missing data have been applied in order to input
missing data for capital variables (see Cannas et al., 2013b for more technical
details). 
Table 1 presents the aggregated sample
amounts of selected SYMBOL input variables. Sample data for individual MS are
presented in Appendix 2. It should be noted that capital levels and RWA as used
in the simulations are modified with respect to current balance sheet data and
are therefore different from the ones presented in Table 1. These modifications
reflect an estimation of the impact of different capital and RWA definitions,
as detailed in the description of the regulatory scenarios below. The last two
columns compare the total assets in the sample with the total assets from the
population of banks obtained from ECB data. The second to last column shows
that our sample covers roughly 72 % of these total assets.
Table 1: Sample used for SYMBOL simulations
(aggregated amount of selected variables, data as of December 2012).
Source:
Bankscope, ECB and JRC estimations. 
(*)
Following the methodology adopted in the Impact assessment of BRRD Proposal, a
correction factor for the volume of interbank debts/credits has been applied to
the following MS to correct for the inclusion of some classes of debt
certificate. The same correction factors as in the BRRD Impact Assessment have
been applied. 
(**)
In this exercise G1 banks are those with Tier1 Capital larger than EUR 3
billion.
Capital and RWA adjustment
Among many other issues, the crisis has
shown that the quality of banks' capital was poor and that banks' risks weights
were not adequately calibrated under Basel II. Basel III rules aim to tackle
these problems (see Basel Committee on Banking Supervision, 2010 rev 2011). In
order to assess the benefits of such improvements for EU public finances and
their macro-economic impacts, it is therefore necessary to estimate the effects
of these definition changes on capitalisation levels.
To properly estimate the effects of
introducing Basel III (and thus CRD IV), we make use of the results of the
Basel III monitoring exercise run by the European Banking Authority (EBA) (see
European Banking Authority, 2013 and Committee of European Banking Supervisors,
2010). The aim of the EBA exercises, which started in 2009 and since then have
been regularly updated,[25] is to assess and monitor the impact on a specific sample of EU
banks of the new capital standards foreseen in the Basel III Accord.
In particular we use the average reduction
in the capital ratio and average increase in the RWA from the monitoring
exercise (see Table 2 differentiating between G1 and G2 banks).[26] These adjustments reflect the more stringent definition of capital
as well as the new RWA rules,[27] as foreseen in the Basel III Accord. The table should be read as
follows: if a G1 bank has capital and RWA in 2012 equal to K(2012) and RWA(2012),
its capital and RWA under the new Basel III rules be:
.
In other words, the amount of capital of
good quality (i.e. capable of absorbing losses) under Basel II is lower than
under Basel III. In the same way, RWA under Basel II were not adequately
reflecting some risks faced by the banks.
We will refer to these adjustments as QIS
adjustments.
Table 2: EU average capital and RWA change by banking
group due to the CRD IV implementation.
   || G1 banks || G2 banks 
 RWA 2012 - QISRWA(2012) || 1.128 || 1.102 
 Capital 2012 - QISk(2012) || 0.71 || 0.76 
Source: EBA
Basel III monitoring exercice JRC estimation 
Regulatory
scenarios
In order to measure the benefits of
introducing the CRD IV package and the BRRD, SYMBOL is run under various scenarios,
aiming to reflect the introduction of improved regulation on capital standards
and of resolution tools.
The baseline scenario is meant to proxy the
situation where banks comply with Basel II rules, in terms of lower quality of
regulatory capital and lower level of the MCR (MCR equal to 8 % of RWA) with
respect to what is foreseen in the CRD IV package (i.e. 10.5 % of RWA). The
alternative scenarios introduce CRD IV rules in Scenario 1, leading to improved
quality and quantity of capital, and bail-in and RF tools (in addition to the
CRD IV package) in Scenario 2.
SYMBOL is run considering contagion among
banks in the baseline scenarios and in Scenario 1. This aims to represent the
fact that without BRRD being implemented, the regulatory setting does not
assure that contagion is stopped. The aim of BRRD is, among others, to prevent
contagion. Thus in Scenario 2 contagion is not allowed.
One crucial issue for determining the
benefits is the treatment of actual capital above the MCR. We will refer to this
additional capital on top of MCR as the capital buffer. Banks might hold these
buffers because they want to hold a “cushion” of capital above regulatory
minima, or they might hold it for reasons that may not be related to regulation
and/or as part of a transition towards the CRD IV rules. 
Intuitively, not considering the buffers
may lead to an overestimation of the benefits, since this implies an assumption
that, solely due to CRD IV package, all banks move from 8 % RWA to 10.5 % RWA
as a result of the rules: in reality there are banks which already hold an
actual capital between 8 % RWA and 10.5 % RWA, or even above the MCR as in CRD
IV package. However, considering currently existing buffers in the baseline may
lead to an underestimation of the benefits, since it is not certain that banks
currently holding a buffer will not maintain its size above the 10.5 % RWA new
minimum. Moreover, to the extent that the analysis focuses on the adjustment to
the new capital levels as of 2012, looking at actual buffers may ignore some of
the adjustment that has already taken place prior to 2012. 
It is very difficult to univocally
determine the sign of the bias, since the reaction of the banks to CRD IV is
not predictable a priori and it is hard to discern if banks are already
in a transition toward the higher capital level required by CRD IV or not. For
these reasons we run each scenario twice, with and without the buffers, and we
build ranges of benefits using these alternative assumptions. 
The scenarios implemented are displayed in
Table 3, with more detail provided below.
Table
3: Summary of the regulatory scenarios
·                    
Baseline scenario: No CRD IV, contagion. This scenario aims to represent the situation where banks comply
with Basel II rules as it was before the crisis. The regulatory capital
available to each bank depends on whether buffers are considered or not:
No buffers:      

Buffers:           
, 
In the first
case (no buffers), it is assumed that banks hold exactly the MCR foreseen in
Basel II, with the RWA measured under Basel II rules. Any capital buffer above
this MCR is not considered. Data show that the large majority of the banks
comply with the minimum 8 % RWA requirement when the adjustment is applied to
the actual level of capital. Therefore the QIS adjustment for capital is not
applied in the no buffers case. Applying the QIS correction would lead to an
artificial overestimation of the benefits of CRD IV and BRRD. 
In the second
case (buffers), we also consider any eventual buffer above the MCR. To take
into account the possibility that part of the capital is not of good quality we
correct the current level of capital using the QIS adjustment.
JRC tested the
impact of the QIS adjustment on the level of 2012 total capital: the analysis
shows that the vast majority of banks (roughly 98 %) already have capital level
larger than 8 % RWA after applying the QIS adjustment.
·                    
Scenario 1: CRD IV, contagion. This scenario aims to measure a framework as if CRD IV rules were
applied to banks balance sheet as of December 2012. All banks are assumed to
hold a total capital KCRD IV at least equal to the minimum of 10.5 %
RWA foreseen by CRD IV package. Also the new Basel III definitions of capital
and RWA are employed. Thus, the regulatory capital for each bank in Scenario 1
is computed without and with capital buffers as:
No buffers:      

Buffers:           
where  is the EBA adjustment introduced in Table 2.
In the first
case the RWA are increased using the QIS correction to represent the impact of
the new CRD IV rules on their measurement. Any capital buffers above the 10.5 %
RWA that banks might hold are not considered.
In the second
case banks keep any buffer above the MCR that may remain after applying the QIS
adjustment to their current levels of capital.
Note that the
model does not capture the impact of the new buffers introduced in the CRD IV
package other than the capital conservation buffer.
·                    
Scenario 2: CRD IV, bail-in and RF, no
contagion. This scenario aims to measure the
benefits of the BRRD rules combined with the CRD IV package. This scenario
considers the bail-in tools that impose a LAC equal to 8 % of total assets, and
the intervention of RF up to a maximum of 5 % TA. Total RF funds are equal to 1
% of country-aggregate covered deposits. The safety net tools are assumed to
block any contagion mechanism via the interbank market. As discussed above, the
use of remaining tools is subject to discretionary choices of the resolution
authority and thus not further considered in this specific scenario. 
Moreover, when
reading results, it should be kept in mind that two extreme situations are
compared: a full contagion mechanism via the interbank market versus a
zero-contagion one. In the first case the model could overestimate losses since
all banks are potentially exposed to the failure of others and no reaction
mechanism is modelled to stop this domino effect.[28] In the second case it is assumed that the BRRD is capable to
completely prevent direct contagion, and the model does not allow for indirect
contagion dynamics.
Table 8 of Appendix 2 shows the regulatory
capital and RWA for the scenarios analysed, computed as described above. 
In all
scenarios the average implied obligor default probability (IOPD) is estimated
assuming a MCR equal to 8 % of RWA under CRD IV definition of RWA, i.e. RWA are
increased using the results of the EBA monitoring exercise:
The level of 8 % is kept constant through
the scenarios as the additional 2.5 % of capital required under Basel III
represents a capital conservation buffer, while the capital requirement proper
remains 8 % of RWA.[29]
Results
Benefits for public finances
SYMBOL is run for 27 EU MS using data as of
December 2012. Results are rescaled from the sample of banks to the population
of banks in each MS, using the sample ratio shown in the last column in Table
1. The outputs of SYMBOL are simulated distributions of losses in excess of
capital plus recapitalization needs. These distributions are aggregated first
at MS level and then at EU level.
We make use of data on State Aid to the
financial sector during the recent crisis (2008-2012) to calibrate the model in
order to reproduce similar events. The total amount of recapitalisation
measures in the period 2008-2012 is roughly EUR 410 billion (see DG Competition
state aids Scoreboard[30]).
Moreover, banks went on the markets to raise additional capital to face their
distress: the cumulated issuance of equity in the markets in the same period
amounts to roughly EUR 130 billion,[31]
leading to a total of EUR 540 billion. A total of roughly EUR 180 billion was
also provided to the financial sector via asset relief during the same period
(see DG Competition state aids Scoreboard). These figures lead to an estimate
of total losses and recapitalisation needs due to the crisis of up to EUR 590
billion.
As in the current financial crisis
contagion was limited thanks to bail-outs and state aids, to calibrate the
SYMBOL output we focus on a no CRD IV scenario, without contagion.[32]
A loss compatible with the figure above is observed at percentile 99.95 %
(about EUR 670 billion) of the distribution of losses plus 8 % recapitalisation
needs.[33]

In Table 4 below we present the benefits
for public finances of introducing CRD IV package and BRRD. As already
discussed above, these benefits are computed on the distribution of losses plus
8 % recapitalisation needs. Benefits are measured as the relative decrease in
the losses moving from the baseline scenario to the alternative ones, at
percentile 99.95 %. 
Table 4: Losses for public finances under the
various scenarios and estimated benefits of introducing CRD IV and BRRD.
The results
can be summarized as follows:
·                    
Moving from baseline to Scenario 1 the decrease
in potential costs for public finances is between 22 % and 33 %, depending on
whether we account for buffers or not. In absolute terms, the gross benefits
(without considering the costs of regulation) would be between EUR 0.5-1.1 trillion.
This result should be read by taking into account the following key
assumptions: (i) there is no intervention from government to stop contagion, as
instead it was the case in the current crisis[34]
and (ii) no other tool than capital (CRD IV) is used to absorb losses.
·                    
Moving from baseline to Scenario 2, where the
contagion is stopped, reduction of potential costs for public finances is
between 92 % and 94 % (in absolute terms roughly EUR 2.3 trillion and EUR 3 trillion
respectively). Also here the result should be read taking into account that
supervisors have additional tools – and the flexibility on how to use them – to
absorb potential residual losses beyond those covered in Scenario 2, including
(i) additional bail-in of unsecured debt that banks can hold on top of the 8 %
minimum, (ii) the use of additional RF funds, on top of the 5 % cap set in the
BRRD, (iii) bail-in of eligible non-covered deposits and only when other means
deployed the (iv) DGS intervention. Moreover, it is assumed that the BRRD is
effective in resolving banks, including the large banks for which structural
reform may be necessary to achieve resolution.
Macroeconomic
benefits
The estimation of macroeconomic benefits
relies on a stylized methodology similar to the one also used by the Bank of
England, 2010. This approach allows estimating macroeconomic benefits on the
basis of two pieces of information: first, how the implementation of the CRD IV
package and the BRRD may reduce the probability of a systemic crisis (Systemic
PD) and, second, the (avoided) potential costs associated with a banking
crisis, measured as the present value of deviations from baseline trend GDP.
Estimations are based on the following assumptions:
·                    
A systemic crisis is defined as a crisis where
the total amount of covered deposits held in distressed banks (i.e. defaulted
and undercapitalized up to 4.5 % RWA) exceeds a certain threshold, assumed to
be equal to 3 % of GDP. 
·                    
It is assumed that the reduction in GDP and its
shortfall on trend GDP are solely due to the systemic banking crisis. 
·                    
The initial cost of a systemic banking crisis is
assumed to be the drop in GDP from 2008 to 2009 plus the lost trend growth of
GDP. Trend GDP is the GDP that would have been observed in 2009 if economies
would have grown at their potential growth rate for this period. This rate is
currently estimated at an average equal to 1.96 %[35] for European countries (see D'Auria et al., 2010).
·                    
The drop in the GDP due to the crisis is assumed
to be partly a temporary effect and in part a permanent loss. In particular in
this analysis, 67 % of the initial GDP reduction due to the crisis is assumed
to be reabsorbed in 5 years, while the remaining 33 % is assumed to be a
permanent loss.[36] (In other words, a systemic banking crisis is assumed to induce a
permanent level shift in the growth path of GDP. See Appendix 3 for details.)
·                    
The real discount rate used for the discount
factors to calculate present values is i=2.5 %. 
In practical terms, to obtain
macro-economic benefits, the following steps have been implemented:
1.     
The initial cost of a banking crisis is
estimated using data on the recent crisis and is assumed to be the variation in
GDP from 2008 to 2009,[37] plus the lost trend growth of GDP (see first and second columns in
Table 5 below):
2.     
The total (avoided) cost of a systemic banking
crisis is the net present value of the initial costs considering the permanent
and temporary effects (see third column in Table 5):
where:  is the share of the initial costs which are temporary
in nature (67 %);  is the n-years rent discount factor, defined as  with n = 5, which is equal to 4.76;  is the permanent rent discount factor, defined as  which is equal to 41.
Table 5: GDP change from 2008 to 2009, estimated
initial (avoided) cost of a systemic banking crisis and estimated total
(avoided) cost of a systemic banking crisis[38].
3.         
The yearly benefits are obtained as the total
(avoided) cost times the reduction in the Systemic PD estimated in
SYMBOL, when moving from the baseline scenario to the alternative regulatory
scenarios (see first and second row in Table 6 below): 
where  is the reduction Systemic PD. 
4.         
Total macro-benefits are finally obtained
applying the permanent rent discount factor ()
to the yearly benefits, as the reduction in Systemic PD is considered to
apply every year in the future, originating a permanent stream of benefits (see
third row in Table 6 below):
Table 6: Estimation of macroeconomic benefits
 
The results can be summarized as follows:

 Moving from baseline to Scenario 1 the
     reduction in Systemic PD ranges from 0.6 % to 3 % depending on
     whether buffers that banks hold on top of the MCR are considered or not.
     The yearly macroeconomic benefits of introducing CRD IV are between 0.5 %
     and 3 % of GDP and the net present value of benefits ranges from 21 % to
     122 %.
 Moving from baseline to Scenario 2 the
     reduction in Systemic PD ranges from 1 % to 4 %. The yearly
     macroeconomic benefits of introducing CRD IV package are between 1 % and 4
     % of GDP and the net present value of benefits ranges from 44 % to 156 %.

JRC performed the estimation of
macroeconomic benefits considering also a lower total avoided cost of a
systemic banking crisis equal to 50 %, instead of 98.6 % used above (as
presented in table 6). Results are presented in Table 7 and show that
considering a lower cost of crisis, the benefits are halved but remain
substantial. In particular, the most conservative benefit estimation –
calculated with the lower cost of crisis assumption and counting capital
buffers – gives an yearly GDP benefit of 0.59 % when moving from the baseline
to scenario 2.  
Table 7: Estimation of macroeconomic benefits with 50 % costs of crisis.
 
Conclusions
This annex presents estimates of the
benefits of introducing strengthened rules for capital
requirements (CRD IV package) and safety net tools (bail-in and resolution fund
as foreseen in BRRD). 
Two different aspects have been considered
when measuring benefits: (i) the decrease in losses left uncovered by available
tools, which may potentially hit public finances, and (ii) the macroeconomic
benefits due to reduction in the probability of occurrence of a systemic
banking crisis. 
The exercise has been conducted using the
SYMBOL model, a simulation engine developed by the EC JRC, the Directorate
General Internal Market and Services, academics and experts on banking
regulation (see De Lisa et al., 2011). 
Being based on a statistical model, results
are estimates and they are sensitive to model assumptions. In particular, banks
are described through an average risk measure of the portfolios they hold, and
their resilience to shocks is assessed via the amount of their total capital.
The model simulates the situation at one fixed point in time (end of the year).
Moreover, the scenarios simulates extreme situations, like a full-contagion
mechanism (where all banks in a country are affected by the default of others),
or zero-contagion (where no spill-over take place). The reality most probably
lies in between these two extremes. 
It has been assumed that the capital
requirements are not enough to completely absorb losses in a severe crisis and
to avoid contagion, while the introduction of the resolution tools set up in
the BRRD can effectively stop it. The model has been run separately for the EU
27 MS using 2012 data from Bankscope for a sample of roughly 3,000 EU banks.
Benefits of introducing CRD IV package and
BRRD have been assessed running SYMBOL for alternative scenarios. The baseline
scenario reflects the situation where the Basel II is in still in place;
Scenario 1 introduces CRD IV increased quality and quantity of regulatory
capital; Scenario 2 implements some of the tools set up in BRRD according to
the agreement reached in the trilogue in December 2013 (a minimum bail-in to
trigger RF intervention and RF funds up to a maximum of 5 % TA for each
distressed bank). 
Results show that the introduction of CRD
IV package leads to a relative reduction in potential costs for public finances
between 22 % and 33 %, depending on whether buffers that banks hold on top of
the MCR are considered or not. When the BRRD tools (bail-in and resolution
fund) are considered, contagion is stopped and the relative reduction in losses
increases up to 92 %-94 %. Extra tools could become available to reduce losses
further. As they are discretionary and depend on the judgement of supervisors
they have not been considered in the present exercise. These tools include (i)
full bail-in of unsecured debt; (ii) the full use of resolution fund; (iii)
bail-in of eligible non-covered
deposits (above EUR 100 000) and eventually, in the extreme case, DGS
intervention.
The yearly macroeconomic benefits of
introducing the CRD IV package are about 0.5 % of GDP (Scenario 1) if buffers
that banks hold on top of the MCR are fully considered (and only counting
adjustment from 2012). Introducing the BRRD tools, i.e. bail-in and resolution
fund, on top of the CRD IV package raise these benefits to 1.1 % of GDP
(Scenario 2). 
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Appendix
1: Estimation of the IOPDs – Technical details
For each exposure l
in the portfolio of bank i, the FIRB formula derives the corresponding
capital requirement needed to cover unexpected losses[39] over a time
horizon of one year, with a specific confidence level equal to 99.9 % (see
Figure 1):
where  is the default probability of exposure l, ϱ is the
correlation among the exposures in the portfolio, LGD is the Loss Given
Default[40]
and M(PDi) a maturity adjustment
and 

                                                          
MCR of each bank is obtained
summing up the capital requirements for all exposures: 
where   is the
amount of the exposure l.
The average IOPD of a bank’s
asset portfolio can be derived as 

 
where  and  are the minimum capital requirement and
the total assets of the banks, publicly available in the balance sheet.
Appendix 2: The SYMBOL database
Description of the sample
Table 8 presents values of some selected variables used in SYMBOL
simulations aggregated per MS. The third from last column of the table shows
the sample ratio, i.e. the share of total assets that the sample covers
compared to the ECB data (second to column). The sample ratio is used to move
from the sample-based figures to an estimate of the country’s population.[41]

Table 8: Selected Bankscope variables for the
sample of banks used for SYMBOL simulations (the last columns show ECB
aggregate total assets by country (foreign branches excluded) and coverage
ratio for SYMBOL input sample) 
   || SYMBOL sample || ECB total assets || Share of covered deposits (***)  
 Banks || G1(**) Banks || Total Assets || RWA || Customer Deposits || IB Credits (*) || IB Debts (*) || Capital || Sample Ratio 
  BE || 21 || 2 || 531 || 166 || 276 || 108 || 115 || 28 || 54 % || 978 || 43 % 
  BG || 17 || 0 || 34 || 25 || 26 || 2 || 2 || 4 || 81 % || 42 || 63 % 
  CZ || 16 || 0 || 120 || 55 || 80 || 13 || 13 || 9 || 69 % || 174 || 53 % 
  DK || 75 || 3 || 726 || 243 || 217 || 57 || 112 || 51 || 66 % || 1,099 || 63 % 
  DE || 1540 || 6 || 5,336 || 1,632 || 2,365 || 828 || 976 || 276 || 66 % || 8,124 || 50 % 
  EE || 2 || 0 || 8 || 6 || 6 || 1 || 1 || 1 || 62 % || 13 || 49 % 
  IE || 5 || 4 || 319 || 200 || 143 || 95 || 108 || 35 || 41 % || 779 || 41 % 
  GR || 6 || 0 || 30 || 25 || 21 || 1 || 4 || 4 || 8 % || 397 || 60 % 
  ES || 87 || 5 || 1,686 || 1,085 || 763 || 137 || 332 || 125 || 50 % || 3,388 || 43 % 
  FR || 174 || 15 || 6,886 || 2,323 || 2,002 || 790 || 779 || 325 || 89 % || 7,753 || 70 % 
  IT || 463 || 9 || 2,698 || 1,026 || 878 || 94 || 217 || 249 || 68 % || 3,954 || 32 % 
  CY || 3 || 0 || 10 || 7 || 9 || 2 || 0 || 0 || 8 % || 118 || 50 % 
  LV || 19 || 0 || 24 || 16 || 16 || 5 || 4 || 3 || 98 % || 24 || 34 % 
  LT || 8 || 0 || 18 || 12 || 12 || 2 || 4 || 2 || 96 % || 19 || 50 % 
  LU || 53 || 2 || 506 || 178 || 178 || 172 || 168 || 37 || 87 % || 582 || 14 % 
  HU || 13 || 1 || 37 || 21 || 19 || 4 || 8 || 4 || 36 % || 104 || 50 % 
  MT || 7 || 0 || 8 || 4 || 6 || 1 || 1 || 1 || 15 % || 55 || 25 % 
  NL || 22 || 3 || 1,786 || 701 || 631 || 445 || 277 || 119 || 75 % || 2,390 || 52 % 
  AT || 178 || 0 || 290 || 127 || 130 || 38 || 40 || 20 || 30 % || 971 || 53 % 
  PL || 34 || 2 || 237 || 163 || 158 || 7 || 31 || 24 || 69 % || 345 || 37 % 
  PT || 14 || 2 || 216 || 138 || 90 || 28 || 51 || 18 || 42 % || 515 || 50 % 
  RO || 15 || 0 || 57 || 35 || 34 || 1 || 13 || 6 || 69 % || 83 || 43 % 
  SI || 15 || 0 || 35 || 28 || 20 || 1 || 9 || 3 || 69 % || 51 || 63 % 
  SK || 9 || 0 || 41 || 25 || 30 || 1 || 2 || 4 || 74 % || 55 || 53 % 
  FI || 8 || 0 || 89 || 34 || 37 || 18 || 10 || 6 || 16 % || 545 || 57 % 
  SE || 66 || 3 || 609 || 184 || 241 || 141 || 79 || 36 || 55 % || 1,110 || 53 % 
  UK || 86 || 10 || 7,029 || 2,056 || 2,563 || 1,382 || 1,550 || 332 || 98 % || 7,205 || 42 % 
 Total || 2,956 || 67 || 29,368 || 10,514 || 10,950 || 4,374 || 4,907 || 1,720 ||   || 40,875 ||   
Source Bankscope, ECB, JRC elaborations. 
 (*) Following the methodology adopted in
the Impact assessment of BRRD Proposal, a correction factor for the volume of
interbank debts/credits has been applied to the following MS to correct for the
inclusion of some classes of debt certificate. The applied correction factors
are the same as in the BRRD impact assessment (see appendix 4, Table 1, p.183).
(***) The share of covered deposits is taken
from Cannas et al. 2013a and is an estimate based on data collected from EU DGS
and ECB data. 
Regulatory
capital and risk-weighted assets under different scenarios
Table 9 shows the
regulatory capital and RWA for the scenarios analysed, computed as described
above starting from 2012 balance sheet data. For each country, amounts are
referred to the sample, while the Total EU has been calculated by means of the
sample to population ratio (see third from last column in Table 8).
Table 9:  Regulatory capital and RWA in the various scenarios, 2012 data
   || Regulatory capital no CRD IV (bn€) || Regulatory capital CRD IV (bn€) || RWA CRD IV (bn€) 
  Country || No buffers || Buffers || No buffers || Buffers 
  BE || 15 || 20 || 20 || 20 || 186 
  BG || 2 || 3 || 3 || 3 || 27 
  CZ || 5 || 7 || 6 || 7 || 61 
  DK || 22 || 37 || 29 || 37 || 272 
  DE || 145 || 204 || 190 || 214 || 1811 
  EE || 1 || 1 || 1 || 1 || 7 
  IE || 18 || 25 || 24 || 25 || 225 
  GR || 2 || 2 || 3 || 3 || 28 
  ES || 98 || 94 || 128 || 134 || 1219 
  FR || 208 || 237 || 273 || 273 || 2598 
  IT || 92 || 181 || 120 || 187 || 1145 
  CY || 1 || 0 || 1 || 1 || 8 
  LV || 1 || 2 || 2 || 2 || 17 
  LT || 1 || 1 || 1 || 1 || 14 
  LU || 16 || 27 || 21 || 28 || 198 
  HU || 2 || 3 || 2 || 3 || 23 
  MT || 0 || 1 || 0 || 1 || 5 
  NL || 63 || 85 || 83 || 87 || 788 
  AT || 11 || 15 || 15 || 16 || 140 
  PL || 14 || 18 || 19 || 20 || 181 
  PT || 12 || 13 || 16 || 16 || 154 
  RO || 3 || 5 || 4 || 5 || 38 
  SI || 2 || 2 || 3 || 3 || 31 
  SK || 2 || 3 || 3 || 3 || 27 
  FI || 3 || 4 || 4 || 4 || 38 
  SE || 17 || 26 || 22 || 26 || 207 
  UK || 185 || 237 || 243 || 244 || 2314 
  Total Sample || 941 || 1,252 || 1,235 || 1,366 || 11,761 
  Total EU || 1,386 || 1,822 || 1,820 || 2,023 || 17,330 
Source Bankscope,EBA QIS exercise,
JRC calculations. 
 
Appendix 3: Technical details on the estimation of
the cost of crisis
In the macro-benefit analysis, the initial
cost of a systemic banking crisis is estimated following a stylized approach
previously used also by the Bank of England (2010)[42]. Using this methodology the cost is based on the initial drop in
GDP at the onset of the crisis, i.e. from 2008 to 2009: part of this fall is
assumed to be temporary in nature, and part of it is assumed to be a permanent
fall in the level of GDP. In particular, actual GDP after the crisis is assumed
to stay below pre-crisis trend GDP for 5 years, after five years from the
inception of the crisis, 67 % of the initial drop in GDP is absorbed, while the
remaining 33 % is a permanent level shift.[43] Taking the present value of the differences from pre-crisis trend
GDP based on a 2.5 % discount rate, the cost of the crisis is estimated to be
98.64 %.[44] 
Figure
3: GDP paths
Source: AMECO database, JRC elaboration,
D'Auria et al. (2010)
In Figure 3, the green line is the 2008 GDP
projected forward at average growth rates in the pre-crisis period. The growth
rate is estimated at an average equal to 1.2 % for western European countries
(for more details on the estimation procedure, see D'Auria et al. (2010)).[45] The black line is the actual or forecast real GDP path as from
AMECO. The blue line is the GDP as estimated in our stylized model. 
Our projection for GDP path in case of
crisis, seems to be in line with actual data, based on the Leven and Valencia (2013) measure of the cost of a crisis, which is based on cumulated losses for the
crisis year and the three subsequent years. To calculate this indicator with
actual data from the current crisis, we add up the yearly differences between
the 2008 GDP projected forward at average growth rates in the pre-crisis period
(green line) and the real GDP 2009-2012 (black line) to get a cost of the
crisis of about 23 % under the Laeven and Valencia indicator. Instead,
estimating this cost with our model, we obtain 24 %. As Laeven and Valencia estimate that the typical cost of a crisis in advanced countries should be equal
to 32 % for the first four years, we could also hypothesize that the current
crisis is a “mild” crisis, and that a larger impact of the “typical” crisis
could be used in the context of a cost-benefit analysis. 
We also note that the hypothesis of
assuming a permanent level shift in GDP is compatible with the analyses
developed by Economic and Financial Affairs (ECFIN 2009 and ECFIN 2013). In
particular in the latter publication, scenarios developed in 2009 for the GDP
path after the crisis are tested and it results that a permanent loss in GDP
has been realized.[46] 
JRC tested the robustness of the
assumptions regarding the share of the permanent loss on a set of alternative
assumptions. Looking at the AMECO database, the difference between GDP
potential 2013 and forward projection of GDP potential 2008 at pre-crisis trend
growth can be considered as an estimation of the permanent loss (‘Reduction in
Potential GDP’ in Figure 4). This permanent loss is around 58 % of the initial
cost of crisis leading to a present value of total avoided cost of around 150 %.
The overestimation of the permanent effect could be due to a decrease in real
GDP from 2011 to 2012. 
Figure 4: GDP potential
paths
Source: AMECO database, JRC elaboration, D'Auria et
al. (2010)
Finally, we also tested what would be the
impacts of including or excluding the output gap 2008 from the estimate of the
initial impact of the crisis. If we consider the output gap, the initial cost
of crisis would be lower because in 2008 the real GDP was higher than the
potential one. However, the permanent effect observed in absolute terms in 2013
would remain constant, and therefore the permanent part would be more than 33 %
of the initial cost considering the output GAP, thus leading to a higher cost
of crisis. 
Our estimation of the total cost including
the closing of the output GAP as part of the initial costs and based on a
permanent effect of 33 % can therefore be seen as a lower bound. We have
decided to be conservative in the estimation of crisis costs because in this
exercise they are positively correlated with the macro-benefits – i.e. the
approach seeks to ensure that benefits are not overestimated.
Annex 5:
Quantitative modelling of costs
This annex presents QUEST results on the
macroeconomic effects of bank regulation. The following measures are analysed:
Increasing capital requirements, introducing a bank resolution mechanism (BRF)
and a bail in scheme. The focus of these calculations is on the social cost of
increased capital requirements from CRD IV as well as the major tools (Bail-in
and resolution fund) in the Bank Recovery and Resolution Directive. 
There is a controversy concerning the cost
of bank regulation. Industry representatives (IIF 2010) have claimed that the
increase in the capital requirement increases funding costs for banks because
they have to use more equity to fund loans. This in turns increases capital
costs for investors and slows down growth. This statement has been contested by
some academic economists (e.g. Admati et al. (2011)), who make reference to the
Modigliani Miller (MM) theorem (1958) which stipulates that the structure of
corporate financing does not matter (if one disregards tax and subsidy
considerations which may affect debt and equity differently) because a change
in the composition of corporate liabilities only distributes the risk which
must be borne by shareholders. Under the assumption that the change in capital
requirements does not change the riskiness of bank operations, an increase in
capital requirements leads to a proportional decline in the equity premium,
because the same risk is distributed over a larger equity base.
This cost assessment follows a middle
ground between these two extreme opposite views, a position which has been
adopted by other policy institutions which have conducted macroeconomic
assessments such as the Bank of International Settlements (BIS (2010a, 2010b,
2010c) or the Bank of England (Miles et al. (2013). We present two scenarios
which closely follow the assumptions made by these two institutions. In a first
scenario we follow the BIS assessment and assume that stronger bank regulation
does not lead to an increase in the risk premium on bank equity (i. e. leaves
long run funding costs for banks unchanged) (i.e. 0 % MM offset). In a second
scenario we follow the BoE assessment and allow for a 50 % MM offset. That
there is a significant, but not a full MM effect seems to be the outcome of the
empirical literature. The empirical evidence in Miles et al. (2013) and Kashyap
et al. (2010) shows indeed that there is a systematic relationship between bank
capitalisation and the equity premium. The risk premium effect is such that it
offsets about 50 % of the increase of funding costs implied by a funding cost
calculation where the equity premium is kept unchanged. That there is no or not
a full MM offset can be justified in case there is an implicit bail out
guarantee for banks. In this case, increasing bank capital effectively shifts
insurance provided by the government to shareholders. Thus, the degree in which
MM holds depends (inversely) on the stringency in which there is perceived to
be a bail-out guarantee for banks. 
This note is organised as follows. Section
1 and 2 briefly describes the model and the calibration. Section 3 presents the
results for the individual measures and the cumulative impact. Section 4 shows
results from a simple cost benefit analysis.
QUEST
model with financial sector
We modify a closed economy version of the
QUEST model,[47]
which has been calibrated to the EU aggregate economy by adding a banking
sector with bank capital. In order to allow for a meaningful financial
intermediation function of banks we disaggregate the household sector into
savers and borrowers (entrepreneurs). In order to ensure a positive share of
loans in the balance sheet of entrepreneurs it is assumed that they have a
higher rate of time preference. In this case, solvency of entrepreneurs requires
that banks restrict lending by imposing a collateral constraint. This
specification closely follows Kiyotaki and Moore (1997).
Savers: 
We follow van den Heuvel (2008) and assume
that savers maximise an intertemporal utility function with consumption, liquidity
services provided by deposits and leisure as arguments. Savers can hold wealth
either in the form of government bonds, bank deposits or bank equity and
receive interest income from bonds and deposits and dividends. Savers require
an equity premium on bank stocks. Savers also offer labour services to
entrepreneurs and receive wage income.
Entrepreneurs: 
Enterpreneurs are assumed to maximise an
intertemporal utility function over entrepreneurial consumption, subject to a
budget constraint a capital accumulation constraint and a collateral
constraint. They make pricing, labour demand, investment and financing
decisions and use a Cobb Douglas production function. 
Banks: 
Provide loans to entrepreneurs and demand
deposits from saver households. They maximise the present discounted value
(PDV) of dividends or the stock market value of the bank subject to a capital
and liquidity requirement constraint. The capital requirement demands from
banks that the ratio of deposits to loans should not exceed a certain target
ratio. Concerning liquidity requirements, banks are asked to hold liquid assets
as a fixed share of loans. This imposes an opportunity cost for banks since
liquid assets (government bonds and assets) yield a lower return. Banks can
increase capital either by issuing new shares or via retained earnings. Both
strategies yield identical results. 
Monetary and fiscal policy:
The central bank follows a Taylor rule. Fiscal policy is constrained by a budget constraint. Government debt is held
by saver households and banks (for liquidity purposes). Figure 1 summarises the
economic linkages between the various sectors in a flow chart.
Figure 1: Sector linkages in QUEST III
  
Data and calibration
All parameters describing behaviour of the
non-financial sector are taken from Ratto et al. (2009). We calibrate the model
such that it can replicate the ratio of Tier1 capital to risk weighted assets.
Since we only model an aggregate banking sector, we focus on the consolidated
balance sheet of the EU banking sector. Based on ECB (2013), total assets
amounted to EUR 35.5 trillion in 2012 (based on the ECB data). We distinguish
between three asset categories, loans, government bonds and other assets, with
risk weights of 60 %, 3 % and 70 % respectively. Total loans were 19.8 Trio.
Euro in 2012. We assume that the share of government bond holdings in total
assets in the EU is identical to the share in the EA, namely 8.5 % (or 3.0 trio
Euro). Other assets amount to 12.7 Trio Euro. 
As we are interested in measuring the costs
of moving from Basel II to Basel III/CRD IV our starting point is the
assumption that bank capital is 8 % of risk weighted assets in 2012, so that
our estimate for consolidated tier1 bank capital is 1.68 Trio. Euro. The spread
between loan rate and the deposit rate is set to 250BP and the rate of return
on bank equity is set at 10 %. We assume that the spread between the loan rate
and bank funding cost is entirely due to variable costs related to managing
loans and deposits and not due to cost price margins.
Scenarios
We analyse the following regulatory
measures similar to the scenarios for the benefits' estimations:

 Scenario 1: Increase of bank capital from 8 % to 10.5 % of risk weighted
     assets. (Immediate increase in 2014). 
 Scenario 2:
     Bail in regulation implemented in 2016, resulting in an increase in the
     deposit rate of 15BP and the bank resolution fund of 77 Bio Euro phased in
     over 10 years and starting in 2016. In the model, this has the same
     effects as an increase in the capital requirement. The increase in capital
     requirement is calculated as follows: The BRF increases bank capital by
     4.6 % (over 10 years, which is the time span to build the BRF). This
     increases the share of bank capital in risk weighted assets from 8 % to
     8.37 %. Here it is assumed that the BRF increases bank capital and
     riskless bank assets (government bonds) by 77 Bio Euro. The increase of
     bank capital requirements from 8 to 10.87 % reduces total leverage (total
     assets/bank capital) of the banking system from 21.3 to 15.7. 

We compare this result against the baseline
(business as usual) scenario which is characterised by an unchanged capital
requirement of 8 %, no bail in regulation and the absence of a bank resolution
fund. 
In scenario 1 and 2 we calculate the
effects of increasing the capital requirement only under two alternative
assumptions about the evolution of the bank equity risk premium, namely no
change in the risk premium (zero MM offset) and a 50 % MM offset. In scenario 3
and 4 we calculate the joint effect of all three measures again under the two
alternative assumptions about the MM offset. Concerning the MM offset we follow
Miles et al (2013), they define a 50 % MM offset as a situation where the RoE
is adjusted in such a way that the loan rate only increases by 50 % of the rate
when the risk premium is kept unchanged. Miles et al., estimate this offset
rate by using data on UK banks. In addition we assume that the bail-in also
reduces the riskiness of bank capital. Given the MM offset definition, a 100 %
MM offset would yield zero macroeconomic costs.  
Results
In this section simulation results for
scenario 1 and 2 with MM zero offset and 50 % are presented. The only
transmission mechanism in the model is the credit channel. Banks shifts the
higher funding costs onto the non- financial private sector in the form of
higher loan rates (when MM does not fully apply). This increases capital costs
for firms which partly finance their investment with loans. The cost increase
related to higher capital requirements is partly offset by a reduction of the
deposit rate for banks since the demand shift of banks away from deposits
lowers the deposit rate. However, this effect is relatively small (a reduction
of the deposit rate of about 2bp). A distinction must be made between the short
and the long-term effects of the regulatory measures. An increase in capital
requirement leads to a gradual reduction of output, which is linked to a
slightly slower growth of capital and potential output (table 1). The same
logic holds for the costs related to the resolution fund. 
With bail-in, the short-term adjustment is
slightly more complicated. Since the bail-in is announced to be implemented in
2016, it leads to an upward adjustment of consumption already in the first
year, because households anticipate a lower savings rate (in deposits) and want
to smooth consumption over time. 
Capital buffers vs. no buffers 
In line with the estimations of benefits,
costs are estimated for two cases, with and without capital
buffers, i.e. the actual capital that banks might hold above the MCR. Banks
might hold these buffers because they want to hold a “cushion” of capital above
regulatory minima, or they might hold it for reasons that may not be related to
regulation and/or as part of a transition towards CRD IV rules. 
Intuitively, not considering the buffers,
i.e. the RWA increases by 2.5 percentage points (from 8 % to 10.5) for all
banks, is a conservative estimation of costs. In reality, already hold capital
above the regulatory minimum requirements, so they require less adjustment to
the new minimum capital ratios. Not counting those existing buffers could
overestimate the costs that can be attributed to regulation. However, the
"no buffer" assumption may be deemed justified because using actual
capital data as of 2012 may otherwise not account for any costs incurred in the
transition before that date and in expectation of the higher capital
requirements. Also considering the existing buffers in the baseline may lead to
an underestimation of the cost, since it is not certain that banks currently
holding a buffer will not maintain its size above the 10.5 % RWA new minimum. 
Given considerations, the costs are estimated for both cases, with and
without the buffers, but more weight is given to the result without capital
buffers to be conservative and not underestimate the costs. 
Results for GDP
Tables 1 to 4 present estimation results
for the conservative case, when no buffers are considered.  On average, assuming 50 % MM offset, increasing capital requirements
from 8 % to 10.5 % of RWA has a negative impact on the level of GDP (expressed
as deviation from the output trend per year) by 0.13 % in the long term (table
2). Note that the costs are twice as high (0.27 % of EU GDP per year) without
any MM offset (Table 1).  In the second scenario that includes additional
tools, i.e. bail-in and the introduction of the resolution funds, the results
are as follows: the long-term deviation from the output trend equals 0.34 % EU
GDP per year when 50 % MM offset is assumed. In the most conservative case,
when no MM offset is assumed, the costs are 0.69 % of EU GDP per year. When
capital buffers are considered in the estimations (see Appendix), the annual
costs amount to 0.28 % of EU GDP when 50 % MM is assumed and to 0.55 % of GDP
without the MM offset. 
Results for other macroeconomic
variables
Table 3 and 4
illustrate that investment is particularly
sensitive to the different MM applicability assumptions. For 2020, investment is estimated to fall by 2.53 % below
baseline, if the MM assumption does not hold and by 1.40 % below its baseline
under the 50 % MM assumption. The long term impact on investment varies from
-2.08 % with zero MM offset to -1.00 % with 50 % MM offset. This shows that any negative impact of higher
capital requirements on investment is mitigated over the long run. As the cost
of capital increases and firms shift to using more own resources to fund their
investment projects, they reduce leverage and the rate of firm loan default
decreases. The bank credit risk goes down and the risk premium on the loan
interest rate over the risk-free rate declines[48]. 
The impact of increased
capital requirements on employment is less pronounced than the impact on
GDP and investment. Under the most plausible assumption (i.e. partial applicability of MM), employment
falls 0.08 % below the baseline on average in the long term. 
The positive effect on consumption
in the short term can be explained as follows: capital costs for firms increase,
which lowers investment and thus aggregate demand. This lowers the real
interest rate (e. g. because inflation goes down and the central bank can lower
the policy rate, because of excess capacity in the economy). The declining
interest rates reduce savings of households and increase consumption. This is
only a temporary effect and in the medium to long run the level of consumption
declines (0.27 % in the long term when 50 % MM offset applies).
The stock of loans decreases as a result of changes in bank
regulation, unless there is a 100 % MM offset in which case there is no
macroeconomic impact. Disintermediation occurs because banks pass increased
marginal costs on to customers through higher lending rates and stricter
collateral constraints, and in this process they ration credit. The volume
of loans is between 0.20 % below the baseline in 2020 and 0.34 % below the
baseline in the long term in the case when only the capital requirement is
modelled (with a 50 % MM offset). The volume of loans falls more as additional
regulatory changes are implemented: in the long term loans are 0.86 % below the
baseline when the BRRD measures are implemented. 
Table 1:   Increasing capital requirement from 8 % to 10.5 % (zero MM offset)
Table 2:   Increasing capital requirement from 8 % to 10.5 (50 % MM offset)
   ||   ||   ||   ||   ||   || Long-term 
   || 2014 || 2015 || 2016 || 2017 || 2020 || average    2030-2150 
   ||   ||   ||   ||   ||   ||   
 Impact on macro variables (deviation from baseline in bp for loan rate, in % for other variables) 
 GDP || -0.02 || -0.02 || -0.03 || -0.04 || -0.06 || -0.13 
 Investment || -0.34 || -0.48 || -0.5 || -0.51 || -0.49 || -0.40 
 Consumption || 0.05 || 0.08 || 0.08 || 0.07 || 0.03 || -0.11 
 Volume of loans || -0.07 || -0.16 || -0.18 || -0.17 || -0.2 || -0.34 
 Loan rate || -3.01 || -1.69 || 8.88 || 5 || 4.65 || 5.02 
 Employment || -0.04 || -0.02 || -0.02 || -0.03 || -0.02 || -0.02 
Table 3:   Increasing capital requirement from 8 to 10.5 %
(zero MM offset), resolution fund (EUR 77 billion), bail in (deposit rate up by
15bp)
Note: Resolution
fund is phased in from 2016 to 2026. Bail-in starts in 2016.
Table 4:   Increasing capital requirement from 8 to 10.5 % (50 % zero MM
offset), resolution fund (EUR 77 billion), bail in (deposit rate up by 15bp)
Note: Resolution
fund is phased in from 2016 to 2026. Bail in starts in 2016.
Conclusion
QUEST gives a rough estimate of the
macroeconomic costs of certain bank sector reforms, and the results are subject
to significant modelling uncertainty. First, the transmission mechanism is
based only on the lending channel. Secondly, there is a high uncertainty
related to the MM offset (but zero MM offset is unlikely to be a realistic
assumption). Third, these results are sensitive to the degree of substitution
between capital and labour. In QUEST, a Cobb Douglas production function is
used with adjustment cost for labour and capital. This technology implies a low
elasticity of substitution (below one) in the short run but an elasticity of
substitution equal to one in the long term. The BoE study assumes a long run
elasticity of substitution which is equal to 0.5. Also note that the employment
effects of the bank regulation measures are very small and contribute little to
the fall in output[49].
This is the case because wages adjust to a decline in labour productivity, as
implied by a fall in the capital stock, which stabilises employment. Moreover,
as we are only interested in the effects of the regulatory measures, any
changes the bank capital for other reason than those related to regulation are
not considered.  
Current macro models are not capable of
properly incorporating effects of regulation on (excessive) risk taking of
banks. Therefore, only a very limited cost benefit analysis can be provided.
Nevertheless, it is instructive to compare the cost estimate obtained from
QUEST with the benefits estimated via SYMBOL (as per annex 4). This is done in
boxes 4.2.5 and 6.4.1, which show that the estimated benefits exceed the costs.
This is also consistent with the findings in other studies (e.g. BIS (2010) and
Miles (2013)).
References
Admati, A., DeMarzo, P., Hellwig, M. and
Pfleiderer, P. (2010). “Fallacies, irrelevant facts, and myths in capital
regulation: why bank equity is not expensive”. Stanford University Working Paper no. 86.
BIS (2010a). “An assessment of the
long-term economic impact of stronger capital and liquidity requirements”, Basel
Committee on Banking Supervision, Bank for International Settlements.
BIS (2010b). “Assessing the
macroeconomic impact of the transition to stronger capital and liquidity
requirements”, Basel Committee on Banking Supervision, Bank for
International Settlements.
BIS (2010c). “Results of the
comprehensive quantitative impact study”, Basel Committee on Banking
Supervision, Bank for International Settlements.
Gerali, A., S. Neri, Sessa, L, F. Signoretti
(2008) Credit and banking in a DSGE model. Banca d'Italia mimeo. 
Institute for International Finance (2010). Interim
Report on the Cumulative Impact on the Global Economy of Proposed Changes in
Banking Regulatory Framework, Washington, DC: Institute for International
Finance.
Kashyap, A, J Stein and S Hanson (2010): “An
analysis of the impact of substantially heightened capital requirements on
large financial institutions”, University of Chicago Booth School of Business
and Harvard University, mimeo.
Kiyotaki, N. and J. Moore (1997) Credit
Cycles, Journal of Political Economy 105, pp. 211-248.
Miles, D., L. Yang and G. Marcheggiano
(2013), Optimal bank capital, The Economic Journal 123, pp. 1-37.
Modigliani, F. and Miller, M. (1958). “The
cost of capital, corporation finance and the theory of investment”, American
Economic Review, vol. 48(3), pp. 261-97.
Ratto M, W. Roeger and J. in ’t Veld (2008) ,
QUEST III: An Estimated Open-Economy DSGE Model of the Euro Area with Fiscal
and Monetary Policy, Economic Papers No 33.
Van den Heuvel, S.J. (2008): “The welfare
cost of bank capital requirements”, Journal of Monetary Economics, vol 55, no
2, pp 298–320
APPENDIX
In the following estimations results for
the case with capital buffers are presented.
Table 1:     Increasing capital requirement from 8 % to 10.5 % (zero MM
offset),               considering actual capital buffers
Table 2:     Increasing capital requirement from 8 % to 10.5 % (50 % MM
offset),                         considering actual capital buffers
Table 3:   Increasing capital requirement from 8 to 10.5 % (zero MM offset)
                Resolution fund (77 Bio), Bail in (deposit rate up
by 15bp)
Table 4:   Increasing capital requirement from 8 to 10.5 % (50 % zero MM
offset)
                Resolution fund (77 Bio), Bail in (deposit rate up
by 15bp)
[1] See FSB (2013) for an overview of the measures.
[2] IIF is an industry association that
represents more than 430 institutions headquartered in more than 60 countries.
[3] Australia, Brazil, Canada, France, Germany, Italy, Japan, Korea,
Mexico, Netherlands, Spain, United Kingdom, United States
[4] See "An assessment of the long-term economic impact of
stronger capital and liquidity requirements", BCBS, August 2010. The
report uses bank data that are not restricted to EU Member States.
[5] See BCBS (2010), "An assessment of the long-term economic impact
of stronger capital and liquidity requirements", BIS. For the Euro area
this numbers are slightly higher (see Table 7, LEI report). No changes in RWA
is assumed. 
[6] The effects of more stringent liquidity requirements on output are
calculated to be 25 % increase in the ratio of liquid asset to total asset. it
is however, not clear how the exact calibration on liquidity requirements is
applied. 
[7] Derivatives reform will have different effects on banks depending on
the size of the bank, the profitability of the business, and the structure of
the derivative operations within the bank. Non-financial firms should benefit
on the whole. Standardisation of trading should decrease the transaction costs.
Securitization requirements, currently at 5 % of the total amount, may change.
In addition, taxes and fees are estimated at 5.9 % and 8.8 % related to
financial stability contribution and deposit insurance fee changes,
respectively.
[8] As a result, the table does not include, for example, the various
reports required in Solvency II/Omnibus 2 starting in 2017.
[9] See:
http://ec.europa.eu/internal_market/bank/docs/crisis-management/2012_eu_framework/impact_assessment_final_en.pdf.
and M. Marchesi, M. Petracco Giudici, J. Cariboni, S: Zedda and F. Campolongo
“Macroeconomic cost-benefit analysis of Basel III minimum capital requirements
and of introducing Deposit Guarantee Schemes and Resolution Funds”, JRC
Scientific and Policy Report, 2012, EUR 24603. 
http://publications.jrc.ec.europa.eu/repository/bitstream/111111111/28210/1/lbna24603enc.pdf
[10] In this exercise tools vary according to different regulatory
scenarios and can include capital, bail-in, deposit guarantee schemes and
resolution funds. See also Chapter 4.
[11] Data refer to 2012. Thus, Croatia was still not part of the Union.
[12] see European Parliament and Council,
Directive 2013/36/EU of the 26 June, 2013
[13] SYMBOL is run separately for the 27 EU MS and results are then
aggregated over the EU.
[14] Covered deposits are deposits protected under Directive 94/19/EC.
In rough terms, they represent customer deposits below EUR 100 td . Data on the
amount of eligible and covered deposits in EU countries have been estimated by
the JRC using data collected from EU DGS and complemented by ECB data (see also
Cannas et al., 2013a). These data are used in the current exercise to obtain
covered deposits at single bank level starting from customer deposits. The
coefficients applied are presented in Appendix 2. 
[15] The Basel Committee permits banks a choice between two broad
methodologies for calculating their capital requirements for credit risk. One
alternative, the Standardised Approach, measures credit risk in a standardised
manner, supported by external credit assessments. The alternative is the
Internal Rating-Based (IRB) approach which allows institutions to use their own
internal rating-based measures for key drivers of credit risk as primary inputs
to the capital calculation. Institutions using the Foundation IRB (FIRB)
approach are allowed to determine the borrowers’ probabilities of default while
those using the Advanced IRB (AIRB) approach are permitted to rely on own
estimates of all risk components related to their borrowers (e.g. loss given
default and exposure at default). The Basel FIRB capital requirement formula
specified by the Basel Committee for credit risk is the Vasicek model for
credit portfolio losses, default values for all parameters except obligors’
probabilities of default are provided in the regulatory framework. On the Basel
FIRB approach, see Basel Committee on Banking Supervision, 2005, 2006 and 2010
rev. 2011. 
[16] Banks must comply with capital requirements not only for their
lending activity and credit risk component. Banks assets are in fact not only
made up of loans, and there are capital requirements that derive from market
risk, counterparty risk, and operational risk, etc. The main assumption
currently behind SYMBOL is that all risk can be approximated as credit risk. 
[17] The choice of the 50 % correlation is based on Sironi and Zazzara,
2004. A discussion and a sensitivity check on this assumption can be found in
De Lisa et al., 2011.
[18] In formula, if a bank j fails, losses due to contagion on
bank k equal to: 
where  and  are
respectively the interbank debts and credits of a bank. This is equivalent to a
so-called maximum entropy estimation of the interbank matrix.
[19] According to the agreement reached in June
2013, banks with a capital below 4.5 % of RWA would have to receive help from
their own government before the ESM can step in via direct recapitalisation. ESM direct bank recapitalisation instrument http://www.eurozone.europa.eu/media/436873/20130621-ESM-direct-recaps-main-features.pdf
[20] In particular considering a minimum capitalisation ratio equal to 8
% for determining the Systemic PD would imply counting towards
determination of Systemic PD also banks which are undercapitalised by
extremely small amounts.
[21] The GDP is taken from the AMECO dataset by
the European Commission Directorate for Economic and Financial Affairs. 3 % of
the GDP in terms of covered deposits loosely corresponds to a situation where banks holding assets equal
to 20 % of GDP are in distress. This is also almost equivalent to situations
where banks holding a share of 5 % of total assets in the banking system are in
distress.
[22] Macro-economic benefits are measured using the reduction in the
expected costs of a systemic crisis (i.e. the product of its costs and the reduction
in its probability) due to the implementation of CRD IV and BRRD. See the
section on macro- economic benefits below. 
[23] The total size of DGS funds which can be used in resolution is 0.4
% of covered deposits (according to Article 99(10)) "the liability of the
DGS shall not be greater than the amount equal to 50 % of the target funding
level prescribed for the DGS under applicable Union law", which is 0.8 %
of the aggregated covered deposits).
[24] We refer to the sum of capital and bail-in-able liabilities as Loss
Absorbing Capacity (LAC) The choice to define a threshold on the TA is in line
with the approach agreed by EU institutions in December 2013
[25] The last published update makes use of bank data as of end 2012,
see European Banking Authority, 2013.
[26] In the current exercise G1 banks are those whose Tier1 capital is
larger than EUR 3 billion.
[27] From the change in the capital ratio and the change in the RWA one
can estimate the change in capital.
[28] The use of a proportionality assumption to spread contagion across
a full network of interbank connections could actually tend to dampen contagion
for low levels of aggregate losses, and to amplify it for higher levels of
losses.
[29] Literally, under the FIRB approach, RWA are obtained as 12.5 times
the capital requirement, to be calculated using the model.
[30] Box 3.4.1: State aid measures and central bank support. Some of
this new equity will have been subscribed by government and would thus be
already included in other measures. On the other hand, no estimate is available
for the amount of retained earnings.
[31] Source: DG ECFIN Bank Watch 206 21/03/2014
[32] In practice the capital is the same as the one of the Baseline
Scenario, but contagion is not considered.
[33] While part of the issuance of new equity could be driven by
regulation and not by crisis losses, and asset relief could not entirely
constitute a loss, one should also take into account that banks also issued
subordinated debt, retained earnings and that there exists most probably hidden
losses still not accounted.
[34] Losses in baseline range between EUR 2.5 and 3.3 trillion. We
observe that in baseline contagion takes place, hence the losses cannot be
compared with those observed in the recent crises when contagion was stopped by
State aid. 
[35] GDP weighted average
of growth rate. 
[36] This is also roughly in line with the split used by the Bank of
England, 2010 which is, instead, 75 % and 25 %.
[37] The GDP variation at 2005 market prices (2009 versus 2008) is taken
from AMECO, the annual macro-economic database of the European Commission's
Directorate General for Economic and Financial Affairs. 
[38] The estimate of total (avoided) costs of a
systemic crisis is lower than the median cumulative impact estimated by models
allowing for a permanent effect reported in the Basel Committee on Banking
Stability 2010 Long Term Economic Impact exercise, which is 158 % (https://www.bis.org/publ/bcbs173.pdf
Table 1). The Bank of England also uses a cost of the crisis equal to 138 %
in its 2010 paper cited above, obtained by employing the same methodology
employed here to calculate the cost of crisis, based on an initial cost of 10 %
of GDP and a permanent share of 25 %
.[39]
Banks are expected to cover their Expected Losses on an ongoing basis, e.g. by
provisions and write-offs. The Unexpected Loss, on the contrary, relates to
potentially large losses that occur rather seldom. According to this concept,
capital would only be needed for absorbing Unexpected Losses.
[40] Set in Basel regulation equal to 45 %.
[41] see
http://www.ecb.europa.eu/stats/money/aggregates/bsheets/html/outstanding_amounts_2013-10.en.html
and a recent work of D. Schoenmaker
http://ec.europa.eu/economyfinance/publications/economicpaper/2013/pdf/ecp496en.pdf
[42] see BoE (2010), Box 7. 
[43] In the Bank of England paper referred above, 75 % and 25 % are
used, based on an initial fall of GDP of 10 %. See later for a discussion on
the permanent part.
[44] This estimate is obtained by using data on individual EU countries
GDP growth rates weighted by GDP 2008 at constant prices. AMECO figures for
EU-27 GDP slightly differ as they use a different weighting scheme.  
[45] Actual trend growth rates for all countries from the same
publication are used to obtain the figure.
[46] Also, according to the same publications, the pre-crisis growth
path should be considered an over-estimate of the long term trend due to the
pre-crisis boom conditions. Accordingly, we use estimates developed in 2009 and
2010, which reflect a more realistic long term outlook.
[47] See Ratto et al (2008) for technical details of the model.
[48] The model does not explicitly include firm defaults on their loans
from the banking sector. Providing for bank credit risk could produce an
explicit result for this mitigation.   
[49] In the Miles et al (2013) study it is assumed that there is no
effect on employment.