The future of EU financial regulation and supervision - European Union Committee Contents

Chapter 1: The Financial Crisis

The future of EU financial regulation and supervision

1.  This report examines the structure, and current proposals for the revision, of financial supervision and regulation within the European Union. This has been brought to the forefront of debate by the financial crisis. Although the crisis began in financial markets in the United States, its effects have spread into the real economy around the world, not least in the EU. Measures have been implemented in response to the crisis globally, at EU and at national level.

The causes of the financial crisis

2.  To understand how to prevent a repeat of the financial crisis, it is important to try to understand its causes. The consensus is that global macro-economic imbalances and financial innovation—which amplified the consequences of excessive credit and liquidity expansion—together with failures in regulation, supervision and corporate governance, combined to cause the financial crisis. The collapse of the subprime lending market in the United States triggered the crisis. Many commentators have argued that loose monetary policy did little to counter bubbles in asset prices.

3.  In the belief that central banks had tamed inflation, interest rates were kept historically low. This led to plentiful availability of credit, but low returns on investments, fuelling the housing price bubble and contributing to the build-up of a large current account deficit in the USA and some other countries including the UK. Credit expansion in the US was financed by countries with sizable current account surpluses, notably China and oil exporting nations.

4.  In an effort to achieve higher returns, financial institutions and their employees devised increasingly complex financial products, such as Asset-Backed Securities (ABS). This market expanded rapidly, and by 2007 ABS products were worth £2.5 trillion in the US alone.[1] For many the focus in financial institutions on short-term profit at the expense of long-term stability, and the incentive structure that encouraged bank employees to seek short-term profit, helped to lead to the greatest excesses of financial innovation.

5.  The ability of banks to accrue fees and lower their capital requirements by selling assets in securitised bonds (see Appendix 8) led to increasingly higher leverage (capital to asset) ratios. The originate-to-distribute model and the transfer off-balance sheet of securitised assets removed much of the incentive for the lender to ensure the borrower could repay the loan. This left the institutions vulnerable to even the slightest changes in asset values and was exacerbated by high levels of leverage.

6.  United Kingdom banks were amongst the most highly involved institutions globally in the trading of securitised financial instruments. The complexity and opacity of many instruments led institutions and investors to underestimate the riskiness of underlying assets. These problems were further exacerbated by the speed and volume at which the products were bought and sold. Lord Myners, Financial Services Secretary to the Treasury, described to us how securitisation led to the belief among many that "poor quality assets … assembled as a portfolio … could somehow by alchemy be converted into something stronger than they were" (Q 62).

7.  Each securitised instrument was assigned a credit rating by a credit rating agency, which also rated the issuers of these instruments. The highest triple A rating, the standard rating for government bonds in developed countries, was increasingly given to complex, opaque and (as was later discovered) risky securitised products. Martin Power, Head of the Cabinet of Commissioner McCreevy, told us that around 64,000 securitised products received a triple A rating (Q 423). The major miscalculation of the risks inherent in these products occurred in part through flaws in the methodologies of rating agencies and was exacerbated by conflicts of interest caused by the originator, rather than the investor, purchasing the rating. This undervaluation of risk contributed greatly to the expansion of the securitised debt market and the "aggressive use of leverage by banks" described to us by the Minister (Q 62). The problems caused by complex securitised instruments were exacerbated further by what Marke Raines of Taylor Wessing LLP described as the "market frenzy" with many products purchased with little or no due diligence conducted by the investor (Q 24). Human behaviour and human frailties, in particular greed, played a role. Professor Goodhart told us "greed led them to take positions … which obtained relatively high short-term returns at the expense of excessive risks which were assumed … ultimately by the taxpayer and society" (Q 90).

8.  Highly leveraged funds and the so-called shadow banking system flourished in an environment of easy money and contributed to the build-up of leverage in the system.

9.  The financial crisis itself began when the subprime bubble burst in the summer of 2007, as it became increasingly clear that many borrowers in the USA were unable to meet their debt obligations. The lack of transparency in securitised products led to confusion over the size and location of credit losses, damaging market confidence. The recognition that markets had underestimated risk caused many financial institutions to sell off their assets. Concerns about liquidity helped to prompt banks to hoard cash.

10.  The loss of trust and market confidence in financial products and institutions worsened, particularly following the failure of Northern Rock and Lehmann Brothers in September 2008, restricting the normal functioning of markets. Banks stopped lending to each other and some consumers withdrew their deposits, with panic spreading through both regulated and unregulated financial institutions. This reduced market liquidity further. As institutions struggled to find sources of funding, liquidity problems quickly turned into insolvency problems, with governments stepping in to provide guarantees and recapitalise financial institutions.

11.  As the market value of financial institutions collapsed, pro-cyclical accounting and capital rules exacerbated the crisis (see Box 4). Basel rules stipulate the amount of capital an institution has to hold, in relation to credit risk. They were first set out in 1988 by the Basel Committee on Banking Supervision. Rating agencies lowered the ratings of financial institutions as it became increasingly clear that credit risk was undervalued, which pushed required minimum capital ratios of institutions higher. This forced banks to sell off more assets, pushing their value still lower.

12.  The financial crisis led to the bank run on Northern Rock and its subsequent nationalisation, the merger of the Lloyds TSB and the HBOS group, the recapitalisation of the RBS group, the break-up of Bradford & Bingley and many further Government actions in the financial market in the United Kingdom alone. Up to February 2009, the European Commission approved over 40 applications from Member States to recapitalise financial institutions.

13.  The Global Stability Report of the International Monetary Fund estimates that to return to the bank leverage ratios of the mid-1990s would require capital injections of $500 billion for U.S. banks, about $725 billion for euro area banks and about $250 billion for U.K. banks.[2] This shows the crisis has had a particularly deep impact on the European banking system.

14.  The scale of central bank and government intervention in the financial sector in recent months is unprecedented. The provision of emergency liquidity assistance, the use of conventional and non-conventional instruments of monetary policy (such as quantitative easing), the design of various forms of financial support, including bank recapitalisation and even nationalisation, and the reliance on expansionary fiscal policies have given the State a prominent role in the financial system and in the resolution to the crisis. These are, for the most part, national responses, albeit co-ordinated to some extent at the European and international level. While we recognise, in the words of Czech President Mr Klaus, that fighting the fire has been a priority for policy-makers in recent months, we must also address the issue of writing new fire regulations. In this report we address some important issues with regard to the reform of financial regulation and supervision in the EU, using our witnesses' version of events as the background for our analysis.

Our inquiry

15.  Given the broad nature of financial regulation and supervision within the EU, our report comments on the following specific areas:

  •   The amendments to the Capital Requirements Directive, which create new minimum capital requirements for financial institutions, adopted on 7 April 2009;
  •   The regulation of credit rating agencies, adopted on 23 April 2009;
  •   Crisis managements procedures in the EU;
  •   The structure of financial supervision within the EU. This includes detailed analysis of the recommendations of the de Larosière group, the Turner review, the role of the European Central Bank and the powers of the home and host country supervisors over cross-border financial institutions;
  •   The role of the EU in global supervisory and regulatory structures; and
  •   State aid measures in response to the financial crisis.

16.  This report examines the proposed reform of each of these areas. Though the report focuses on EU responses to the financial crisis, we do not start from the assumption that the EU is the right arena for action. Rather, for each issue we have considered whether it is necessary to take any action and if so whether action is best taken at a national, EU or global level or combination thereof.

17.  This report is intended to contribute to an in-depth review of the current regulatory and supervisory regime. Two previous reports, the Turner Review and the Report of the de Larosière Group, have already made detailed suggestions for the reform of supervision and regulation. The recommendations of these two reports, where they fall within the scope of the inquiry, are considered in our report, along with the suggestions for reform by other groups and individuals, particularly those of Her Majesty's Government, the Financial Services Authority and the European Commission.

18.  The issues involved in any examination of regulation and supervision in the EU are diverse and we do not intend to cover them all in this report. In particular, we have not considered the impact of the crisis on the real economy, UK participation in the single European currency, regulation and supervision of insurance firms, remuneration of bankers and corporate governance issues or the divide between investment and commercial banking. The inquiry focuses mostly on the banking system, although we make reference, where relevant, to other parts of the financial system.

19.  The House of Lords Economic Affairs Committee has conducted a concurrent inquiry into financial regulation and supervision within the United Kingdom.[3] The two reports together provide a broad overview of the supervisory and regulatory architecture in place in the United Kingdom. The House of Commons Treasury Select Committee has published three reports into different aspects of the banking crisis.[4]

20.  The Membership of Sub-Committee A that undertook this inquiry is set out in Appendix 1. Lord Woolmer of Leeds chaired the deliberations on this report in place of Baroness Cohen of Pimlico. We are grateful to those who submitted written and oral evidence, who are listed in Appendix 3; all the evidence is printed with this report. There is also a glossary in Appendix 5. We also thank the Sub-Committee's specialist adviser to the inquiry, Rosa Maria Lastra, Professor in International Financial and Monetary Law at the Centre for Commercial Law Studies, Queen Mary University of London. We make this report for debate.

1   The Turner Review: a regulatory response to the global banking crisis, (Financial Services Authority, March 2009), p. 14 Exhibit 1.5 Back

2   Global Financial Stability Report: responding to the financial crisis and measuring systematic risk, (International Monetary Fund, April 2009), p 37. Back

3   Economic Affairs Committee, 2nd Report (2008-09): Banking Supervision and Regulation (HL 101). Back

4   Treasury Committee, 5th Report (2008-09): Banking Crisis: the impact of failure of the Icelandic banks (HC 402); Treasury Committee, 7th Report (2008-09): Banking Crisis: dealing with the failure of UK banks (HC 416); Treasury Committee, 9th Report (2008-09): Banking Crisis: reforming corporate governance and pay in the City (HC 519). Back

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