Select Committee on European Union First Report


APPENDIX 3: GOVERNMENT CORRESPONDENCE


Letter from Lord Grenfell, Chairman of the Select Committee on the European Union, House of Lords, to Ian Pearson MP, Economic Secretary, HM Treasury, dated 15 October 2008

EM 6996/08 and 11978/07: Directives of the European Parliament and the Council on the taking-up and pursuit of the business of insurance and reinsurance

Thank you for your predecessor's letter dated 7 July 2008, which was considered by Sub-Committee A at their meeting on 14 October. The Sub-Committee were grateful for the detailed answers provided to the issues that they had raised in their report on Solvency II.

In the light of the recent disruptions to the financial markets, the Sub-Committee decided to continue to hold the documents under scrutiny. Has there been any change in attitude towards risk and suitable levels of capital that insurance companies should hold? If so, did this occur in time to feed into the fourth Quantitative Impact Study, and what impact has this had on the Solvency II negotiations?

Letter from Lord Grenfell, Chairman of the Select Committee on the European Union, House of Lords, to Ian Pearson MP, Economic Secretary, HM Treasury, dated 6 November 2008

EM 13713/08: Proposal for a Directive of the European Parliament and of the Council amending Directives 2006/48/EC and 2006/49/EC as regards banks affiliated to central institutions, certain own funds items, large exposures, arrangements, and crisis management

Thank you for your Explanatory Memorandum 13713/08 dated 21 October 2008 which Sub-Committee A considered at its meeting on 6 November 2008. The Sub-Committee decided to hold this document under scrutiny in conjunction with its forthcoming report regarding EU financial regulation. The Sub-Committee would like to request that you keep the Committee updated regarding developments to these proposals.

The Sub-Committee would also like to request clarification of the Government's position in relation to the amendments proposed. The Explanatory Memorandum explains the Government will continue to "seek adjustments to further improve outcomes": which proposals in particular does the Government wish to change and what outcomes are desired?

Letter from Lord Myners, Financial Services Secretary, HM Treasury, to Lord Grenfell, Chairman of the Select Committee on the European Union, House of Lords, dated 11 November 2008

Parliamentary scrutiny—EU dossiers ahead of December ECOFIN

I am writing to update you with regard to the upcoming ECOFIN Council. We have now received the draft agenda for the meeting on 2 December, when the French Presidency plan to seek agreement to several financial services dossiers which are still subject to scrutiny.

These dossiers are Solvency II, the Capital Requirements Directive, UCITS and the Deposit Guarantee Scheme Directive. The Presidency is seeking agreement from ministers to general approaches to allow negotiations with the European Parliament to proceed.

You have been, quite rightly, concerned that the impact of these dossiers should be considered both on their own merits and in the light of the current financial turmoil. The Government agrees that the current climate justifies ensuring that the detail of these dossiers is carefully scrutinised because of the significant potential impact on UK and European customers, businesses and public finances. We have continued to work hard with other Member States and the Commission to ensure that these dossiers meet our specific aims and also link in with our wider ambitions for improvements to regulatory and supervisory systems.

However, this consideration must be balanced with the need for the UK to play a full part in shaping these Directives at ECOFIN. We are now reaching the endgame on all four dossiers and we fully expect that the Presidency will pursue its aim of asking Member States to agree general approaches on all four on 2 December.

On that basis I have annexed to this letter detail on three dossiers on which you and Michael Connarty have requested further information: Solvency II, the CRD and UCITS [not printed]. I hope that this information will be sufficient to enable your Committee to clear the dossiers from scrutiny in time for December ECOFIN.

Solvency II (Explanatory Memorandum 11978/07)

This annex provides an update on the Government's views of the Solvency II project in the light of the current global financial turmoil. It gives information in particular in respect of attitudes towards risk and suitable levels of capital. This annex sets out that information.

The Solvency II Directive sets a calibration standard for the main Solvency Capital Requirement which insurers will have to meet on an on-going basis under Solvency II. This standard is that an insurer should have no more than a One in 200 probability of failure over a one-year period. Subject to meeting this standard, Solvency II allows insurers to adopt the risk appetite which their board and senior managers determine is appropriate as long as they have in place systems to manage those risks effectively and of course adequate capital given the chosen risk profile. This is in line with the current approach adopted by the FSA and remains appropriate.

It should be noted that any given capital requirement imposed by the authorities is a minimum standard which in general will be exceeded, often by a significant margin. The great majority of firms will hold an additional buffer of capital for several reasons. These include the desire to avoid regulatory intervention subsequent to any capital shortfall against the regulatory minimum and, for larger companies, to maintain a given credit rating.

Further, the Solvency II Directive has two capital requirements and when the lower of these, the Minimum Capital Requirement, is breached, the insurer's authorisation to write new business will be withdrawn. This should ensure that well before any insurer's capital comes close to being depleted, its existing policyholders are fully protected from the risks inherent in writing new business. We expect that the Minimum Capital Requirement will typically be in the range 20-50 per cent of the main Solvency Capital Requirement. It is reasonable to expect that companies will in general still have significant amounts of capital at the point when they are prevented from undertaking new business.

Our conclusion is that the calibration standard for the capital requirements under Solvency II remains appropriate.

However we have also considered the issue of the quality of capital which is eligible to meet those capital requirements. In the European Commission's proposals for the Solvency II Directive, the minimum amount of Tier One of highest quality capital that a firm is required to maintain is one third of the amount of the Solvency Capital Requirement. By way of comparison, in the banking sector the equivalent requirement is that one half of the minimum regulatory capital must be matched with eligible Tier One capital.

One key lesson emerging from the impacts of the global financial turmoil is that financial companies require high quality capital to maintain the confidence of counter parties and other financial market participants, as well as of their policyholders. At present in the UK insurance companies are required by the FSA to hold at least half of the regulatory minimum capital requirement in the form of Tier One capital. In practice in many firms the share of Tier One in total capital held is significantly higher.

Since the current FSA capital requirements are calibrated to achieve a similar prudential standard to that proposed for the Solvency Capital Requirement under Solvency II, it follows that, on the basis of the current proposal, Solvency II would permit a material dilution in the overall quality of capital held by UK insurers.

Of course it need not follow from the change in regulatory requirements that insurance companies would necessarily alter the share of Tier One capital in their total capital held. Nevertheless, given the events of the past year the Government's view is that it would not be appropriate to choose a lower minimum for the amount of highest quality Tier One capital. We therefore propose to advocate with the Presidency and other Member States that under Solvency II insurance companies are required to maintain Tier One capital equal to at least one half of the Solvency Capital Requirement.

The fourth Quantitative Impact Study

The purpose of the fourth Quantitative Impact Study (QIS 4) is to analyse the impact on insurance companies of the proposed quantitative elements of the Solvency II framework. At the time the specification of QIS 4 was developed by CEIOPS and then agreed by the Commission—late 2007 through to early 2008—global financial markets had not yet experienced the extraordinary disruptions we have recently witnessed. As a result the specification of QIS 4 is of course consistent with the Directive as proposed by the Commission but has not been altered in the light of the recent events in global financial markets.

Nevertheless, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) has produced analysis of the financial stability of the insurance sector at EU level, including an assessment of its exposure to US sub-prime mortgage risk either via holdings of Asset Backed Securities, or through investment in hedge funds. The conclusion reached is that across the exposure to this risk category is modest for the EU insurance sector as a whole.[11]

Further, the fact that it was not possible for QIS 4 to reflect the implications for policy of the global financial turmoil does not imply that it cannot be taken into account in the Solvency II legislation.

The Solvency II framework has the flexibility to be adjusted to the lessons of the financial crisis once the policy implications are fully analysed. As you are aware Solvency II adopts the Lamfalussy arrangements for developing financial services legislation. This means that the Directive currently under negotiation provides a framework and core principles but leaves considerable areas of the detailed technical legislation for so-called 'level two' implementing measures.

The Lamfalussy arrangements were deliberately designed to achieve flexibility in EU financial services legislation so that it could respond to significant changes in the financial sector. This will allow lessons that are relevant to the insurance sector to be applied in the detailed legislation of Solvency II. However, we must avoid knee-jerk reactions to the current financial problems and in particular we need to be careful to ensure that the economics of the insurance sector, which is fundamentally different from the economics of banking, is taken into account fully where any read across between the sectors is envisaged.

Along with other Member States' authorities, HM Treasury and the FSA have a central interest in ensuring that the level two implementing measures in Solvency II provide the technical requirements to deliver a robust prudential framework whilst also being proportionate in the regulatory burden imposed on industry.

Capital Requirements Directive (Explanatory Memorandum 13713/08)

This annex sets out how negotiations on the Capital Requirements Directive are developing and gives a clarification of which outcomes the Government desires and which aspects it wished to change.

Its sets out updates on negotiations and the proposed timetable for completion. Firstly, on the timetable. There is a high probability that the French Presidency will seek to achieve a general approach among Member States at the December meeting of Finance Ministers. While this timetable poses significant challenges, especially in regard to the ongoing scrutiny process, negotiations have progressed well in a number of areas.

On the negotiations themselves, the proposal covered four main areas:

  •   The large exposures regime: limits to ensure financial institutions are not exposed too heavily to any single or connected counterparty;
  •   The supervisory framework and supervisory colleges: reinforcing the efficiency and effectiveness of supervision of cross-border banking groups by formalising supervisory colleges in legislation and requiring closer cooperation on the determining of group capital levels;
  •   The definition and limits on hybrid capital: providing a common interpretation of the three main eligibility criteria that correspond with 'higher quality' capital, permanence, loss absorption and flexibility in payments, and establishing harmonised quantitative limits for the extent to which hybrids may be accepted as firms' original own funds; and
  •   Securitisation and risk transfer activities: revisions aimed at improving risk management by better aligning potentially misaligned incentives, disclosure and diligence requirements on the investor before they can invest and monitoring requirements on an ongoing basis, alongside transparency requirements on originators before they can sell.

In terms of the large exposures regime, the current approach sets out a maximum limit for all exposures from banks to non-banks and all interbank (bank to bank) exposures over one year, but contains a national discretion on interbank exposures for less than a year.

So far in negotiations the main thrust of the Commission's original proposal, to extend the current limit for inter-bank exposures to all exposures regardless of maturity, has been maintained. Further to this, our key negotiating objective, that of ensuring a proportionate regime for the UK's smallest banks and building societies, has also been maintained.

The Government believes this will represent a significant improvement to the stability of the financial sector in the UK, decreasing the risk of large systematic linkages between institutions. The original Commission proposal aimed to reinforce the efficiency and effectiveness of supervision of cross-border banking groups by formalising supervisory colleges in legislation. It also required agreement between supervisors of entities in the same group on issues for the whole banking group such as total capital for the group, the distribution of capital across subsidiaries, liquidity in subsidiaries and branches and reporting requirements, and where agreement is not reached, a mediation mechanism was proposed using CEBS[12] as an advisory body. Ultimately it was proposed that the consolidating supervisor (that is the supervisor responsible for the parent institution or holding company) would take the final decision.

This approach would produce significant benefits for cross-border banking groups, and potentially deliver more efficient supervision and reduce burdens. The current draft of the compromise text maintains this general approach, which the UK has broadly supported. Furthermore, on the issue of determining the total required capital for the group, the text now proposes that the final decision on key supervisory issues shifts back to the local supervisor. The Government believes this approach strikes the right balance between efficiency of supervision and the distribution of supervisory powers and responsibilities, and will be seeking to ensure this option remains in the text, which will allow the Financial Services Authority to remain ultimately responsible for the capital levels of UK institutions.

The Commission's original proposal on hybrid capital [which] was to introduce a common interpretation of the three main eligibility criteria that correspond with 'higher quality' capital (permanence, loss absorption and flexibility of payments), and establish harmonised quantitative limits for the extent to which hybrids may be accepted as firms' original own funds, has largely been maintained. Subject to some modifications to ensure that instruments issued by mutuals (who cannot issue pure equity) can, in some circumstances, be deemed as comparable to equity, this is an approach the Government continues to support and one that will bring significant benefits to cross border financial institutions.

Finally, the Commission had proposed revisions aimed at improving risk management by better aligning potentially misaligned incentives, specifically by requiring investor institutions in the EU to only invest in credit risk transfer products if the originator has committed to holding a net economic interest of at least five per cent. It has also proposed disclosure and diligence requirements on the investor before they can invest and monitoring requirements on an ongoing basis, alongside transparency requirements on originators before they can sell.

The Government initially had concerns over the scope of the quantitative retention requirement, which would effectively cover a wide range of instruments beyond simply securitised assets. Negotiations are progressing well, and the scope is being narrowed. This will help ensure that the requirements reflect a proportionate response to the financial market disruption. We hope to see continued progress on further refining the scope as negotiations proceed. In terms of disclosure and diligence requirements, the Government was supportive of these improvements, but has agreed amendments to ensure they are workable in practice and are less burdensome on the industry.

Letter from Lord Grenfell, Chairman of the Select Committee on the European Union, House of Lords, to Lord Myners, Financial Services Secretary, HM Treasury, dated 18 November 2008

EM 14317/08: Proposal for a Directive of the European Parliament and of the Council amending Directive 94/19/EC on deposit guarantee schemes as regards the coverage and payout time for depositors

Thank you for your Explanatory Memorandum 14317/08 about deposit guarantee schemes. This was considered by Sub-Committee A at its meeting of 18 November 2008. The Sub-Committee cleared the item from scrutiny. The Sub-Committee would like to ask about certain issues raised by the proposed amendment. How does Directive 94/19/EC define "credit institutions" and does this prevent customers recovering deposits in separate banks which are part of the same banking group? Does the UK FSCS guarantee deposits (a) per person, per "brand", (b) per person, per institution or (c) per person, per group? Do the proposals modify this status and will any modification require a subsequent change to United Kingdom primary legislation?

The Sub-Committee would also like to ask when the FSA expects to publish the results of its consultation paper on compensation limits referred to in paragraph 14 of the Explanatory Memorandum.

Letter from Lord Myners, Financial Services Secretary, HM Treasury, to Lord Grenfell, Chairman of the Select Committee on the European Union, House of Lords, dated 24 November 2008

EM 14317/08: Proposal for a Directive of the European Parliament and of the Council amending Directive 94/19/EC on deposit guarantee schemes as regard the coverage and payout time for depositors

Thank you for your letter of 18 November 2008. I would like to respond to the questions raised by Sub-Committee A and update you on the progress of the negotiation.

I am grateful to the Sub-Committee for clearing the proposal. As you will know, the Presidency intend to seek agreement to it among several financial services dossiers at the ECOFIN Council on 2 December in order to allow negotiations with the European Parliament to proceed.

Sub-Committee A has asked how Directive 94/19/EC defines 'credit institutions' and what effect this may have on depositors in separate banks which are part of the same group. The Directive defines a credit institution as 'an undertaking the business of which is to receive deposits or other repayable funds from the public and to grant credits for its own account'. This embraces banks and building societies.

The Directive applies the guarantee to deposits with separate companies within the same group. Depositor protection in the UK is framed in terms of all accounts held in firm operating under a single authorisation by the FSA.

The FSCS (Financial Services Compensation Scheme) protection limit therefore applies on a per-person, per-authorised institution basis. The European proposals would not modify this, except insofar as the Commission is tasked, among other things, with reporting by December 2009 on the scope of products and depositors covered.

Any future modification is likely to be implemented through changes to FSA rules, not through primary or secondary legislation to amend the Financial Services and Markets Act 2000. The FSA has invited comments on the per-authorised institution criterion in its consultation on compensation schemes, published in October (CP08/15). It has said that it will consider simplifying the eligibility criteria and may bring forward proposals in a further consultation in the New Year. The Sub-Committee has asked when the FSA expects to publish the results of its consultation paper on compensation limits. That is a matter for the FSA. However, I understand that the consultation closes on 5 January 2009 and rule changes and a policy statement will be published later in 2009.

I would also like to update you on progress of the negotiations on amendments to the Directive. The Government has continued to support an increase in the minimum level of compensation, a shorter payout deadline and the move to compensate 100 per cent of eligible deposits.

Member States have reached an agreement, subject to the views of the European Parliament, on an increase to €50,000 when the Directive enters into force and to €100,000 by 31 December 2011. The limits will be inflation-linked. The payout delay should be reduced from three months to 20 days, with a further 10 days in exceptional circumstances, by December 2010. Compensation will extend to 100 per cent of eligible deposits. Further measures include a requirement for guarantee schemes to cooperate and schemes must be stress tested regularly.

A provision authorising the Commission to propose temporary increases in a crisis has been withdrawn. Instead there is a commitment to further work in a number of areas. The Commission is tasked with reporting by December 2009 on:

  •   the effectiveness of payout procedures
  •   the determination of contribution schemes
  •   the effectiveness of cooperation arrangements
  •   the potential impact of increasing the limit to €100,000
  •   whether €100,000 should become an upper limit, it will do so unless the report finds against.

I believe that, taken together, these changes represent a significant improvement in the protection afforded to depositors and the effectiveness of the Directive. Further improvements are likely to follow the Commission's report in December 2009.


11   As outlined in CEIOPS Spring 2008 report on financial conditions and financial stability in the European Insurance and Occupational pension find sectors 2007-2008
http://www.ceiops.eu/media/docman/public_files/publications/reports/CEIOPS-FS-10-08.pdf  
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