On 25 February, the de Larosiere Group published its report on financial supervision in the EU. The report made some hard-hitting criticisms on the causes of the global financial crisis and 30 recommendations for change.
Here, we look at some key parts of the report and highlight the main recommendations, many of which have also been the subject of other recent regulatory announcements and initiatives.
What is the de Larosiere Group?
The Group is a high-level group chaired by Jacques de Larosiere, former IMF Managing Director and ex-Bank of France Governor, and comprising seven other experts including Callum McCarthy, former FSA Chairman. The Group has acted on a mandate from the European Commission to give advice on the future of European financial regulation and supervision.
What are the main recommendations?
The Group recognises the need for urgent action. Although its specific focus is on European aspects of regulation and supervision, it stresses that US factors were substantial causes of the crisis and exacerbated by failings in US regulation. Not surprisingly, then, it underlines the importance of global action.
Also, it sees the need for “repair” in three areas:
- policy and regulatory;
- EU supervisory; and
The report is a curious mix of hard-hitting criticism, constructive though radical recommendations and trite observations.
Causes of and contributors to the problems
This article will not recite the history of the crisis. Rather, we have picked out the various market participants at which the Group directs blame. Many of these have been blamed by others, but the Group saves its most savage attack for Credit Rating Agencies (CRAs). It singles out:
- risk assessment within financial institutions and their regulators and supervisors;
- the failings of Basel 1 (which it says have not been adequately covered in Basel 2);
- institutions and supervisors significantly underestimating liquidity risk;
- CRAs significantly underestimating credit default risks of instruments collateralised by sub-prime mortgages, a factor which was aggravated by conflicts of interest within CRAs;
- senior management who failed to understand products their firms dealt in, and did not apply appropriate checks and balances;
- remuneration and incentive schemes which, combined with shareholder pressure, encouraged risk-taking for short-term reward;
- inadequate regulatory appreciation of the importance of liquidity and failure to pay proper attention to the use of off-balance sheet vehicles. Many of the failures were compounded by regulators receiving insufficient information about institutions’ exposures in other countries;
- supervision too focused at a micro-prudential level;
- no efficient multilateral supervision at IMF level; and
- inadequate crisis management infrastructure within the EU.
What does the Group think of:
Colleges of supervisors? It likes the idea, as it likes the idea of pan-EU regulators. It wants stronger regulation at EU level, maximum harmonisation (so Member States can’t gold plate EU requirements) and makes new suggestions for macro-prudential supervision and how to deal with group supervision.
Parallel banking? It blames hedge funds less than others have done, but recognises the EU should take proportionate measures to regulate and get information from key market players.
Credit reference agencies? They are too influential, and their errors in judgement proved disastrous to many. The Group wants strong regulation of CRAs, coupled with less blind reliance on them and independent due diligence.
Supervisors? It makes several trite recommendations on giving supervisors more powers and making more sanctions available to them, with little or no evidence that absence of relevant powers contributed to failure to contain the financial crisis. It also makes interesting distinctions between failings in regulation as opposed to failures in supervisory competence.
Key recommendations: Policy and regulatory repair
Recommendation 1: Basel 2 rules
It is common ground that Basel 1 did not address the risks now seen to be fundamental. However, the Group is alone in suggesting that Basel 2, although better in some ways, is still fundamentally flawed, yet its prescriptions for change are not so different from others’. The Group wants amendments that:
- gradually increase minimum capital requirements;
- reduce pro-cyclicality;
- introduce stricter rules for off-balance sheet items;
- tighten norms on liquidity management; and
- strengthen the rules for banks’ internal control and risk management, in particular by reinforcing the “fit and proper” criteria for management and board members.
Recommendation 2: Regulatory capital
The Group wants a common, EU-wide definition of regulatory capital, agreed by the Basel Committee. In particular, it wants certainty on what, if any, hybrid instruments are acceptable as capital.
Recommendation 3: Credit rating agencies
The Group is concerned at how much reliance others have placed on a few agencies whose opinions often turned out to be wrong. It stresses that reliance on CRAs, even properly regulated ones, should not be a substitute for due diligence by investors or improved supervision. That said, it does not agree with the Commission’s “cumbersome” proposal for a Regulation to govern CRAs. Instead, it recommends that:
- within the EU, a strengthened CESR (recast as one of three new European financial supervisory authorities – see Recommendation 18 below) should register and supervise CRAs;
- there is a fundamental review of CRAs’ business models and financing, concentrating on removing the conflicts within the agencies, and possibly separating ratings and advisory activities;
- regulators have caused problems by insisting on top ratings for many purposes and the Group wants to see the regulatory importance of ratings reduced; and
- there should be custom-made codes for structured products to help with understanding their ratings.
Recommendation 5: Insurance
The Group singles out insurance companies, pointing out they have not been immune from the crisis. It wants Solvency 2 (the proposed new financial resources regime for insurers) adopted as soon as possible and criticises Member States that are holding up negotiations. Solvency 2 must include a balanced group support regime, coupled with enough safeguards for host Member States, a binding mediation process between supervisors and harmonised insurance guarantee schemes.
Recommendation 7: Parallel banking system
Many political and some other commentators have singled out hedge funds for attack, alleging they have caused the same problems as banks without being regulated as such, or at all. This has been used as a basis to call for regulation of hedge funds. The Group recognises that in the EU most hedge fund managers are registered and in some jurisdictions, specifically the UK, regulated. However, it recommends:
- extending appropriate regulation, proportionately, to all firms or entities conducting financial activities of a potentially systemic nature, even if they have no direct dealings with the general public;
- improving transparency in all financial markets - and notably for systemically important hedge funds - by imposing, in all EU Member States and internationally, registration and information requirements on hedge fund managers, about their strategies, methods and leverage, including their worldwide activities. These recommendations mirror initiatives already started in the US; and
- introducing appropriate capital requirements on banks owning or operating a hedge fund or otherwise carrying out significant proprietary trading, and closely monitoring the activities of such institutions and funds.
Recommendation 8: Securitised products and derivatives markets
The Group recognises the importance of dealing with the lack of understanding of certain markets. For securitised products and derivatives markets, the Group wants to:
- simplify and standardise OTC derivatives;
- introduce and require the use of at least one wellcapitalised central clearing house for credit default swaps in the EU, supervised by the new European Securities Authority (CESR’s replacement) and the ECB (which is already being actioned); and
- guarantee that issuers of securitised products keep on their books for the life of the instrument a meaningful amount of the underlying risk (non-hedged).
ISDA has already criticised these conclusions, and some of the arguments the Group puts forward to support them.
Recommendation 9: Investment funds
The Group wants more common rules for investment funds in the EU, particularly for money-market funds and to address redemption and liquidity issues. It is concerned that delegating outside the EU should not be used to avoid EU rules. Following the fall-out from the Madoff scheme collapse, there should also be tighter supervisory control over the independent role of depositories and custodians
Recommendation 10: A consistent set of European rules
The Group falls short of suggesting one single pan-European regulator, which will hearten some national regulators, but it makes some radical recommendations – see below. However, EU legislation should not allow inconsistent transposition and application: regulatory inconsistencies should be ironed out at both global (through international arrangements) and EU levels. Nevertheless, superequivalence (or “gold plating”) on financial stability grounds would be permissible (within limits).
Recommendation 11: Corporate governance and remuneration
The Group considers that employee remuneration incentives must be better aligned with shareholder interests and long-term, firm-wide profitability by basing the structure of financial sector remuneration schemes on the principles of:
- assessing bonuses in a multi-year framework, spreading bonus payments over the cycle;
- applying the same principles to proprietary traders and asset managers; and
- making bonuses reflect actual performance and not guarantee them in advance.
Supervisors should take greater responsibility over the suitability of remuneration policies and have a range of powers to deal with concerns over institutions’ attitudes.
Recommendation 12: internal risk management The Group recommends that:
- the risk management function within financial institutions must be independent and responsible for effective stress testing;
- senior risk officers should hold a high rank in the company hierarchy; and
- internal risk assessment and proper due diligence must not be neglected by over-reliance on external ratings. Supervisors must also play their part by frequent inspections of firms’ internal risk management systems.
Recommendation 14: Deposit Guarantee Schemes; branch supervision
The Group is concerned at divergence in current levels of protection under Deposit Guarantee Schemes (DGS) in the EU. It says they should be harmonised and preferably be pre-funded by the private sector. It wants similar standards in the insurance and investment sectors. In principle, therefore, host states should not need or allow “top-ups”.
The Group recognises a point raised by FSA, that the present arrangements for safeguarding the interests of depositors in host countries have not always worked, and recommends the existing powers of host countries in respect of branches be reviewed.
EU supervisory repair
Recommendation 16: European Systemic Risk Council
To address the lack of cohesion and co-operation between supervisors, and the problems caused by regulators ignoring macro-prudential issues, the Group recommends setting up a new body called the European Systemic Risk Council (ESRC), to be chaired by the ECB President.
The ESRC should be composed of the members of the General Council of the ECB, the chairs of CEBS, CEIOPS and CESR1 and one representative of the European Commission. It could involve relevant national supervisors as needed.
The Group stresses there must be a proper flow of information between the ESRC and the microprudential supervisors.
Recommendation 17: Effective risk warning system
Europe needs an effective risk warning system and this could be the responsibility of the ESRC and of the Economic and Financial Committee (EFC).
The ESRC should prioritise and issue macro-prudential risk warnings: there should be mandatory follow-up and, where appropriate, relevant competent authorities in the EU should take action.
Where the risks relate to global system issues, the ESRC should warn the IMF, the Financial Stability Forum (FSF) and the Bank for International Settlements in Basel (BIS) so they can together decide appropriate action at both EU and global levels. The ESRC would have power to notify the EFC if it felt any national supervisor had not taken appropriate action following a warning.
Recommendation 18: European System of Financial Supervisors
Turning to “micro-supervision”, the Group recommends setting up a European System of Financial Supervisors (ESFS):
- existing national supervisors would continue to carry out day-to-day supervision;
- three new, more powerful, European Authorities would replace CEBS, CEIOPS and CESR, and would coordinate the application of supervisory standards and guarantee strong cooperation between the national supervisors; and
- colleges of supervisors would be set up for all major cross-border institutions.
The ESFS will need to be independent of the political authorities, but be accountable to them.
It should rely on a common set of core harmonised rules and have access to high-quality information.
Recommendation 23: A new framework for supervision
The Group envisages the new system working with the ESRC (See Recommendations 16 and 17 above) working with members of the European Central Bank/ European System of Central Banks, chairs of the reformed 3L3 Committees and the Commission on macro-prudential supervision. The transformed 3L3 authorities, with national supervisors, would work on micro-prudential issues.
Global supervisory repair
Recommendation 25 : Financial Stability Forum (FSF)
The Group recommends the FSF, in conjunction with international standard setters like the Basel Committee, should be responsible for promoting the convergence of international financial regulation to the highest level benchmarks.
The Group feels it is important to enlarge the FSF to include all systemically important countries and the European Commission. It should receive more resources and its accountability and governance should be more closely linked to the IMF.
The FSF should regularly report to the IMF’s International Monetary and Financial Committee (IMFC) about the progress made in regulatory reform implementing the lessons from the current financial crisis. The IMFC should be transformed into a decision-making council.
Recommendation 27: IMF
The Group recommends the IMF, in close cooperation with other interested bodies, takes charge of developing and running a financial stability early warning system, with an international risk map and credit register.
The early warning system should aim to deliver clear messages to policy makers and to recommend preemptive policy responses, possibly triggered by predefined “danger zones”.
All IMF member countries should commit themselves to support the IMF in undertaking its independent analysis. Member countries should publicly provide reasons whenever they do not follow these recommendations.
The Group says work must start immediately on the issues it raises. Jose Barroso, President of the European Commission, praised the report as being “balanced and rich”. He said it identified many areas for further work which the Commission already recognised as critical. He supported the need for a basic core set of high-level rules applied consistently by top-class supervisors.
Mr Barroso confirmed that the Commission intends to present detailed proposals during April on private equity, hedge funds and immediately after that on remuneration schemes. Nevertheless, even where the Commission finds consensus as to the problems and issues, it is likely to encounter difficulty in obtaining political agreement on legislative reform.
For the UK, the Group’s recommendations for reform of the European Financial Supervisory Structure would be likely to mean less power and discretion for FSA. Although Mr de Larosiere recognised it was probably unrealistic to suggest an EU regulator, the Group’s proposals would keep more power and guidance on regulation at EU level while leaving day-to-day supervisory issues to individual Member States.