The former governor of the Banque de France Jacques de Larosiere's report on the reform of the financial system has proved highly influential at the G20 summit and a consensus is developing on many of the proposals of the report on how to reform the financial system. Joe Beashel examines the report and its proposals which, if implemented, would re-shape the global financial industry and directly affect all financial services firms whatever their size.  

As the international financial crisis unfolded, it was clear to all that the global financial system was in need of significant reform. What has not been clear is exactly what changes are needed. In the last few weeks, three reports by the working group on Financial Reform have started the process to chart a way forward. These reports are led by the former Chairman of the US Federal Reserve, Mr Paul Volcker, Lord Turner from the UK’s Financial Services Authority and the former governor of the Banque de France Mr de Larosiere. There is a high degree of consensus between the three reports which is an encouraging start but one would not underestimate the difficulty of forging an international consensus across such a broad range of complicated issues. In this article, I focus on the de Larosiere report (the “Report”) which, as an EU view, is most likely to directly affect Ireland in the future. The Report is divided into four chapters which address the cause of the crisis, how matters can be addressed now and how EU and global regulatory infrastructures might change in the future.  

CAUSES OF THE FINANCIAL CRISIS  

The Report identifies a number of the causes of the financial crisis such as the existence of excess liquidity, which led to rising asset prices and growth in credit volume. This in turn led to a housing bubble which was exacerbated by increased mortgage lending and poor lending practices. The use of structured financial products to manage such credit exposure and their lack of transparency meant that the extent of the risk being taken on by financial entities was unknown or unquantifiable. The Report also identifies a failure on the part of regulators to identify systemic issues, rather than those related to a particular firm or industry, as contributing significantly to the crisis. A failure to react to the crisis, caused by inadequate information exchange and a marked lack of collective decision making between national supervisors, is also blamed for the failure to mitigate the impacts of the crisis as it developed.  

POLICY AND REGULATORY REPAIR  

The Report proposes that changes in regulation are required to achieve future financial stability. In particular, it notes the weaknesses in the current regulatory capital regime under Basel II. It identifies an over reliance on internal risk models and Credit Rating Agencies (“CRA’s”). CRAs are blamed for giving inflated ratings to structured financial products, hence lowering the perception of their risk. The Report also notes that CRA’s in the lead up to the crisis were plagued by conflicts of interest, arising in part, from the fact that issuers shopped around between them to ensure an AAA rating for their product. It recommends that the EU’s Committee of European Securities Regulators (“CESR”), be given the responsibility of licensing and monitoring such entities in the EU rather than individual national regulators. The Report also stresses that the use of ratings should always be complemented by the application of judgement on the part of those making investment decisions. Further, a new code is proposed for alerting investors as to the complexity of structured financial instruments.  

Additional amendments to the Basel II rules recommended by the Report include a gradual increase in capital requirements, reduction of the impact of economic cycles by means of capital buffers, the introduction of stricter rules for off-balance sheet items and the strengthening of rules for banks’ internal control and risk management, notably by reinforcing the ‘fit and proper’ criteria.  

The Report also believes that mark to market accounting should be re-evaluated, in particular they believe it is inappropriate for traditional loan activity and for long term investments. The Report also addresses situations where assets cannot be marked to market because no active market exists for such assets. In such instances, the internal pricing of financial institutions should be both audited and overseen by an appropriate EU body such as the Committee of European Bank Supervisors to ensure consistency and avoid competitive distortions. The need for consistency in the valuation of impaired assets is also stressed.  

The Report criticises the current sanctioning regimes of Member States as weak and heterogeneous and recommends that such regimes be strengthened and harmonised. This is likely to result in more frequent and sizeable fines for contraventions in the future.  

Further recommendations made by the Report include the extension of appropriate regulation to all entities conducting financial activities which may have a systemic impact, such as hedge funds. It proposes the introduction of a well-capitalised central clearing house for credit default swaps in the EU which would be supervised by CESR and the relevant monetary authorities. It also suggests that issuers of securitised products be required to retain on their books a meaningful amount of the underlying risk in respect of all live products. As regards investment funds, the Report stresses the need for tighter supervision of custodians in light of the Madoff scandal.  

The Report also criticises the lack of cohesiveness caused by the national implementation of EU directives, and questions the potential for regulatory repair in the absence of a harmonised set of EU rules. In this regard, it recommends the identification and removal of national exceptions by the level three committees. The Report recommends the overhaul of remuneration schemes such that the assessment of bonuses be set in a multi-year framework, and that they be based on actual performance, rather then being guaranteed in advance. It also proposes that the compensation policies of financial institutions should be overseen by supervisors.  

The Report suggests that crisis management for national banks should be kept at a national level, but effective handling of cross-border institutions in the EU will require the removal of national legislative obstacles. Further, the Report recommends that Deposit Guarantee Schemes in the EU be harmonised and pre-funded by the private sector.  

EU SUPERVISORY REPAIR  

In respect of the future EU regulatory infrastructure, the Report recommends the establishment of a new Report within the ECB called the European Systemic Risk Council (“ESRC”) to oversee macroprudential policy, issue risk warnings and give direction on macro-economic and prudential developments. In order for this entity to be effective, the Report suggests that there should be a proper flow of information between national supervisors and the ECB and an effective early warning mechanism as to weaknesses in the financial system should be put in place.  

The Report proposes that national supervisors, being closest to the markets and institutions they supervise, continue to carry out day-to-day micro-supervision. However, it also recommends the establishment of a European System of Financial Supervision (“ESFS”), a so-called super regulator, which, along with the level three committees, will co-ordinate the application of high level supervisory standards across the EU. The proposed ESFS would be independent from political and industry influences at EU and national level.  

The Report proposes a two stage process for improving regulation, supervision and crisis management in the EU. In stage one, the Report recommends certain legislative changes be brought about, for example the transformation of level three committees into three European Authorities (Banking, Insurance and Securities). The Report also proposes that Member States, in conjunction with the EU Institutions, should identify and remove key differences in national legislation. It also proposes that supervisory colleges be put in place for all cross border financial firms in the EU by the end of 2009. Legislative changes are also suggested in respect of company and insolvency laws to facilitate future crisis management.

At stage two, the transformation of the level three committees into the three Authorities, as detailed above, would be completed. Their key-competences would include a mediation role as between national supervisors, the adoption of binding supervisory standards, the oversight of colleges of supervisors and the licensing of certain EU-wide institutions such as CRA’s.  

GLOBAL REPAIR  

The Report recognises that no country can isolate itself from developments elsewhere in the world and that, consequently, global coordination is required in the areas of regulation, supervision and crisis management. Most of the regulation recommendations above, such as those addressing international accounting standards and Basel II, apply on a global setting. The Report suggests that the coordination of high level regulation at the international level should be the role of a strengthened Financial Stability Forum (“FSF”), which would be enlarged so as to include all systemically important countries. The FSF should also undertake the roles of supervising the colleges of supervisors once established, and enforcing international financial standards in areas such as corporate remuneration schemes.  

The Report finally recommends that the International Monetary Fund (“IMF”) head up surveillance and crisis management globally by developing a financial stability early warning system, international risk map and international credit register. The risk map would consist of a database of risk exposures of financial institutions, thereby assisting with the identification of systemic risks on a global level. The credit register would be a similar model, focussed on the risk exposure of key financial players.  

CONCLUSION  

These reports indicate a roadmap for change of the international financial system is starting to develop. Although at this stage it is still too early to predict with any degree of certainty what proposals will be adopted, when they will be adopted and what shape they will actually take, it is clear that new regulation will both re-shape the global financial industry and directly affect all financial services firms whatever their size.