The impact of the EU regulatory framework for financial services

Well, here we are. Just three days left as Commissioner for Financial Services. Really I should be packing instead of coming here to talk about financial regulation – which goes to show just how much I like packing.

Although I had had no direct experience of financial services before I came to Brussels, I obviously arrived with a set of attitudes and experiences already in place. I was a small businessman who had taken the plunge and set up my own business. A small state Conservative, who was – who is – sceptical of big institutions and big government.

I certainly wasn’t an expert on financial regulation – not in itself a bad thing as it meant I had to go back to first principles. But I had seen regulation at first-hand in the British system – because contrary to the myth, not all rules are made in Brussels. As an Education Minister I had seen well-meaning but over-detailed rule-making demotivate head teachers and make them feel hemmed in and de-professionalised.

Also, both in politics and professionally, I had had a ring-side view of a series of crises. These taught me how often some patterns of behaviour repeat themselves; one of the most frequent is first failing to identify a problem before then massively over-reacting to it.

These then were some of the attitudes – what others might call prejudices – that I brought to the job.

My thinking was also shaped by other factors. For example, I joined a Commission which was dedicated to legislating less and legislating better. And I took up the reins at a time when the biggest challenge Europe faced was the lack of growth and jobs.

Indeed, I guess it has been the desire to support growth and jobs which has informed my whole approach to financial regulation. The realisation that while we want stability, we don’t want the stability of the graveyard. That without risk there is no growth. And it is that which first led me to reflect that in various areas we need to think again, and that we needed to think about macro-prudential and not just micro-prudential considerations: we needed, in other words, to think about the bigger picture.

If you think about it, it is natural that when a micro-prudential regulator or supervisor has to assess risk, they take a highly cautious approach, especially if there has been a crisis caused in part by a lack of regulation or a failure of oversight. No one wants to be accused of being asleep on the job.

While that is perfectly understandable – and may indeed be what they are required to do under their terms of reference – the problem comes if a number of different regulators or supervisors are all taking an equally risk-averse approach. Then the cumulative impact of a series of micro-prudential judgements can itself become a source of macro-prudential risk. In short I concluded that whereas after 2008 the greatest threat to financial stability had been the financial crisis, over time the greater threat had become the lack of growth itself. In other words, too little risk itself became a big stability risk. That is what led me to argue that in Europe, the regulator – me – must therefore be prepared to deviate from the advice given by the supervisors if macro-prudential considerations demand it.

So looking back, what lessons have I learned? What advice would I give to a new me? Here are some principles which I wish someone had told me when I started.

Don’t imagine that legislation is a science. It is not. It is a series of judgements. Clever people can make it sound as though there is only one answer. But it’s not true. So always be open to doubt and to admitting that you might have got those judgements wrong.

Recognise that the broader economic and political environment in which regulations are drawn up change over time. So keep an open mind. Be ready to change as the facts change. Looking again at legislation is not a sign of weakness. It’s a sign of self-confidence. Only people who are unsure of themselves – or madly over sure of themselves – could argue that everything they have done is perfect and mustn’t be looked at again.

Be brave enough not to regulate. Here, I am afraid that the incentives for politicians and regulators are generally not aligned with good regulation. No one wants to have a finger pointed at them for doing nothing. Politicians tend to want to be seen to be part of the action. It is hard to do nothing when you’re surrounded by people whose job it is to do something. But resist. Acting too soon can be as much of a mistake as acting too late. And long after the politician has put out his press release and moved on, business is still living with the consequences.

Always work as hard as possible to understand the impact of what you are doing on the marketplace. As a regulator you cannot expect to win popularity prizes with the businesses you regulate. But you should seek to avoid unnecessary conflict between the regulator and the regulated. And always work with business to make sure you understand the real world consequences of what you do.

Keep it simple. A lot of regulation is so complicated that only a handful of people can possibly understand. It’s like some high priesthood speaking in a special language that is beyond the comprehension of mere mortals. But complex legislation is good only for lawyers and compliance officers. It is bad for values-based leadership. It weakens individual responsibility. It leads people to ask “can I get away with it?” rather than “is it the right thing to do?” It eats away at trust in law making.

Try to legislate in a way that can accommodate the rapid pace of technological change. Most legislation is, by its nature, backward looking, paper-based, related to old products and challenges. That is why developments with so-called regulatory sand boxes are so interesting – where regulators and regulated work together in the interest of encouraging innovation and business growth. If I had been here longer, this is an approach I was keen to encourage, spreading best practice across Europe.

Aim for an international approach, but don’t be a slave to it. It makes a lot of sense to work on agreed international principles so that you can reduce the practical difficulties of reaching equivalence decisions after the event – as I have had to do with the United States on CCPs. That is why I have been working to strengthen regulatory cooperation with the US and to set up an Asia-Pacific forum. But at the same time, you should be prepared to deviate from the work of global standards-setting bodies like the Basel Committee if you think their conclusions are too sweeping or fail to take into account the particular circumstances of the very diverse European banking sector. And always remember that regulators are herd animals too – they are as prone to group think as everybody else.

When I came to Brussels, just under two years ago, it was at the end of a period of intense rule-making. To stabilise the markets, to make our banks better capitalised, and to restore trust – a new legislative architecture was being put in place.

As a result, our financial system is stronger and more resilient. But when you fix a roof in the middle of a storm it’s only to be expected that you won’t get everything 100% right.

That’s why I wanted to take a second look at the 40 or so pieces of financial services legislation passed after the crisis. To see how the different rules were interacting with each other and whether our legislative framework could be made more growth friendly. That was the thinking behind the Call for Evidence I launched last year.

Today, as my swansong, I want to set out some next steps for the Call for Evidence and explain how we could increase funding to the wider economy; make our legislation more proportionate; and reduce the compliance burden for businesses, without compromising on our regulatory objectives.

I have been clear from the outset that we need to take Europe’s interests into account when agreeing global rules. In the banking sector, we need to be sure that measures being considered by the Basel Committee – like the Leverage Ratio, the Net Stable Funding Ratio, and the Fundamental Review of the Trading Book – work for Europe. Many people who replied to the Call for Evidence said they worried about the impact of those measures and how they interacted with existing rules. They are also worried about the impact of future measures on areas like trade finance, market liquidity and on access to clearing services.

I believe that these sorts of issues are best addressed upstream with our international partners. So we will write to Mario Draghi in his role as the Chairman of the Group of Governors and Heads of Supervision, the governing body of the Basel Committee on Banking Supervision, to ask for these issues to be looked at again. We have also asked the EBA to look at those issues as part of the review of the Capital Requirements Regulation and the EBA will publish their recommendations later this month.

I’m also clear thatwe need to reconsider how we treat the loans that power international trade. Trade finance loans are typically less risky than standard corporate loans. But people have told us that this is not recognised properly by the Basel measures being developed. They worry that neither the leverage ratio nor the NSFR will recognise the specific nature of trade finance. So we need to look at whether these measures can be adjusted and see whether we can lower the NSFR Required Stable Funding factor and exempt trade financing altogether from the leverage ratio calculation.

There’s also a lively debate been going on about the causes of declining market liquidity, particularly in corporate bond and repo markets. Many argue that regulation has had a hand in that decline. For others, the jury is still out. But to give us the evidence we need, we’re carrying out a comprehensive review of liquidity in the corporate bond markets.

I am already clear that we need to take seriously the claims that the cumulative impact of different rules has reduced banks’ willingness and ability to act as market makers.

I don’t think we can ignore this. Market makers are central to maintaining liquidity and a fair and orderly market. So this is another issue we will raise with the Basel Committee.   The Commission will work with the EBA and the European Systemic Risk Board to get NSFR and leverage ratio calibrations right.

We’ve already revised MiFID level 2 measures to take a more cautious approach to pre-trade transparency requirements for non-equity investments. I think it would also be sensible to tackle the narrow definition of who can qualify for the market making exemption in a future review of the Short Selling Regulation.

The feedback to the Call for Evidence has also helped us understand the interplay between rules designed to reduce bank leverage and rules to strengthen derivatives markets, which could make access to clearing services difficult. Unless it’s properly designed, the leverage ratio could increase the cost of clearing to such a degree that it will reduce the number of banks offering these services to clients. This would directly contradict EMIR’s requirement for more transactions to go through CCPs. And it would also make it more difficult for companies, investment funds and pension funds to manage risk.

Again we’ve asked for these concerns to be raised with the Basel Committee. We’ll also tackle this in our review of the CRR and EMIR regulations. Exemptions from clearing obligations for certain Non-Financial Counterparties, pension funds and some small non-systemic financial companies will be considered in the EMIR review.

Across Europe, there is widespread support for encouraging lending to SMEs. Responses to our Call for Evidence focused on the importance of keeping the SME supporting factor and increasing the scope for banks to buy SME bonds. I have already announced that we will keep the SME supporting factor. But I want to go further. So today I can announce that we’ll extend the supporting factor to loans to SMEs above the existing threshold of 1.5 million euros. There will be no upper limit and a capital charge reduction of 15% above 1.5 million euros.

I have also been working to encourage more long term investment.

We took a first step last year as part of CMU by amending Solvency II and reducing capital requirements by a third for insurers wanting to invest in infrastructure projects. But our analysis shows that capital charges for some asset classes don’t take into account the long term nature of other investments. We need to work out how this can be better recognised when we review Solvency II.

We should be ready to take action before this review. We should consider revising the equity and debt calibrations for infrastructure corporates that would recognize their better performance compared to other corporates. We have received EIOPA’s advice on this, which is a good starting point but we need to consider whether we can go further. And as part of the CMU action plan we are looking at private equity and privately placed debt to see whether these should be treated as a separate asset class. With EIOPA’s help we will also look at how to address a number of other issues such as the non-life risk calibrations or inconsistencies with other sector specific rules.

A huge number of Call for Evidence responses called for a more proportionate application of our rules. There’s a strong sense that rules could be getting in the way of diversity. That they’re not attuned enough to companies’ business models, to their risk profiles and to their size. So for me, it’s absolutely clear that we need to find a more proportionate approach.

This is particularly true for the banking sector. Reporting and disclosure obligations need to take account of different sizes and business models. So should prudential requirements, and we’re looking at how to do this in our review of the CRR. In particular, we need to respond to claims that the standardised approach to credit risk and the Systemic Risk Buffer put small and regional banks at a competitive disadvantage. And also listen to concerns that capital buffer requirements are felt to have the same effect. For smaller banks, we should look at whether we can take a simpler approach to capital requirement calculations or exempt the smallest players – in the same way we’re working to do for credit unions. We should also be careful that the leverage ratio does not reduce diversity by putting pressure on business models like specialised community banks, building societies or mortgage banks.

The way investment firms are treated by the CRR also needs to change. We need to distinguish between large bank-like investment firms and smaller firms, and set capital requirements accordingly. That’s also the EBA’s view. They’ve already called for a more proportionate prudential regime for smaller investment firms that are not systemic. Now they’re preparing advice as to how to do this. We’ll need to act on it.

But the need for more proportionality goes well beyond the banking sector.

We need to apply the Solvency II Directive in a way that’s more proportionate for small and medium size insurers. They raise concerns about the cost of contracts they’re obliged to have with credit rating agencies. And that reporting requirements are not proportionate for smaller insurance companies with a simple risk profile.   We will ask EIOPA for advice on how to take a simpler, less burdensome approach.

Asset managers have called for a more proportionate approach to rules governing remuneration.   At the moment they are required to comply with rules that differ across EU legislation, under the CRR, UCITS, AIFMD and MiFID. This makes compliance difficult. We should follow up when this legislation is reviewed this year and next. Some asset managers are to some extent covered by the remuneration rules of the CRD. My colleague Commissioner Jourova is due to publish a report reviewing the application of the CRD remuneration rules, including the proportionality aspect. I certainly hope this can help us make some of these rules less burdensome.

The third big theme that came out of Call for Evidence responses is the sheer quantity of reporting obligations. Many companies claim they are required to report the same data, in different formats, to different bodies and to different standards.

I think we have to reduce this burden. It’s not good enough to have inconsistent or overlapping reporting requirements under EMIR, MiFID II and the Securities Financing Transactions Regulation. As part of the EMIR review, we should look at ways to deal with the burdens resulting from the ‘dual reporting’ obligation, at least for non-financial firms, without compromising on the quality of the data that is reported. And reporting requirements – for example, those placed on non-financial counterparties, small financials or pensions funds that are not systemic – need to be looked at again.

The volume of data collected and exchanged between national authorities and the European supervisory authorities has drastically increased. That’s clear. Less clear is whether it’s all essential. So we’re taking forward a project on data standardisation to improve reporting with new technology. This should also give us a better idea of where the burden is unnecessary, so we can reduce it.

None of this has reduced our focus on maintaining a fair balance between consumers and businesses. MiFID and PRIIPS are coming on stream to give consumers more protection. And we’re working to give consumers more choice through our Green Paper on consumer financial services. Follow up actions will be announced in autumn. Many of them will tackle concerns raised in the responses to the Call for Evidence.

The Call for Evidence also has practical lessons for the future. The crisis may have made the scale and the pace of regulatory change inevitable. But the various layers of regulation could have been better aligned. The timelines for implementation and transposition could have been more realistic. The deadlines for primary legislation could have left more flexibility to finalise secondary legislation and more time for implementation.

If we want to keep financial service companies focused on their clients, creating growth and jobs, these are lessons we need to learn.

As you can perhaps see, the Call for Evidence sits at the heart of my approach to financial regulation and my wish to see rule-making that is respected.

I think the lessons it is teaching us will help us strengthen our drive for growth and jobs. But I hope it also has a wider application.

I hope first that it can be used as a model internationally so far as financial services legislation is concerned. Already global bodies like the FSB and other jurisdictions are looking at the lead we have given and saying that they want to apply a similar approach. It also fits perfectly with the approach developed by Frans Timmermans to legislate less and review more. So I hope that it can also be applied in other areas of European legislation.

That is of course no longer up to me. It will now be up to my colleague Valdis Dombrovskis to take it forward with you. I could not be leaving the Call for Evidence in better hands. I know he is committed to it. And I know the ECON Committee, and Burkhard Balz in particular, is committed to it too and has had a key role in getting us where we are today. I’m counting on you all to keep up the momentum, and help deliver these recommendations. If we can make this a living process, if we can return to the evidence and check that our rules are working, we’ll have achieved more than that. We’ll have shaped a lasting agenda for a regulatory framework that manages risk but also supports investment and powers growth and jobs. Brussels is synonymous with rule making. I hope that this approach can help it be associated with good rule-making and that really would be a prize very much worth having – if only just a little late for me.