Wednesday, February 25, 2009

“De Larosiere Report” - IN THE NAME OF THE ROSE

Looking at regulatory restructuring of the world's finances, the metaphor of the Titanic and rearranging deckshairs comes to mind, but when considering the policy institutions of Europe, US the rest of the world, a certain film seems more appropriate. When all else is up in the air and being restructured with the whole world on the floor, this is the time for the men of big ideas to make their career-defining moves, as is happening with all financial regulatory organisations. The past-masters at this are undoubtedly the pragmatic ironic British and the paradoxical French alongside dutiful 'can do' Americans followed some way back by others like the baroque Italians, and the theoretically-thorough Germans. As a regulatory risk expert and Cambridge-educated I have much empathy with the political-economy diplomats in international organisations from the Grand Ecole mandarinate of France, among whom I count many friends in various pan-European and global networks, a few shadow versions of which I've helped in over the years. We macro-political-economists luxuriate in the big numbers of that seem a most sublime power, that of ideas, intellectual, academic, vicarious and virtual, therefore of the morally cleanest sort, well-filtered. For us, the power of ideas is status and influence, but not money-wealth - that appeals to me, but as an outsider, and so I identify more with the William de Baskerville character or maybe his junior sidekick Adso de Melk, in the film and Umberto Eco's book The Name of the Rose. Following on from my last blog into the monastic corriders of geo-euro-political power-grabbing for the financial heights of the world's economics, I can now report the latest discovered scroll issued today to be approved by the European Commission on March 4th - regulatory reform at lightning speed before the April G20.
The “DeLarosiere” Report will be published by the EU Commission today at noon CET, it’s the call for the European Super Regulator shrouded in rosicrucian titles like “reforming / strengthening regulation in Europe”. As I expected, the ECB made a bid to the Commission's ECFIN DG to take this euro super-regulator under its wing and locate it in Strasbourg, that remote monastery of the European Parliament that has drifted away inexorably, like evaporating share value, to the heart of strife-torn Brussels where the real action is.
But, two theological objections are countervailing upon that bid, not unlike how IMF's political power is represented by its voting structure, in this case to do with the ECB structure; its plenary authority being of two brotherhoods: a), national representatives who are ‘CEOs etc’ of each member-state's central bank, and b), members appointed by DG ECFIN. The former group have apparently (for various reasons in this fast-moving crisis) completely lost the short-term faith in the ECB, or at least become seriously doubting Thomases. They feel the dualism restriction of the ECB's current structure, it's now outmoded constitution and its tight control of open money market operations etc. Countering the ECB itself as super-regulator pontificate is the argument from the Banque de France that there is a conflict of interest between the ECB being the lender of last resort and the super-regulator at the same time (not neglecting the anaemic C-ebs). This is not to undermine Jean-Claude Trichet whose term in office remains secure, but there is general disbelief in the ECB's ability to truly see or to effectively respond with the rapidity required given how fast circumstamnces are changing. Days and weeks have rarely been such a long time in geo-political-economy. Let us be absolutely clear, the Euro-Super-Regulator would emasculate national regulators who are all collectively in the dungeons reviewing their testimonies and confessions and awaiting their fate, like the FSA in the UK, the IFRSA in Ireland, CBFA in Belgium, NDB in the Netherlands, and others, not least the BIS whose crime appears to include among other offences that it resides in tax-evader haven Switzerland, though why that should be a factor I can't understand. And there are those in the various national finance ministries and even within the regulators who would support a new super-regulator as a good thing, at least good enough to deal forcefully with Europe's top 45 cross-border bank holding companies that (until the credit crunch knocked them over like pins in a bowling alley) were not just too big to fail, but too big and financial-market-powerful to be beholden to national interests and Europe's winder communitaire interests. Like central banks whose task was to defend the currency regardless of politics, the biggest banks considered one of their tasks to be to attack currencies and related financial interests regardless of politics, arrogantly above all that. The Euro is testimony to political anger at the financial markets. In fact the Euro cost the banks about half a € trillion in lost trading profit over 5 years plus lower than necessary Euro Area GDP growth and in part is what propelled the banks to seek faster growth through asset backed securities and other derivatives and structured finance. Now that the banks and financial markets have imploded, lost their ammunition train, where the Euro was Europe's defence, now comes Europe's counter-attack against the big banks. This de Laroisiere Report is the alternative to nationalisation of the banks by offering multi-national, coordinated regulatory oversight. There will be nowhere else to hide. Of course, the big banks who are nationalised will not be subject to regulatory laws and this new super-regulator of 3committees etc. Government agencies are not subject to regulatory-supervisory laws. Police is another matter. The police raided the offices of Anglo_irish bank yesterday thanks to a new law permitting criminal arrests, despite the bank now being nationalises. Where The US has led in police-action against bankers, over 250 FBI arrests, Ireland now follows and the rest of Europe will also follow.
Gordon Brown and Barack Obama have declared an end to the era of irresponsibility. By that they both mean the irresponsibility of international and global banks, of the big banks and securities houses trading with customers' deposits and high-risk leveraging directly for their own profits, and through unregulated financial markets, letting unqualified so-called 'bankers' with maths degrees and one year MBAs cause mayhem to the world's economies for their get-rich-quick bonus rewards.
It is now the era of responsibility and that means the Politicians' revenge on the big banks who are the targets of all this. For at least twenty years the financial markets and the top bankers have terrorised governments, been financially more powerful than elected governments when they wanted to be (not unlike the great monasteries and religious oprders of the middle ages). There is the same cleaning of the Augean Stables idea, of hypocrisy and greed, pluas some payback for all the chaos and effort. They who have to be cut down by size and deprived long term of their arrogant, undemocratic, irresponsible, self-aggrandizing, profit-seeking, Gordon Gekko greed-is-good, financial power, each to be cut back, beginning with by a quarter to a third of their assets, principally all of their own trading books and toxic assets.
The Euro and the Eurozone, let's not forget was a necessity born of desperate defence of Europe from international banks who deemed it their perfect right to arbitrage and short-sell Europe's currencies and rattle the cages of governments and whole economies whenever they decided to conspire to do so! Given all this emotion and righteous anger, what chance has the ramrod ECB with its history of monetary rectitude and politically-neutered constitutional role.
The Eurozone member-states desperately need their money-market operations back, back under some political control, under the political direction that the ECB sorely lacks. All might be different of course if the EU had got its constitution voted hrough and could have established a permanent presidency with a new voting structure. The Irish insistence on democratic voting scuppered that and its voters don't look like changing their vote anytime soon. Notwithstanding that the Dutch and French electorates voted No, and probably the British electorate would have too given the chance. I understand that President Sarkozy wants the Euro-Super-Regulator somewhere near INSEAD (and the fine libations of the Cote du Rhone). I cannot imagine the Germans or the British not wanting that for the pleasurable aspects, but politically and practically this remains a matter of London is where the Anglo-Saxon financial markets are including half of the EU's banking assets, while Germany is where the image of monetary rectiude is part of its national culture and vital brand-image. But as discussed yesterday, Brown will grant Sarkozy the Euro-super-regulator (shortly to be re-named the new finance-super-collider en pays de CERN?) as the bargaining chip on his way to getting the world's super-regulator agreed to be vested in the IMF in Washington, although actually located in NY City near the UN complex.
What is happening here is a well-programmed set of dominoes falling to plan, managed between the mandarinates of the UK FCO & the French Foreign Ministry, with the EU handled in a high-stakes geopolitical game, which has been à gout sournoise invisible to the 4th estate as usual asleep at the bar! One reason the British (Anglo-American-French) can succeed with this is the Czech Presidency of the EU until June. The British and the French (and why not the Italians, Spanish and irish too) want this done before the Swedish Ministries take over in July since all are aware that the Swedes have alternative plans in this domain, and after all of the famous Swedish Banking Crisis they believe they do know something about it. The Czech government is as you are aware I am sure, profoundly grateful to the American in loco parentis!
The authors are a high-level group led by ex-IMF MD, ex-Bank of France Governor Jacques de Larosiere, and ex-BNPP. They seek reform of cross-border financial supervision in the EU to remedy flaws in the network of national based supervisors, which is directly taking on the job of C-ebs! For loss of local regulatory sovereignty, the report suggests changes over 4 years and "stops short of introducing an all-powerful, pan-EU regulator", according to a draft copy. But, this is somewhat bizarre as C-ebs already exists as a supra-national supervisor overseeing all national supervisory-regulators in implementing Bsael II and Solvency II (EU CRD law), and which only in recent months has sharply narrowed any differences between national standards orptions? The report offers a 2-tier reform - new oversight of systemic risks and a beefing-up of coordination among national supervisors in day-to-day oversight. That is certainly a difference. C-ebs does not exert a day-to-day oversight. Of course, this all really only is focused on the top 45 banks. Both tiers are closely linked.
The report's main recommendations are focused on Pillar II of the CRD, although that is not the direct expression used. The idea seems o be o give C-ebs more political power via the ECB. But, this may not be enough when political backing is needed as we have seen has been essential in all the major bank failures in the last year?
Systemic risk is part of CRD PIllar II and requires stress-testing of banks' economic capital models (as has been initiated vy the Fed and US Treasury to be done today in the US for the top 100 major banks). The De LaRosiere Report proposes:
- A "European Systemic Risk Council" (ESRC) to be chaired by the ECB President and composed of members of the general council of ECB, a member of the European Commission and the chairs of the 3 existing pan-EU committees of banking, insurance and securities supervisors i.e. from C-ebs. - A risk warning system by the ESRC and the Economic and Financial Committee made up of national treasury officials. If the ESRC thinks a local supervisor is taking inadequate action, it can take action.
- Improvements in how a bank crisis is handled e.g. EU states to agree detailed criteria for burden-sharing with whoever bails out a failed cross-border bank.
- Creating a European System of Financial Supervisors and a decentralised network, with existing national supervisors continuing day to day supervision.
- 3 new EU authorities will replace 3 pan-EU committees of banking, insurance and securities supervisors (C-ebs, CEIOPS and CESR). - Colleges of Supervisors would set up for each major cross-border insitutions (of which 45 have been identified).
In a deference to the legacy of depoliticised central banking, the report proposes that ESFS should be independent of political authorities but be accountable to them. Is this logical? Moreover, is it any longer practical?
ESFS should rely on a common set of core harmonised rules. We have these already in the CRD. It is hard to see what this is adding other than elevating the systemic risk aspect that had been overlooked by banks for practical difficulty reasons that are intellectually immense. There are very few people who know how to make sense of this. It is hoped that the committees will make more headway here.
Other reforms proposed:
- fundamental review of globally-agreed Basel II rules on capital requirements for banks, such as stricter rules for treatment of off balance sheet items. This is not new insofar as accounting stajndards and incremental additions to Basel II are proceeding.
- A common EU definition of regulatory capital should be adopted. Hard to see that there has been a problem here, if regulatory capital means Tier 1 capital. If the total of reserve capital is implied then the issue is undoubtedly the economic capital buffers. - National supervisors should collectively be responsible for registering and supervising credit rating agencies.
- A wider reflection on mark-to-market accounting standards, blamed by some for exacerbating the impact of the credit crunch. Oversight and governance of the IASB, which sets accounting standards used in the EU, should be strengthened.
What is really likely to be needed here is auditors have more of a risk audit scope based on IFRS.
- Draft EU insurance industry rules known as Solvency II must be adopted and include a binding mediation process between supervisors and the setting up of harmonised insurance guarantee schemes.
- Regulation should be extended to the so-called parallel (shadow) banking system, and there should be registration and information requirements on all major hedge funds. There should be capital requirements on banks owning or operating a hedge fund or engaged significantly with a hedge fund (for which read Altrnative Investment and Private Equity Funds). - Supervisors will oversee suitability of compensation at financial institutions.
NOTE: hedge funds and corporate bonds: Jean-Claude Trichet has on Monday backed his bid with a strong call on Monday that hedge funds, credit rating agencies and all other important market players should be subject to regulation based on a global approach, that the worst financial crisis in over 80 years has sparked a rethink of how markets should be supervised to cut excessive risk-taking by banks. This would be strong if not for the fact that he is pushing at an open door. Next day in London, The Alternative Investment Management Association, a hedge fund body threw its weight behind regular disclosure of large holdings and risks to regulators. And, in the US where financial regulation is at state level as well as federal level, Connecticut legislators, a state home to hundreds of hedge fund firms, are proposing tougher oversight for the industry ending the state's longstanding hands-off approach that attracted so many financial firms and banks there in the first place. Dublin's financial services centre became to the City of London what Connecticut is to Wall Street.
The hedge fund industry can survive the credit crisis according to the chairman of the Hedge Funds Standards Body told the CESR conference on Monday. One way it is doing so is feeding the desertion of private investors abandoning bank bonds for corporate bonds, especially big brand names that are thought to be too big brands to fail and paying 8-9% coupon, which in any book should be a high-risk, junk-bond signal! Private investors are in for a switch-back ride as hedge funds dump corporate bonds assets on the market; default rates have not yet peaked. When they do yields will rise dramatically. default rates are currently north of 6% and 10% on sub-investment grade, which S&P expects to exceed 23% at peak sometime this year. That will be another MADOFF plus Stanford scale loss to HNW wealth-classes. There is rising interest from private equity and hedge funds to scoop up debt in secondary markets once the peak has passed and the surviving paper will book them double-digit profits.

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