Post-crisis financial regulation: intentions vs. consequences
17 February 2015
SUGGESTED
Government and Institutions
Tax and Fiscal Policy
17 February 2015
Economic Theory
11 November 2024
Tomorrow, Financial Markets Commissioner Lord Hill will be releasing his much-awaited Green Paper on creating a Capital Markets Union (CMU) in the EU. One of the landmark initiatives of the Juncker Commission, the CMU will aim to boost the ability of companies to use equity and debt securities as an alternative to bank financing, on which they are currently overwhelmingly dependent. It will also seek to increase the overall amount of finance available to EU businesses.
If companies are starved of financing, the growing regulatory burden very likely has played a role. In the wake of the 2007-09 financial meltdown, EU authorities have passed a raft of measures aimed at curbing systemic risk in banks and non-bank financial institutions, exemplified by an ‘alphabet soup’ of newly-minted regulators, which together form the European System of Financial Supervisors (ESFS).
This has been complemented by comprehensive new regulation of financial markets, aimed at bolstering the capital buffers of financial institutions and minimising the potential for a taxpayer bailout in the event of insolvency. Yet little attention has been paid to the unintended consequences of the new rules, which may not only have contributed to a dearth of financing but could also increase rather than protect against systemic risk. Let’s review the most important ones in detail.
Solvency II
Solvency II, passed in January, is the Directive regulating insurance companies in the EU. As key providers of long-term capital on financial markets due to their steady stream of premium income, insurance companies will be a fundamental pillar of the CMU. Yet some of the changes introduced by Solvency II might lead to the opposite of what the Commission intends: by favouring sovereign and covered (asset-backed) bonds over corporate debt in its capital requirements, it makes insurers less likely to provide debt financing for companies. Moreover, there is little technical justification for this favourable treatment, as certain Eurozone sovereigns and some mortgage-backed securities are probably riskier than the debt issued by European companies. Additionally, this regulatory preference may increase systemic risk, by encouraging insurers to concentrate on a particular segment of the capital markets.
MiFID II
The Markets in Financial Instruments Directive (MiFID) II, expected to come into force in 2017, will regulate intermediaries dealing in bonds, shares, derivatives and other investment vehicles, as well as trading therein. Among other things, the new regulation seeks to increase transparency and liquidity in financial markets, in response to their perceived opacity pre-crisis. Related measures have introduced additional reporting and clearing requirements for over-the-counter (i.e. non-exchange-traded) derivatives trades, as well as the mandatory use of central counterparties (CCPs) to mediate and clear the transactions. While the ostensible aim is to reduce counterparty risk in trading, mandating the use of CCPs increases their systemic relevance and therefore the potential problems if one of them fails. (The Commission is now working on proposals for the recovery and resolution of CCPs, which are likely to lead to yet more unintended effects.) Furthermore, the increased compliance costs implied by MiFID II may deter market participants from trading in securities, hampering the flow of capital in Europe even more.
AIFMD
The Alternative Investment Fund Managers Directive (AIFMD), which came into force in 2013, regulates the activities of (most saliently) hedge funds, private equity funds and venture capital funds. Much like MiFID II, the Directive introduced new reporting and disclosure requirements on the part of alternative investment fund managers which operate in the EU, whether they are domiciled there or not. It also provides for an ‘EU passport’ enabling funds to operate in Member States different from where they are based, while non-EU ones may also obtain authorisation subject to compliance with EU rules.
The type of investment managers subject to the AIFMD are key providers of capital to SMEs, particularly start-ups and businesses in need of a turnaround. As of 2009, EU-based hedge funds accounted for just five percent of the global hedge fund sector, with the private equity and venture capital sectors similarly underdeveloped. By providing for a single rulebook across the EU, the new Directive could boost cross-border capital flows and attract new investment to Europe. Yet this could be more than offset by an increased compliance burden, which is likely to lead globally active fund managers to turn to other markets. Additionally, much more could be done to attract retail investors and savers to these types of funds, particularly in a context of ultra-low interest rates.
The financial crisis that began over seven years ago prompted EU institutions to come up with a new, comprehensive regulatory framework intended to increase the transparency and safety of financial markets. But there is reason to fear that new regulations, despite their benign intentions, have enhanced rather than curbed systemic risks in crucial sectors like insurance, while also contributing to the lack of financing and investment that continue to afflict much of Europe.
The Capital Markets Union could unlock finance for companies across the EU, helping to put an end to years of anaemic growth. But in order to make it work, the Commission must be led by a genuine will to reduce regulation, both to diversify risk across the market and to attract providers of capital and finance. Anything less than that will fall far short of what the EU needs.
If companies are starved of financing, the growing regulatory burden very likely has played a role. In the wake of the 2007-09 financial meltdown, EU authorities have passed a raft of measures aimed at curbing systemic risk in banks and non-bank financial institutions, exemplified by an ‘alphabet soup’ of newly-minted regulators, which together form the European System of Financial Supervisors (ESFS).
This has been complemented by comprehensive new regulation of financial markets, aimed at bolstering the capital buffers of financial institutions and minimising the potential for a taxpayer bailout in the event of insolvency. Yet little attention has been paid to the unintended consequences of the new rules, which may not only have contributed to a dearth of financing but could also increase rather than protect against systemic risk. Let’s review the most important ones in detail.
Solvency II
Solvency II, passed in January, is the Directive regulating insurance companies in the EU. As key providers of long-term capital on financial markets due to their steady stream of premium income, insurance companies will be a fundamental pillar of the CMU. Yet some of the changes introduced by Solvency II might lead to the opposite of what the Commission intends: by favouring sovereign and covered (asset-backed) bonds over corporate debt in its capital requirements, it makes insurers less likely to provide debt financing for companies. Moreover, there is little technical justification for this favourable treatment, as certain Eurozone sovereigns and some mortgage-backed securities are probably riskier than the debt issued by European companies. Additionally, this regulatory preference may increase systemic risk, by encouraging insurers to concentrate on a particular segment of the capital markets.
MiFID II
The Markets in Financial Instruments Directive (MiFID) II, expected to come into force in 2017, will regulate intermediaries dealing in bonds, shares, derivatives and other investment vehicles, as well as trading therein. Among other things, the new regulation seeks to increase transparency and liquidity in financial markets, in response to their perceived opacity pre-crisis. Related measures have introduced additional reporting and clearing requirements for over-the-counter (i.e. non-exchange-traded) derivatives trades, as well as the mandatory use of central counterparties (CCPs) to mediate and clear the transactions. While the ostensible aim is to reduce counterparty risk in trading, mandating the use of CCPs increases their systemic relevance and therefore the potential problems if one of them fails. (The Commission is now working on proposals for the recovery and resolution of CCPs, which are likely to lead to yet more unintended effects.) Furthermore, the increased compliance costs implied by MiFID II may deter market participants from trading in securities, hampering the flow of capital in Europe even more.
AIFMD
The Alternative Investment Fund Managers Directive (AIFMD), which came into force in 2013, regulates the activities of (most saliently) hedge funds, private equity funds and venture capital funds. Much like MiFID II, the Directive introduced new reporting and disclosure requirements on the part of alternative investment fund managers which operate in the EU, whether they are domiciled there or not. It also provides for an ‘EU passport’ enabling funds to operate in Member States different from where they are based, while non-EU ones may also obtain authorisation subject to compliance with EU rules.
The type of investment managers subject to the AIFMD are key providers of capital to SMEs, particularly start-ups and businesses in need of a turnaround. As of 2009, EU-based hedge funds accounted for just five percent of the global hedge fund sector, with the private equity and venture capital sectors similarly underdeveloped. By providing for a single rulebook across the EU, the new Directive could boost cross-border capital flows and attract new investment to Europe. Yet this could be more than offset by an increased compliance burden, which is likely to lead globally active fund managers to turn to other markets. Additionally, much more could be done to attract retail investors and savers to these types of funds, particularly in a context of ultra-low interest rates.
The financial crisis that began over seven years ago prompted EU institutions to come up with a new, comprehensive regulatory framework intended to increase the transparency and safety of financial markets. But there is reason to fear that new regulations, despite their benign intentions, have enhanced rather than curbed systemic risks in crucial sectors like insurance, while also contributing to the lack of financing and investment that continue to afflict much of Europe.
The Capital Markets Union could unlock finance for companies across the EU, helping to put an end to years of anaemic growth. But in order to make it work, the Commission must be led by a genuine will to reduce regulation, both to diversify risk across the market and to attract providers of capital and finance. Anything less than that will fall far short of what the EU needs.
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