The
September 2009 edition of the International
Association of Hedge Funds Professionals (IAHFP) newsletter This month we will
discuss what is changing in the European Union, and we will try to
understand better the new regulatory and supervisory environment.
Breaking News:
The House of Lords EU Committee have
announced a new inquiry into the European Commission's proposal
for a Directive on Alternative Investment Fund Managers.
The proposal is a result of the G20 decision to regulate
alternative financial markets such as hedge funds and private
equity funds.
EUROPEAN UNION COMMITTEE
Sub-Committee A (Economic and Financial Affairs and International
Trade) - Directive on Alternative Investment Fund Managers - Call
for Evidence
EU Sub-Committee A, chaired by Baroness Cohen of Pimlico, is
conducting an Inquiry into the European Commission's proposal for
a Directive on Alternative Investment Fund Managers (COM (2009)
217), adopted on 29 April.
This proposal represents the Commission's
response to the G20 pledge to regulate unregulated financial
markets, including hedge funds and private equity firms.
The proposal would create a regulatory regime for investment fund
managers managing funds worth more than €100 million.
There is currently no specific EU regulatory regime at all for
alternative investment funds, although some regulation does occur
at both EU and Member State level.
The proposal aims to
provide a robust and harmonised regulatory regime for the whole
single market, creating greater transparency for investors and
public authorities and enabling more effective macro-prudential
oversight of the sector.
The aim of our inquiry is to provide an opinion on the
Commission's Proposal, with a view to informing the debate
surrounding the Directive within the UK Government and the EU
institutions.
Particular questions raised by the Commission's draft Directive to
which we invite you to respond are as follows (there is no need
for individual submissions to deal with all of the issues):
All questions refer to the draft of the Directive proposed by the
Commission on 29 April 2009. 1.
What economic benefits arise from Alternative Investment Funds?
What risks to financial markets arise from Alternative Investment
Funds?
Will the Directive help reduce these risks?
2. To what extent is there a need to create a single regulatory
regime for Alternative Investment Fund Managers in the European
Union?
Does the Directive achieve its objectives? Should the objectives
of the Directive be modified? 3.
What risks arise from Alternative Investment Funds?
Is the Directive proportionate given the role of AIF in the
financial crisis?
Will the Directive introduce over-stringent regulations or does it
not go far enough?
4. Is it appropriate to regulate Investment Fund Managers, rather
than the Fund itself?
Does the Directive contain appropriate provisions to distinguish
between different types of alternative investment?
Does the scope of the Directive create a danger of unintended
consequences? 5.
What is your evaluation of the Commission's consultation in the
preparation of the Directive?
Regulatory aspects 6.
Will the passport system help create a single market in
investments funds within the EU?
How will the passport system established affect the EU and the UK
industry and particularly their position in the global market? 7.
Is the threshold for defining "systemically relevant" Alternative
Investment Funds appropriate?
Should the Directive include provisions on capital requirement?
Does the Directive contain appropriate rules on leverage?
Is the requirement for independent valuation agents and
depositaries for Alternative Investment Funds adequate? 8.
Will the provisions strengthening disclosure requirements help to
create a more transparent market or do they go too far?
Impact
9. What effect will the Directive have upon the position of the
City of London and the EU as a whole as a leading location for
Investment Fund Managers?
Could it cause many hedge funds to relocate outside of the EU?
What impact would the Directive have upon professional investors
and institutions?
10. How does the Directive compare to existing or proposed
regulation of Alternative Investment Funds outside of the European
Union, particularly that of the United States?
How will the Directive affect the position of EU Alternative
Investment Funds in the global market?
11. What effect will the Directive have on flows of capital and
financial innovation?
Interested parties are invited to submit a concise statement of
written evidence to this inquiry by Wednesday 9 September 2009.
Note
The EU
Economic and Financial Affairs, and International Trade
Sub-Committee, chaired by Baroness Cohen of Pimlico, is one of the
seven sub-committees of the House of Lords European Union Select
Committee.
The primary purpose of the Select Committee and its Sub-Committees
is to scrutinise EU law in draft before it is agreed in the EU, to
expose difficulties and propose improvements.
This is carried out by each Sub-Committee through Correspondence
with Ministers, evidence sessions with Ministers or officials and
inquiries.
The Sub-Committee conducts inquiries based either on the scrutiny
of EU documents (documents currently being scrutinised are listed
in the Progress of Scrutiny) or on issues concerning economic and
financial affairs within the European Union and international
trade with the rest of the world, as chosen by the Sub-Committee.
It invites written and oral evidence from government departments,
EU institutions and other interested bodies and individuals, in
order to consider a wide range of points of view before reaching
conclusions. Reports range from major reviews of significant
policy issues to shorter analyses of specific legislative or
policy proposals.
House of Lords
European Union Committee - The future of EU financial regulation
and supervision
Summary of Conclusions
The future of financial regulation in the European Union
Although we welcome attempts to remove conflicts of interest and
improve transparency of rating agencies, we question whether rapid
action on the regulation of credit rating agencies was necessary.
The
degree of uncertainty over the effects of this Regulation cast
doubt over whether careful consideration was given to these
proposals in line with the Better Regulation principles.
Concerns over the initial Commission draft of the Regulation
limiting the scope for EU-registered institutions to trade in
overseas financial instruments were also justified.
We agree that as far as possible the Commission should remove the
reliance on ratings for regulatory purposes, in conjunction with
similar changes to the Basel rules
The Commission's 5% retention requirement on complex securitised
instruments is an effective compromise to limit the more excessive
securitised transactions and we agree with it
We recommend that the Commission should work towards an overt
counter-cyclical capital regime through further amendments to the
Capital Requirements Directive.
This should take place in conjunction with changes to the Basel
rules to
ensure international consistency
The introduction of a harmonised standard for deposit guarantee
schemes provided a rapid solution to the dangerous distortions in
the single market caused by different levels of deposit guarantees
across the EU and the European Economic Area.
Problems remain with the Directive and we ask the Commission to
address these in its review of the Directive in December 2009
We agree that there is a case for further harmonisation of rules
on the winding up and reorganisation of credit institutions
It is imperative that the Commission properly consider the global
effects of its proposals on alternative investment funds
The consensus of our witnesses was that the influence of
alternative investment funds in the financial crisis was limited
and we recommend that the Government should work to prevent
proposals for EU regulations from stifling these markets.
There is currently no pressing requirement for rapid EU
legislative action in this area
Rapid action must not come at the expense of thorough
consultation, impact assessment and risk analysis by the
Commission in line with their own Better Regulation principles.
Where necessary, the Commission should review the effectiveness of
emergency legislation, to check that it is achieving its original
objectives
We urge the Commission to ensure that proposals for new regulation
of financial services in the EU are coordinated with global
regulatory initiatives
Financial supervision in the EU: an introduction
We note that under the existing Treaty there is likely to be
little opportunity to provide any EU supervisory body with the
power to issue binding rulings or decisions on national
supervisors.
The establishment of any EU body with supervisory authority and
far-reaching micro-prudential supervisory roles and powers to
mobilise fiscal resources in the event of crisis, or passing such
powers to the European Central Bank, is difficult if not
impossible whilst national governments bail-out financial
institutions
While we recognise the benefits of further harmonisation, we
believe that the establishment of a single supervisory authority
can not happen unless there is a facility or burden-sharing
arrangements on the bail-out of financial institutions at an EU
level. In addition, the institution of any single EU supervisory
authority would require substantial revision of the EC Treaty
The reform of macro-prudential supervision
We conclude that a new body at the EU level to assess
macro-prudential systemic risks, arising from financial
institutions and markets, should be supported.
There must be structures in place to strengthen the likelihood of
macro-prudential risk warnings from any EU-wide body leading to
mitigation of risk by national supervisory bodies
We conclude that the Government differs from many witnesses,
including M de Larosière, in its version of the role, powers and
structure of a new EU-wide macro-prudential body.
It appeared to us that the Government's thinking on those
important issues was less than fully developed.
We recommend the Government clarify its thinking and proposals
speedily in order to contribute most effectively to the
discussions on the development of a new macro-prudential
supervisory structure
The reform of micro-prudential supervision
Colleges of supervisors provide a useful forum of cooperation
between supervisors and their existence is possible within the
current Treaty.
We welcome the move to expand colleges to all cross-border EU
banks and agree provisions for meetings of core supervisors are
necessary to maximise efficiency of supervisory cooperation.
We recommend that while the Level 3 Committees exist (in their
current form) they should provide guidance on the role of
colleges. Such guidance should be provided on a flexible basis to
ensure colleges are adaptable to differing and changing
circumstances
Level 3 Committees, or a similar coordinating and standard-setting
body, are well-placed to lend consistency to the work of colleges
of supervisors and currently play an effective role in the
supervisory structure of the EU.
We welcome the Committees playing a linking role between any
macro-prudential supervisory structure, national supervisors and
colleges of supervisors as envisaged in the first stage of the de
Larosière proposals. This role can in principle be accomplished
under the current Treaty
The treaty and fiscal issues create significant problems for the
proposal to upgrade Level 3 Committees into Authorities. However,
the de Larosière report made a powerful case for reform when it
identified weaknesses and failures of micro-prudential supervision
of financial services in the single market (see paragraphs 165-166
of the de Larosière report).
We agree that a debate on the powers of any new body is crucial
for the reform of the structure and process of EU supervision.
There is a
need to reconcile the limitations of the EC Treaty and the
location of fiscal authority with the need to improve upon
micro-prudential supervision of the single market.
We recommend the Government set out in further detail its own
proposals for achieving this
We agree that the question of whether the new Authorities should
remain as three separate institutions or merged into two or one
institution is not the relevant issue.
It will be crucial to establish close working procedures in all
proposals, but still have an understanding of particularities of
the three areas of banking, securities and insurance.
The proposal of the UK Government should begin an important debate
over what structure any coordinating supervisory body at EU level
should take
The creation of colleges of supervisors and the increase of the
role of the Level 3 Committees in providing a forum for
cooperation and information sharing between national supervisors
are to be welcomed. They offer pragmatic steps to greater
coordination of supervision within the EU that do not require
Treaty amendment or provide difficulties over the location of
supervisory authority
Home-host country supervision
The call for increased powers for the host supervisor must not
lead to a retreat from the single market and the emergence of
protectionism.
We recommend that there should be no shift of power to the host
country supervisor. Colleges of supervisors must provide an
effective forum in which legitimate concerns and responsibilities
of home and host supervisors can be resolved within the clear
framework of a single market in financial services. It is clear
that there are difficulties in achieving this, and it remains a
matter of real concern to us .
The role of the EU in global supervision and
regulation
The IMF's surveillance role should be expanded, whilst a
well-resourced FSF/FSB should continue to operate as an
international standard setting body helping mitigate the risks
outlined by the IMF
We recommend the Government to work towards an EU statement at G20
meetings and the Commission to coordinate EU regulation with
international responses.
The EU can play a leading role in producing well-considered
reforms that can provide a standard for global solutions, as long
as it recognises that all regulation must be in coordination with
global initiatives
State aid in the financial crisis
We welcome the flexible, rapid and pragmatic approach demonstrated
by the Commission in applying state aid rules
We recommend the Commission to be vigilant in their assessment of
restructuring plans in order to minimise the threat to the single
market posed by state aid. The Commission must ensure that a
viable time-based exit strategy is produced and followed for those
institutions that receive state aid. State aid should be the
exception and not the norm
The definition of regulation and supervision
We observed an inconsistency among our witnesses in the use of the
terms regulation and supervision, which were often used
interchangeably.
Supervision has to do with monitoring and enforcement, and
regulation with rule making.
Clive Maxwell, Director for Financial Stability at HM Treasury,
described regulation as "actual hard rules that are written down"
and supervision as "the application of those rules to a particular
firm or group of firms and going in there and making sure that
they are following those rules" .
An example of regulation is the EU's Capital Requirements
Directive (CRD), which transposes the Basel II rules into EU law.
These rules are applied by the UK national supervisor, the
Financial Services Authority (FSA). The FSA ensures that financial
institutions are adhering to the capital rules set out in the CRD.
The purpose of regulation and supervision
The pursuit of financial stability is the common goal of both
regulation and supervision.
Regulation should aim to safeguard a stable financial system,
whilst also offering protection to consumers. Rules should be as
simple and clear as possible, to avoid both confusion and
loopholes.
However, more regulation is not necessarily better. Hastily
applied regulation addressing a newsworthy problem can often cause
more harm than good. The quality of regulation is therefore more
crucial than the quantity.
Professor Goodhart told us that what makes sense for the
institution individually frequently makes no sense at all for the
system as a whole.
For example, if an institution runs into difficulties, its normal
response is to cut back on new loans. If every institution does
this the whole system can implode.
Regulation must therefore work in the interests of the whole
system rather than individual institutions.
Regulation within the EU must also support the development of the
single market.
Irregularity in the implementation of regulations across the 27 EU
Member States can undermine the effectiveness of the single market
in financial services.
Supervision should ensure that a bank or financial institution
subject to regulation follows the rules correctly and uniformly,
that they adequately manage their risks and that they adhere to
certain minimum standards.
It should also examine the system of banks and financial
institutions as a whole to detect risks affecting the entire
system.
Supervisors can issue binding decisions and impose penalties on
those institutions that do not adhere to the rules.
The work of a supervisory body usually consists of four separate
roles:
Licensing-the granting of permission for a financial institution
to operate within its jurisdiction;
Oversight-the monitoring of asset quality, capital adequacy,
liquidity, internal controls and earnings;
Enforcement-the application of monetary fines or other penalties
to those institutions which do not adhere to the regulatory
regime; and
Crisis management-including the institution of deposit insurance
schemes, lender of last resort assistance and insolvency
proceedings.
A distinction is now made between macro- and micro-prudential
supervision.
Macro-prudential supervision is the analysis of trends and imbalances in the
financial system and the detection of systemic risks that these
trends may pose to financial institutions and the economy.
The focus of macro-prudential supervision is the safety of the
financial and economic system as a whole, the prevention of
systemic risk.
Micro-prudential supervision
is the day-to-day supervision of individual financial
institutions.
The focus of micro-prudential supervision is the safety and
soundness of individual institutions as well as consumer
protection.
The same or a separate supervisor can carry out these two
functions.
If different supervisors carry out these functions they must work
together to provide mechanisms to counteract macro-prudential
risks at a micro-prudential level.
Because micro-prudential supervision monitors the degree to which
the banks abide by the rules, there is a connection between
regulation and supervision, since the very process of supervision
is subject to regulation.
For example, the adequacy of capital, a key element that
supervisors assess to determine the health of the bank, is
described in detailed rules.
Throughout the report, we refer back to the definitions of
regulation and supervision and their functions to assess the value
of proposals for reform.
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