Financial Convergence The Political Economy of Europe and the Eurozone

1. Financial Convergence The Political Economy of Europe and the Eurozone

2. Outline • Financial Sectors Overview • New Organizational Structures for Financial Sector Supervision • International Coordination • Approaches to Financial Reform on Each Side of the Atlantic • Capital Requirements / Basel • Derivatives • Consumer Protection • Too Big to Fail / Volker Rule • Accounting Rules

3. Financial Sectors Overview • Demand – Increased need for transparency • Technology – Makes convergence feasible • Market – Global financial market • Availability of information • Ability to products • Global regulation • Increasing liquidity • Timing – Current market promotes change • Government alignment • Social-cultural push • Investors – Demand for transparency • Reduce risk • Increase stability

4. New Organizational Structures for Financial Sector SupervisionIllustrative Example of Regulatory Complexity for Securitization Products

5. New Organizational Structures for Financial Sector Supervision The EU Structures

6. New Organizational Structures for Financial Sector Supervision The USA Case

7. International Coordination Process • The US and Europe use multiple channels to coordinate their regulatory reforms, including: • Summits of the G-7/8 and G-20 nations • Permanent multi-lateral organizations • The Basel Committee, the Financial Stability Board, and the Bank for International Settlements, which hosts those two entities, are among the important multi-lateral organizations that focus on the financial system. The G-20 further bolstered the roles of the Basel-based organizations by explicitly delegating specific responsibilities to them in the wake of the financial crisis. • Direct talks between the US and EU institutions • Various high-level Administration and Fed officials from the US talk to equivalent officials from the European Commission, Council of Ministers, and European Central Bank. Less frequently there will be discussions with key members of the European Parliament. Congress, for its part, maintains some sporadic dialogue with EU officials, including those from the Parliament, which has now set up its own office in Washington. • Bilateral national talks

8. D B C A D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules Consumer Protection Capital Requirements Derivatives

9. D B C A D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules Consumer Protection Capital Requirements Derivatives • Basel III minimum capital requirements:

10. D B C A D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules Consumer Protection Capital Requirements Derivatives • Transatlantic Controversy on Leverage Ratio adoption • Risk Weighted Assets Leverage Ratios • Total Leverage Ratio • Based on Capital ratios to TOTAL ASSETS • VS.

11. D A C B D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules Consumer Protection Capital Requirements Derivatives • Derivatives are financial instruments whose value is derived from the value of some underlying instrument. • Most derivatives are relatively straightforward products whose principal users are hedging existing risks. However, the financial crisis was significantly exacerbated by • the excessive complexity of some newer types of derivatives, • the opacity of the markets for many derivatives, • the counterparty risks created by the manner in which most derivatives were cleared, • and, some would argue, by the excessive use of derivatives such as credit default swaps (CDS) for speculative purposes rather than hedging. • Generally in agreement regarding derivatives: The high degree of parallelism arose in significant part because there has also been a great degree of consultation across the Atlantic. Policymakers in both the US and Europe clearly recognize the importance of getting derivatives regulation right and of ensuring that the global markets for these products function smoothly • Basel III in summary: • Total capital levels will be increased. • More of the capital will have to be in the strongest form • Risk-weighted asset calculations will be tightened. • A “leverage ratio” will be added, over time • New liquidity tests will be added. • The issue • EU-USA

12. D A B C D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules Consumer Protection Capital Requirements Derivatives • A major problem in the US crisis was that many consumers were offered mortgages and other loans that were inappropriate for their circumstances and often not understood by the borrowers. In some cases, mortgage brokers, the initial lenders, appraisers, and sometimes the borrowers themselves were complicit in legally or morally fraudulent activities. • In other instances, borrowers were lured with very low “teaser” mortgage rates that were bound to increase sharply after a few years, rendering the loan insupportable at the borrower’s current income level. This created an almost inevitable default, unless house prices rose to allow a refinancing, perhaps with a new teaser rate. • Consumer protection problems were clearly a more major issue in the US than in Europe, which probably explains why enhanced consumer protection was a major part of Dodd-Frank, but has not received the same emphasis in Europe. • Dodd-Frank created a new Bureau of Consumer Financial Protection (BCFP) that has taken over most of the consumer protection functions (previously resided within the Federal Reserve Banks and the Federal Deposit Insurance Corporation (FDIC). • The issue • EU-USA

13. D A B C D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules Consumer Protection Capital Requirements Derivatives • The EU already had a strong consumer protection directive in place: MiFID

14. D C A B E D ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail (I) AccountingRules Consumer Protection Capital Requirements Derivatives • There has been a great debate around the globe about “Too Big to Fail” (TBTF) financial institutions, as well as about the overall size of the financial sector relative to the economy. • Virtually everyone agrees that it is unfortunate that the largest financial institutions are too big for governments to allow them to fail in the middle of a severe financial crisis, because the blow to confidence and the direct impact on other financial institutions would be too dangerous to risk. • However, there are a wide range of views about how best to eliminate or mitigate the problem. • One way to ameliorate the problem is to make it easier and less painful to resolve a troubled financial institution. • Other proposals include: putting an absolute limit on the size of financial institutions; empowering regulators to break up institutions whose size imposes excessive systemic risks on a case-by-case basis; and limiting the range of permitted activities to reduce the size and riskiness of banks. • The US and European responses to this problem vary quite significantly. A key reason for this is that the largest US banks are substantially smaller as a percentage of the total system than is true for individual European nations, despite the continuing consolidation of the US industry. • The issue • US vs EU

15. D C A B E D ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail (II) AccountingRules Consumer Protection Capital Requirements Derivatives • Dodd-Frank modestly tightens existing limitations on the size of commercial banking groups. • Similar to existing rules, there will be a severe limitation on the ability to grow by acquisition once a bank surpasses a 10% limit on their liabilities as a portion of the total banking system. However, those that are already larger than this are not being reduced in size and they and others are permitted to grow organically. • In addition, the regulators are given the power to force a systemically important financial institution to divest activities which are believed to contribute excessive systemic risk. In practice, though, this provision appears likely to be used only in extreme circumstances. • There were proposals to reimpose some of the Glass-Steagall limitations as a way of re-separating investment banking and commercial banking activities, but policymakers generally concluded that this was no longer feasible in the modern financial system. • Instead, a more limited form of division was imposed through the Volcker Rule, which will force banks to cut back significantly on their proprietary investment activity. • The Volcker Rule provisions require commercial banks and their affiliates to cease their proprietary trading and investing activities over a period of several years, but leaves significant leeway for regulators to decide what is meant by “proprietary.” One area where the law is fairly clear is that banks are forbidden to continue owning significant stakes in hedge funds and private equity funds and are not allowed to provide major support in other ways to these funds, including using the group name with their funds. • US Actions

16. D C A B E D ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail (III) AccountingRules Consumer Protection Capital Requirements Derivatives • The EU has not directly addressed this with any legislative proposals. However, some of the regulatory changes that are being discussed to deal with troubled or potentially troubled institutions might indirectly lead to actions in this area. • In particular, the “living wills” concept could conceivably lead regulators to force a divestiture of certain activities if they appeared to create too much risk. Sometimes also known as “funeral plans,” these are formal documents that banks would be required to create detailing how they suggest that they, or some of their subsidiaries, would be unwound in the event • EU Actions

17. D C A B D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules (I) Consumer Protection Capital Requirements Derivatives • The FASB & IASB have undertaken the following six key initiatives: • A) Active Involvement: • Joint projects being conducted with the IASBCurrently, the FASB and IASB are conducting joint projects to address Revenue Recognition and Business Combinations. • The short-term convergence projectProject is limited to those differences between U.S. GAAP and IFRS in which convergence around a high-quality solution appears achievable in the short-term. • Liaison IASB member on site at the FASB officesPresence of a full time IASB member in residence at the FASB offices. The role was created to facilitate information exchange and increase cooperation between the FASB and the IASB.

18. D C A B D E ConvergenceApproaches to Financial Reform on Each Side of the Atlantic Too Bigto Fail AccountingRules (II) Consumer Protection Capital Requirements Derivatives • B) Pasive Involvement: • FASB monitoring of IASB projectsIASB projects are monitored by the FASB based upon the FASB’s level of interest in the topic being addressed. • The convergence research projectProject seeks to identify all of the substantive differences between U.S. GAAP and IFRS and to catalog those differences according to the Board’s strategy for resolving them. • Explicit consideration of convergence potential in all Board agenda decisionsFactors that the Board considers in assessing topics for the agenda include (a) the possibility that resolution would increase convergence of standards worldwide, (b) the opportunities the topic presents for cooperation with other standard setters, and (c) whether appropriate and sufficient resources are available for a joint or other cooperative effort.

19. The Political Future of Regulatory CoordinationQuotes from analysts, executives and other commentators • “It’s a bloody nightmare. The regulators have no respect for one another at all. Each country is looking after itself,” • A Senior executive in charge of regulation at one of the world’s biggest banks, echoing a sentiment voiced by peers at five other global institutions. • “The trend is for countries or the EU to put in place legislation that on the face of it implements G20 commitments but in practice is uncoordinated with other countries. So the outcome is not so much conflicting objectives as conflicting solutions.” • Michael McKee, a lawyer at DLA Piper. • “Global unity is now noticeable by its complete absence, […] What it demonstrates is that we need a greater degree of international co-ordination than we actually have.” • Simon Gleeson, a UK-based regulatory partner at Clifford Chance, the law firm.

20. Keys for Future Regulatory Convergence • Finish the key regulatory reforms • Finalize the Basel III accord without sacrificing its strength • Design reforms to achieve the necessary safety at the lowest economic cost • Jointly engage major Asian countries and other emerging markets in financial reform • Demand that consistent global accounting standards be applied by all parties • Harmonize the regulation of financial market infrastructure • Fix the housing finance system in the US • Address the underlying macroeconomic, social, and political causes of the crisis • Stay focused on key unresolved structural issues • Resolve transatlantic conflicts • Find compatible approaches to regulating hedge funds and private equity funds • Coordinate approaches to credit rating agencies • Repair the process of supervision • Improve banking supervision and hold regulators accountable • Create effective rules for dealing with cross-border banks that run into trouble • Enhance the processes for global cooperation • Engage Congress and the EU parliament more deeply in international discussions of reform • Define a clear, robust future for the G-20, linked to existing multilateral institutions • Coordinate macroprudential policies globally • Coordinate carefully any significant changes in taxation of financial institutions or transactions