European Commissioninternal market and services

Towards more responsibiliTy and compeTiTiveness in The european financial secTor

© European Union, 2010Reproduction is authorised provided the source is acknowledged.

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Towards more responsibiliTy and compeTiTiveness in The european financial secTor

2

Table of conTenTs

1. inTroducTion 4

2. a more sTable financial sysTem 7 2.1 Capital levels in finanCial institutions 9 2.2 Crisis management and resolution 11 2.3 Credit rating agenCies 12

3. a properly supervised financial sysTem 13

4. a more TransparenT financial sysTem 16 4.1 alternative investment funds 16 4.2 derivatives 17 4.3 short selling 20 4.4 finanCial auditing and aCCounting 21

5. a more responsible financial sysTem 21 5.1 Corporate governanCe and remuneration 22 5.2 sanCtions 24

6. a more consumer-friendly financial sysTem 24 6.1 Consumer proteCtion 24 6.2 responsible lending 26 6.3 finanCial inClusion and payments 26 6.4 retail investment produCts 27

7. an inTernaTional financial sysTem 28

8. conclusion 30

3

Dear fellow European citizen,

The financial crisis hit Europe very hard. Our economies and our citizens are still suffering its consequences today. We cannot let such a crisis happen again.

We need to learn all the lessons of the crisis. And put those lessons learnt the hard way into action, as agreed by the leaders of the biggest world economies, the G20, when they decided a set of measures to build a safer, sounder and stronger financial sector. Financial markets need to be at the service of the real economy, and not the other way round.

I am determined that Europe will put into action all the commitments made at the G20. And that is what this booklet is about: it is our roadmap to meet those commitments. It explains the measures already taken, what is currently being discussed and what is still to come.

We are taking action in many areas - from supervising financial institutions, to regulating complex financial products or requiring banks to hold more capital. Our objectives though are consistent: greater responsibility and greater transparency across the board.

Michel BARNIER Member of the European Commission in charge of Internal Market and Services

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1. inTroducTion

The financial crisis that started in 2007 is the worst Europe has faced since the 1930s. Originating primarily in the United States, it proved to be highly contagious and complex, spreading rapidly to other regions and countries.

Massive government spending was needed to stabilise our banking systems, creating huge debts that current and future generations will have to repay.

We are all experiencing the fall-out in the real economy. Unemployment has increased and various Member States have had to launch ambitious budgetary reforms due to gigantic bailout operations, leading to concerns about the sustainability of overall public finances.

The situation would have been much worse had governments, central banks, the European institutions and other international organisations not responded forcefully.

The crisis is not over, but we need to start rebuilding. We must reform and find European solutions where they really have added value.

5

Financial markets were at the heart of this crisis. They cannot remain the same. We need to tackle the key causes of the crisis. These include:• an unstable and inadequately supervised financial system,• opaque financial operations and products,• irresponsibility in some financial institutions, who pursued

short-term profit, neglected risk management and paid unjustifiable bonuses, and

• a financial system that overlooked the fact that it was supposed to serve the real economy and society as a whole, contributed to the creation of bubbles, and often disregarded consumer interests.

The crisis was international and calls for an international response. The principal forum for a coordinated global approach is the G20, bringing together major advanced and emerging economies. Europe has played a key role in driving forward the G20 agenda, and is fully committed to implementing it.

As the crisis unfolded the importance of the EU dimension became increasingly clear. The single market has been a driver of growth, creating millions of jobs, and making Europe more competitive and more efficient. We must continue to strengthen the single market, avoid any protectionist tendencies and revert to the principles of a social market economy which serves the needs of our citizens and companies.

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impacT of The crisis

The financial crisis triggered a deep and widespread recession. Labour markets could not escape the downturn either and unemployment rose in the EU. Public finances were also severely hit, largely due to bank bail out operations. As a result, the general government deficit has tripled in recent years.

Real Gross Domestic Product (GDP) Growth in the EU (2009) -4.2%

Unemployment in the EU (Autumn 2010) 9.6%

General Government deficit in the EU (2009, % of EU GDP) 6.8%

State aid for banks, including unused guarantees(% of EU GDP) 13%

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2. a more sTable financial sysTem

The crisis showed how instability can spread from within the financial system to the real economy and damage growth. It demonstrated how problems in the US mortgage market can impact lending and investment in Europe, and how the failure of important segments of the banking sector and their subsequent bailout can affect the daily lives of European citizens.

Global financial services regulation failed to prevent or contain the crisis. This prompted a wide-ranging review of our regulatory policy. In Europe a high level group chaired by Mr Jacques de Larosière, the former governor of the Banque de France, was asked to reflect critically on the existing regulatory and supervisory arrangements and invited to make proposals to strengthen European supervision of all financial sectors.

8

The de larosière Group

In November 2008 the Commission mandated a high-level group chaired by Mr Jacques de Larosière to make proposals on how to organise the supervision of financial institutions and markets in the EU; to strengthen European cooperation on financial stability oversight; and to enable EU supervisors to cooperate globally. The Group also analysed and presented recommendations on regulating financial markets.

Its report, presented on 25 February 2009, set out a balanced and pragmatic vision to take the European Union towards a new regulatory agenda, stronger coordinated supervision and effective crisis management procedures.

Building on the group’s recommendations the Commission quickly developed proposals to establish a new European financial supervisory system.

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2.1 Capital levels in finanCial institutions

One of the key elements of our reform programme has been to strengthen the resilience of the banking sector and prevent it from generating losses which are then absorbed by taxpayers’ money.

To protect against failure banks are required to hold a minimum level of their own financial resources, i.e. capital. This serves as a buffer against potential losses, thereby protecting depositors and ensuring financial stability.

The Commission has already tightened up some rules on banking capital and will propose further legislative changes in 2011.

Determining how much capital is needed is a key challenge. If the level is too low banks are unable to absorb potential losses. If too high, then it may make lending to the real economy too costly. The Commission’s upcoming proposals to increase bank stability will, therefore, take due account of the needs of the economy.

Banks should be able to face sudden requests for funds. New liquidity requirements are being developed to strengthen their ability to withstand stress and prevent the sudden outflow of capital. They will reduce the risk of having too many short-term liabilities and too many long-term investments.

These reforms will allow banks to regain their primary role of lending money to the real economy and, thereby, help global recovery.

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A new supervisory framework will introduce risk-based capital requirements for insurance companies and place greater emphasis on risk management. The combination will enable much closer supervision of developments in insurance companies so that potential problems can be detected early on.

Source: Bloomberg and European Commission calculations. The graphs above refer to capital injections from both private and public investors.

fiGure: WriTe-doWns (losses) in The financial secTor and capiTal injecTions

Cumulative (€ bn)

1,400

1,200

1,000

800

600

400

200

0

Loss Capital injection

Worldwide America Europe Asia

300

250

200

150

100

50

03 04 01 02 03

20082007PriorLoss - WorldwideLoss - AmericaLoss - Europe

Capital injection - WorldwideCapital injection - AmericaCapital injection - Europe

Evolution 2007 - 2010 Q1 (€ bn)

2009 2010

04 01 02 03 04 01 02

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2.2 Crisis management and resolution

Various high profile banking failures during the crisis provided clear evidence of the need for more robust crisis management arrangements at the national level, as well as the imperative of putting in place arrangements better able to cater for cross-border banking failures.

Without procedures to organise an orderly winding up of banks, many countries felt obliged to bail out their banking sector. State aid for banks represents 13% of Europe’s GDP.

The crisis clearly demonstrated that when problems hit one bank, they can spread to the whole financial sector and well beyond the borders of any one country. It showed that systems were not in place to manage financial institutions facing difficulties. Very few rules exist to determine what action should be taken, and by which authorities, in the event of a banking crisis.

This is why the Commission will come forward with legislative proposals. These will create a comprehensive crisis management framework for banks and investment firms. The cost of a banking crisis should be borne by shareholders, creditors and, ultimately, by the whole banking sector through bank levies.

The proposals will be wide-ranging and aim to equip authorities with common and effective ways of tackling bank crises as early as possible, and to avoid costs for taxpayers.

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2.3 Credit rating agenCies

Credit Rating Agencies (CRAs) should provide independent opinions on the safety of certain investments, assessing the probability that companies or governments will be able to repay their debt. The crisis showed that often CRAs failed to produce sufficiently reliable ratings. This could be because of conflicts of interest where they were being paid by the organisations they rated. This, combined with a trusting approach by financial institutions and investors, who often relied unquestioningly on the CRAs’ opinion, resulted in credit being granted even if it was not justified by fundamental economic principles. This market failure contributed significantly to the financial crisis.

Against this background, legislation was adopted to ensure better supervision and increased transparency in the credit rating market. However, there are still strong concerns that users rely too much on these ratings and do not carry out their own proper assessments. The Commission is considering how to address this. It is examining the reliance on ratings in general, the impact which a small number of actors can have on European markets, and special factors linked to sovereign debt ratings.

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3. a properly supervised financial sysTem

Strengthened rules are necessary, but not sufficient. Strict supervision by competent authorities is essential. The crisis has shown the results of failing to do so. Our nationally based supervisory architecture has been overtaken by the integrated and interconnected reality of today’s markets. Many financial firms operate across borders. The crisis also exposed serious deficiencies in the cooperation, coordination and trust between national supervisors.

To address this the Commission proposed a package of legislative measures to reform the existing EU supervisory architecture by establishing three new European supervisory authorities and a European Systemic Risk Board.

Adoption of these proposals in 2010 was a milestone for Europe. The new supervisory architecture will contribute to a safer, sounder, more transparent and responsible financial system, working for the economy and society as a whole.

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The neW european supervisory archiTecTure

From January 2011, the European Union will have three new European Supervisory Authorities (ESAs) covering banking, insurance, occupational pensions, as well as securities.

They will work in tandem with Member States’ supervisors to combine nationally based supervision with strong European coordination to foster harmonised rules and their strict and coherent enforcement. The ESAs will be able to:• draw up specific rules for national authorities and

financial institutions,• take action in emergencies, including banning certain

products,• mediate and settle disputes between national

supervisors, and• ensure the consistent application of EU law.

A European Systemic Risk Board (ESRB) will be established at the same time to monitor and assess potential threats to the stability of the overall financial system. It will provide early warning of system-wide risks that may be building up and, where necessary, issue recommendations to deal with these.

15

european systemic risk board (esrb)

european banking

authority (eba)

european insurance and occupational

pensions authority

(eiopa)

european securities

and markets authority

(esma)

national supervisory authorities

fiGure: The neW european supervisory archiTecTure

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4. a more TransparenT financial sysTem

For too long complexity was an excuse for a lack of transparency; and thereby a major cause of market instability. The crisis has shown that no financial player, market or product should be exempt from appropriate regulation and supervision. Current rules should be strengthened to ensure proper and reliable information on the way financial markets operate is provided to supervisors, investors and the general public. Regulators should also have the appropriate means to ensure oversight of the sector.

4.1 alternative investment funds

The financial crisis has underlined the extent to which alternative investment funds, including hedge funds and private equity firms, were vulnerable to a wide range of risks. Some of them had developed a particular appetite for the complex and opaque financial products that eventually triggered the crisis.

While these funds may not have been a prime source of recent events, their activities amplified cyclical movements in the market with real costs for wealth, economic growth and employment. Their activities were not sufficiently transparent and the associated risks not sufficiently addressed by the existing regulatory and supervisory arrangements.

Recently agreed legislation corrects these faults and creates a comprehensive set of tools to directly regulate and supervise the alternative fund industry.

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4.2 derivatives

Another important proposal focuses on derivatives. These are financial instruments whose value depends on an underlying commodity or security, e.g., the price of oil or grain or interest rates and currency developments.

They can be used in various ways, including as insurance against certain risks, or for investment or speculation.

The use of derivatives has grown exponentially over the last decade. Most of this growth was driven by contracts which are not traded on a formal exchange, i.e. ‘Over–the-Counter’ (OTC) derivatives.

WhaT is a hedGe fund?

Hedge funds are collective investments encompassing a wide range of different investment objectives, strategies, styles, techniques and assets. They are typically open to selected institutions and wealthy individuals only, and are more flexible in terms of investment options or strategies than more traditional collective investments.

18

800

700

600

500

400

300

200

100

01998 1999 2000

Listed (all markets) Listed (Europe) OTC

2001 2002 2003 2004 2005 2006 2007 2008 2009

Derivatives play an important role in the economy. But they also concentrated risk in some financial institutions and amplified it through the interconnections between our financial firms. For example, the crisis was clearly linked to highly complex derivatives based on bundles of thousands of good and bad US mortgage loans.

At present little reliable information is available on what is happening in derivatives markets. There are substantial risks of losses if one party does not make the required payment when due to another. Recent proposals from the Commission aim to increase transparency and reduce risks. This will improve financial stability.

High price volatility in commodity markets and speculation in commodity derivatives has given rise to specific concerns which call for additional measures.

fiGure: The size of derivaTives markeTs ($ Trn)

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commodiTy derivaTives

Commodity markets have received a lot of attention in recent years due to the comparatively high price volatility of raw materials such as food and oil. This has given rise to concerns over the position of users and producers of comvmodities, in particular developing countries dependent on their import.

While much of the volatility can be attributed to the growing needs of developing economies and other factors affecting supply and demand (notably natural disasters), many commentators point to the impact of investor speculation.

Against this background, the Commission is assessing concrete proposals to improve the integrity, oversight and transparency of commodity trading, as well as a range of measures to strengthen the functioning of physical markets.

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4.3 short selling

“Short selling” was extensively discussed during the crisis. This is a technique used by investors who think the price of a security will fall. They sell it without owning it, planning to buy it back at a later stage at a lower price, thereby making a profit.

In normal times short selling may be beneficial for markets and contribute to efficient pricing. But in some circumstances, it can fuel downward prices, leading to disruptive markets and systemic risks.

The Commission has tabled a proposal to increase transparency, and make it easier for regulators to detect risks in the relevant markets. In exceptional circumstances, supervisors will also have the power to restrict or ban short selling.

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4.4. finanCial auditing and aCCounting

Several banks announced huge losses between 2007 and 2009 after being given a clean bill of health from auditors, who had clearly failed in their duty to sound the alarm on unhealthy companies. This raised issues about the regulation of audit companies and the structure of the market, which is highly concentrated, with four big global companies. The Commission has launched a wide-ranging examination of auditing and its contribution to increased financial stability. It will announce follow-up measures during 2011.

In the wake of the financial crisis a number of international accounting rules have been criticised. The Commission is now working to reach a global agreement around one set of high quality international accounting standards as a fundamental building block for enhanced financial transparency.

5. a more responsible financial sysTem

The financial sector has been dominated by immediate and maximum profit. This led to all sorts of irresponsible short-term behaviour. Longer-term interests were ignored. There was a lack of responsibility and accountability.

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5.1 Corporate governanCe and remuneration

Responsible practices are key to preventing short-termism and excessive risk taking. Proper corporate governance can clearly help to achieve this.

However, corporate governance within financial institutions has been found wanting. Supervision and control of management were insufficient. Risk management was weak. Inadequate remuneration structures led to excessive risk taking and short-termism. Many shareholders did not exercise sufficient control.

These weaknesses played a role in the crisis. Timely and effective checks and balances can help prevent its repetition.

The EU has already introduced binding rules on compensation practices which will apply to bonuses paid out for 2010.It is also considering ways to:

• increase the responsibility of boards,• enhance the supervision of senior management,• establish a sound risk culture at all levels within firms and• make additional changes to remuneration policies in order

to discourage excessive risk taking.

Further legislative initiatives, for example to increase the responsibility of boards and improve the supervision of senior management in financial institutions, are planned for 2011.

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remuneraTion in banks and invesTmenT firms

Recently agreed legislation requires banks and investment firms to have sound remuneration policies in place that do not trigger excessive risk taking and short-termism. From 1 January 2011, the provisions state that:

• upfront cash bonus payments be capped at 20% to 30% of total variable remuneration,

• at least 40% of variable remuneration be deferred for at least three to five years and

• at least 50% of variable remuneration be in shares which must be kept for a certain period.

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5.2 sanCtions

Stiffer penalties can also help to ensure that financial services providers bear full responsibility for their behaviour. But sanctions differ widely across Member States and are sometimes very low.

All national authorities should have appropriate minimum sanctions at their disposal, including the possibility of imposing fines which are sufficiently high to ensure deterrence. Sanctions should also be applied effectively across Europe.

The Commission has suggested action be taken at EU level to achieve greater convergence and sufficient deterrence of national regimes. It will also propose to increase the powers of supervisors to investigate and penalise market abuse, by, for instance, setting a minimum amount for administrative fines. These could be twice as high as any illegally obtained gain.

6. a more consumer-friendly financial sysTem

One major lesson to be drawn from recent market developments is the need to strengthen consumer protection and restore the public’s confidence in financial markets. Consumers and other end-users of financial services need to be closely involved in, and consulted on, policy developments in this area. The Commission is taking measures to achieve this, notably by creating an advisory Financial Services User Group.

6.1 Consumer proteCtion

The most visible effect of a bank failure is on its account holders. They must have confidence that their savings are safe if we are to

25

prevent customers queuing in front of banks to withdraw their savings. This confidence must apply wherever banks are located in the Union.

A quick decision was taken in 2008, ensuring that every bank in Europe will guarantee up to €100,000 for each depositor.

The Commission recently proposed to further harmonise and simplify the protection of deposits, ensure faster payouts, and improve the financing of deposit guarantee schemes, even in situations involving several Member States.

This should, for example, address some of the issues that arose with Icelandic banks, when more than 400,000 depositors in the United Kingdom, Netherlands, Germany, Belgium and elsewhere were unable to access their money for at least six to eight weeks, while waiting for payments under the deposit guarantee schemes.

26

Similar proposals have been tabled to ensure a minimum of €50,000 protection for investors in investment products beyond traditional deposits in the event of fraud or failure by an investment company. In addition, the Commission is looking at ways to improve guarantee schemes for policy holders when an insurance undertaking is wound up.

6.2 responsible lending

Credit plays an important role in our daily lives and economies. For example, taking out a mortgage loan is one of life’s most important financial decisions, committing customers for 20 years or more.

Lending is commonplace, but, in some cases, can become unmanageable and lead to financial difficulties with potentially serious consequences. Developments in mortgage markets played a significant role in exacerbating the effects of the financial crisis in several Member States, such as Spain, Ireland, the United Kingdom, Latvia and Lithuania.

Against this background the Commission will propose legislation on responsible lending and borrowing, ensuring that credit products are appropriate for consumers’ needs and tailored to their ability to repay.

This may be achieved by measures to ensure that all lenders and intermediaries act in a fair, honest and professional manner, before, during and after the lending transaction.

6.3. finanCial inClusion and payments

There are still around 30 million adults in Europe without a bank or payment account who cannot make use of electronic payments, which are increasingly essential for everyday life.

27

The Commission has decided to table legislation granting a universal right of access to a basic payment account for all EU citizens and residents. It has also been working with banks to facilitate payments in the eurozone (known as a “Single European Payments Area“ (SEPA)) and is taking steps to speed up its completion.

6.4 retail investment produCts

The retail investment market is largely dominated by so-called “packaged retail investment products”. These are financial products that typically combine exposure to various different assets, such as shares, bonds and currencies.

However, they can be risky, difficult to compare and often complex for retail investors to understand. Sellers of these investments can face conflicts of interest since they are often paid by the manufacturers rather than directly by customers.

Because of these difficulties, investors must have stronger protection. They need better information about the products, showing risks and costs more clearly and making comparisons easier. They need to know they can trust that those selling to them are acting in their best interest.

The Commission has decided to present proposals to improve investor protection. These will ensure that all retail investors are given a common, short, plainly worded, comparable and understandable document when buying such products. These proposals will be accompanied by further changes to rules on the sale of financial instruments and insurance products.

In the aftermath of the financial crisis some investors lost a lot of money in investment funds through fraud. This revealed

28

differences in the powers of national authorities to act to remedy this. The Commission will introduce measures in 2011 to address this problem.

7. an inTernaTional financial sysTem

Global financial markets require coordinated action by national and regional regulators and supervisors.

The Commission is working to achieve a coherent international approach by:• participating actively in the G20 and the work of

international standard setting bodies, • promoting international convergence, and• developing bilateral discussions on regulatory and

supervisory matters with key partner countries.

The 2008 G20 Washington Summit confirmed that the most effective response to the global crisis was a common roadmap for reform to ensure a level playing field. Since then, the intensity of international cooperation on financial regulation has been stepped up.

An extensive agenda was developed with the aim of preventing future crises, mainly by improving global regulation and supervision. All major jurisdictions now need to implement reforms and do so in a coherent manner.

The G20 Summit held in Seoul in November 2010 confirmed the determination of the international community to fundamentally repair the global financial system.

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G20 and The financial sTabiliTy board

The G20 was established in 1999, in the wake of the 1997 Asian financial crisis, to bring together major advanced and emerging economies to stabilise the global financial market.

To tackle the financial and economic crisis that spread around the globe in 2008, the G20 members were called upon to further strengthen international cooperation.

The Financial Stability Board, in which the Commission also actively participates, oversees implementation of many of the G20 commitments. It coordinates and promotes implementation of effective regulatory, supervisory and other financial sector policies.

30

8. conclusion

The reform of the European financial sector outlined in this booklet started in 2008.

All the measures to bring stability, transparency and responsibility to the financial sector are planned to be in place by the end of 2012.

They will shield our economies and societies from other major financial disruptions and costs.

They will protect the interests of citizens, allowing them to confidently engage with financial services providers.

They will allow the financial sector to contribute in a sustainable way to future growth and job creation.

The Commission will continue to closely monitor practices and behaviour in the financial services sector and will not hesitate to propose measures when necessary.

Together with the Member States, European Parliament, European Supervisory Authorities and national supervisors, the Commission will work to constantly improve the safety, soundness and efficiency of Europe’s financial system.

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Ethics

Enhanced macro-prudential supervision

New supervisory bodies

A stronger regulatory framework

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ore responsibility

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KM-32-10-567-EN

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