For the past year, lawmakers in Brussels and Washington have been overhauling how their financial systems are regulated. The goal is to create frameworks that will prevent a repeat of the near meltdown of the financial sector in autumn 2008, a deeply traumatic episode that plunged the world into a recession from which it is still struggling to re-emerge. As the G20 finance ministers gear up for a key meeting in Pittsburgh, Pennsylvania, on 3-4 September, Europoliticstakes a closer look at three key areas: overall supervision, hedge funds and accounting standards. We examine who is behind the reform process, how quickly proposals are moving, and how similar they are in substance.

The European Union has so far moved more quickly than the United States to plug the regulatory loopholes exposed by the crisis. Whereas over a dozen proposals are wending their way through the EU’s legislative pipeline (see table), the Obama administration only delivered its draft legislation to the US Congress in late July. Europe has gotten a head start in part because the financial crisis hit in the dying days of the administration of Obama’s predecessor, George W. Bush, who was never really keen on regulating and who resisted international pressure to do so right until the end. In contrast, the European Commission was keener to end the laissez-faire culture that Internal Market Commissioner Charlie McCreevy was accused of propagating to the detriment of the financial system.

In addition, US efforts in late 2008 and early 2009 were focused on passing an economic stimulus to jumpstart the economy, with President Obama signing off on the US$787 billion package in February 2009. In Europe, economic stimuli are mostly the remit of individual EU member state governments, so the EU institutions were freer to push on with financial sector reforms. Though Washington has caught up somewhat - beginning with an Obama administration white paper in June - it is still highly likely that Europe will retain its lead on regulatory reform by the time leaders from both sides of the Atlantic meet at the next G20 summit, on 24 September in Pittsburgh.

To view a table on the EU’s response to the financial crisis, click here 

1. Supervision

NEW EUROPEAN STRUCTURE

On 27 May, the European Commission sketched the outlines of a new two-tier supervisory structure ⁽¹⁾, based largely on a report issued on 25 February by European Monetary Union architect Jacques de Larosière. It consists of a European Systemic Risk Board (ESRB) with non-binding powers to monitor developments on a macroeconomic level and three statutory European supervisory authorities (ESAs), which will work with national regulators in the banking, securities and insurance sectors (the European System of Financial Supervision, ESFS).

Made up of 27 central bankers, representatives of the new EU-level authorities, the European Central Bank and the Commission, the ESRB will represent 60 organisations in total and meet quarterly, channelling its risk warnings through Ecofin or the ESAs. It will operate using a ‘moral authority’, or sort of peer pressure, asking countries to act on risk warnings or explain their inaction. Britain, however, is sceptical about appointing the European Central Bank president as the ESRB’s head, and managed to secure itself a second concession from the Council to ensure the board’s head will be elected by the ECB’s General Council.

The three supervisory authorities, comprising 27 national regulators, are to meet more often than the ESRB, will have their own budgets (made up of EU and national money) and will be overseen by a steering committee. They will be able to report non-compliant member states to the Commission and have full supervisory control over credit rating agencies.

However, lines have already been drawn on how far the ESA’s remits should stretch. Britain managed to secure a proviso (see Europolitics3769) that so-called binding mediation - which gives the bodies the power to broker rows between cross-border banks - cannot result in a decision that would force member states to tap into national budgets.

Other countries, including Poland, want clearer lines drawn on whether the home or host country is responsible for bank rescues (burden sharing). The Socialist and ALDE groups in the European Parliament go one further and prefer a pan-EU regulator, fearing that the proposals as they stand are too bureaucratic.

Despite the infighting, however, heads of state and government backed up the draft at a summit, on 19 June.According to French diplomats, their support was galvanised by the release of Obama’s white paper two days before.

US PLANS

President Obama is pushing for the creation of a macroeconomic systemic risk board, which would be called the Financial Services Oversight Council and would be chaired by the US treasury secretary. On the microeconomic front, the office of national bank supervisor would be created, bringing together the various offices charged with supervising banks and other depository institutions. The Federal Reserve (the US central bank) would have expanded powers to oversee securities markets. An Office of National Insurance would be created to accumulate expertise and speak for the US insurance industry internationally. This would fill an important gap as insurance is presently regulated at the state, not federal level. And a Consumer Financial Protection Agency would be established. These plans are fairly similar to what the Commission is proposing for Europe.

But Obama has one handicap the Commission does not have, namely he cannot, under the US Constitution, propose law so he must rely on the US Congress to formally introduce a bill. In practice, the House of Representatives’ Financial Services Committee does intend to begin discussions on his plans in early September. Obama has a problem here, because this issue has slipped down Capitol Hill’s priority list since the manic days of late 2008 as the situation for US banks has improved somewhat. The majority party, the Democrats’ top priorities are advancing Obama’s health care reforms and enacting a ‘cap and trade’ bill to cut greenhouse gas emissions. Thus the window of opportunity for financial sector reform is already beginning to close. Come 2010, Congress will be in an election year once more when little is expected to happen legislatively. If anything does pass, it will probably be populist initiatives the ordinary voter can easily understand, not more technical issues. In that regard, the House Financial Services Committee Chair Barney Frank (Democrat, Massachusetts) has singled out the Consumer Financial Protection Agency idea for attention.

The European Commission will back up its plans with legislation, on 23 September, and all going to plan, hopes to fast-track the new structures through co-decision so they are in place by 2010.

2. Hedge funds

Industry has flown in the face of the Commission’s proposed directive on alternative investment fund managers ⁽²⁾, holding that it will cause a mass exodus of investors from the EU. Released on 29 April, the main thrust of the Commission’s plan is to regulate EU-based funds via their managers, making them – but not the funds themselves – subject to registration with a national authority if they want to operate in the EU (see table).

INDUSTRY FEARS

It means that all hedge funds above €100 million in value and all private equity funds of €500 million or more not using leverage - those that do not borrow to finance their investments - will have to register with the member state in which they are based and will be subject to disclosure and capital requirements, as well as leverage limits. If approved, managers will get a passport to market their products across the 27 member states - much like UCITS [Undertakings for Collective Investment in Transferable Securities] investments do now. However, the industry (led by the UK, where most EU hedge funds are based) fear this will limit managers, who could relocate outside the bloc to avoid regulation. British Treasury Secretary Lord Myners is currently on a media tour of 12 European capitals, trying to stem bad press surrounding the funds. Although the Commission does not hold the industry responsible for the financial crisis, even Internal Market Commissioner Charlie McCreevy, formerly no friend of regulation, has said that managers’ risky behaviour poses a danger to stability.

STATES DIFFER ON REGULATION

France, Germany and left-leaning MEPs hold with this argument, and have long been calling for regulation. But PES President Poul Nyrup Rasmussen has famously called the current proposal “Swiss cheese,” saying it does not go far enough. He wants to see hedge funds rather than managers coming under surveillance, without any exemptions for smaller funds.

The Hedge Fund Standards Board said recently that the directive was rushed through, overly politicised and failed to take account of industry comment. It fears that leverage limits in particular could strangle managers’ profits and limit choice for investors.

But the third-country provision - which will see non-EU funds come under EU regulation three years after the directive enters into force - has been criticised as outright protectionism. The UK, where three-quarters of EU hedge funds are based, is particularly worried about the rule change, with Lord Myners lately echoing industry fears that China, India or the Middle East could take London’s place if the EU clamps down too hard.

Commission officials say the draft is unlikely to be approved before the middle of 2010, meaning it will be transposed into national law by 2012, with non-EU fund managers coming under its remit by 2015.

WASHINGTON’S APPROACH

Meanwhile, no specific legislation is expected to be passed by the US Congress on hedge funds. The US Securities and Exchange Commission (SEC), the government agency charged with regulating the securities market, could adopt new rules if it wanted to but is not thought to have such plans. The Obama white paper has a provision for strengthening oversight of hedge funds by requiring all hedge fund managers above a certain threshold to register with the SEC and report on funds they manage. In addition, a future Financial Services Oversight Board would most likely scrutinise them.

The US approach to hedge funds, therefore, seems to be to increase disclosure requirements. There seems to be little appetite to restrict their operations per se, as there is in certain EU quarters. The danger for US hedge fund managers is that the EU will enact a tough regime that may bar them from doing business in Europe (the third-country provision). The European Commission could help them out, however, by making an ‘equivalence’ finding that the US system is as good as the EU’s, to enable US hedge fund managers to operate in Europe.

3. Accounting standards

A row between the EU and the International Accounting Standards Board (IASB) has erupted over how to value impaired assets during the crisis.

The row centres on an IASB code on fair value accounting (IAS 39), which the EU fears compounds market turbulence by forcing banks to value their assets at lower than market prices.

The IASB is phasing in changes to IAS 39, which will not be completed until 2010, but the EU, which has maintained a carve-out from the rule since 2004, is now demanding clarification on fair value accounting before companies have to publish 2009 year-end accounts.

France and Germany, which wrote a letter to Commissioner Charlie McCreevy to complain about the lack of progress (3789), are concerned that European banks are at a disadvantage compared to their American counterparts, after Washington’s Financial Accounting Standards Board (FASB) introduced a rule in April allowing American companies to reclassify toxic assets on their balance sheets.

At the root of the tension is the fact that the US system for adopting accounting standards is very different to the EU’s. Whereas the EU legislature enshrines the IASB’s rules in European law, and has done so since 2002 in a bid to harmonise markets as part of the Financial Services Action Plan, the Congress does not do this for the US. Instead, the FASB, an independent body that was originally set up and run by the accounting industry, sets the standards. Though the SEC exercises oversight through its powers to regulate the securities market, in principle the US government has no control over the FASB to ensure standards are set in an atmosphere free from political meddling. In practice, however, the FASB does not operate in a vacuum and pays close attention to what the US Congress and US industries say, and to what the IASB does.

Indeed, the FASB was accused of caving in to congressional pressure in April when it changed the rules for recognising impairments on toxic assets. By switching from an ‘intent and ability to hold’ to an ‘intent to sell’ criterion, the FASB enabled struggling US banks to effectively raise their core capital levels in their financial reporting. EU countries like France and Germany then cried foul as the EU has not followed suit. Some in the EU are concerned that the FASB may be straying from its previously stated goal of converging US standards with IASB - and by extension EU - standards by 2014. In practice, although the FASB wants to work closely with the IASB, it is unlikely to simply adopt IASB rules verbatim so it may not be possible to have a single global accounting standard.

Directive on Alternative Investment Fund Managers (AIFM)

Scope:EU-based managers of all non-UCITS investments except hedge funds under 100 million euro and private equity under 500 million euro

Registration:Managers register in home countries, subject to rules on leverage, capital and disclosure

Passport: Approved managers will get a ‘passport’ to market their investments across the 27 member states

Third countries:Three years after the directive enters into force, non-EU funds will need to be approved by European regulators

Leverage:Individual limits set through comitology. Ban on leverage possible in exceptional cases

Capital requirements:0.02% of own funds where portfolio value is more than 250 million euro

⁽¹⁾ COM(2009) 252
⁽²⁾ COM(2009) 207