George Kerevan: Glacial tightening of the regulations needs clarity

Published on Tuesday 26 May 2009 21:06

TODAY should see the publication of the European Commission's working document on overhauling financial regulation within the EU. If acceptable, this draft will go to the meeting of EU leaders next month. What does Brussels have in mind for us?

The conundrum is this: everyone says they want tougher regulation but no-one wants Brussels to intervene too much in their national banking system. Plus no-one wants the European financial services industry to decamp to America or Asia.

Leaks suggest Brussels will move cautiously, especially as the commissioner in charge of competition matters, Charlie McCreevy, is no great fan of tight regulation. McCreevy has been working quietly in the background to tone down the wilder measures being proposed by the European Parliament.

Most likely, the commission will propose beefing up three existing EU "co-ordinating committees" into genuine pan-European supervisory authorities – one each for banking, insurance and securities. National supervisors would continue to handle day-to-day regulation but be subservient to the Big Three.

The new organisations would also supervise directly pan-European institutions such as credit rating agencies and EU central counterparty clearing houses. The commission draft also proposes the creation of a "European Systemic Risk Council" to warn of potential threats to financial stability.

This may sound uncontroversial but it is bound to attract resistance from Britain. The government remains determined to do nothing that would interfere with the competitiveness of the City. Alistair Darling is unlikely to agree to giving binding powers of mediation to the proposed all-European supervisory authorities as that would make the City subservient.

The idea for the innocuous-sounding Systemic Risk Council also contains a few time bombs. For instance, who is going to chair it? The commission wants the president of the European Central Bank but where does that leave non-euro countries?

The commission has also published draft proposals for supervising hedge funds and private equity firms. These are even less far-reaching than the bank regulations, despite a lot of preliminary huffing and puffing from President Sarkozy and Chancellor Merkel. The commission wants EU-based managers of "alternative investment funds" – but not the funds themselves – to be registered and disclose their activities, especially their degree of leverage. This plan safeguards the EU as a place to do international business but it hardly counts as cracking the whip on excessive risk-taking.

Surprisingly, it is the United States that is being more proactive on the regulatory front. Last week, the Obama administration unveiled its master plan to regulate over-the-counter trade (OTC) in derivatives. The move is meant to increase official control over the $680,000 billion market in complex securities which many blame for exacerbating – if not causing – the financial crisis.

The US plan is to force all "standardised" derivative trades to be cleared electronically through regulated exchanges. Before the crisis, most trades were done over the phone, making them hard to track and record – so no-one knew the extent of the exposure. The new rules should reduce the risk of investors being over-exposed to a single counterparty, as exchange members contribute to a central default fund. Exchanges also take out separate insurance cover as an ultimate layer of default protection. Plus regulatory bodies can force traders (especially banks) to maintain higher reserves in case of default.

The idea is so simple you might wonder why no-one thought of it before. Perhaps it had something to do with OTC brokers (ie banks) pocketing fat fees, rather than the exchanges.

In fact, centralised clearing for derivatives is already emerging without being imposed by the authorities, so the US Treasury is pushing at an open door. Most interest-rate swaps – the largest OTC market – have already shifted to centralised clearing. However, there are things to be ironed out in the US plans. For instance, are funds which use derivatives for hedging covered by the regulations?

In Europe, the approach to regulating derivatives has been slow and piecemeal. After much wrangling, EU plans for centralised clearing of credit default swaps, the riskiest of complex securities, should be in force in July – fingers crossed. However, the EU has so far found it difficult to define the range of OTC instruments to be cleared. The commission is due to report back on the problem next month.

There is far more at stake here than the politics of financial regulation. Exchanges, with revenues down amid deteriorating equity markets, see OTC clearing as a potential new source of revenue. Profit-strapped banks don't want to lose the brokerage fees they got from OTC trading.

Europe's glacial moves to reforming financial regulation may have more to do with such infighting that we realise.