Being better informed: August 2014

They say a year can be a lifetime in politics. In the financial system, six years feels like an eternity. Many will remember August 2008 as if it were yesterday, but in many ways we are still struggling to understand the full implications of what happened. August 2008 was a watershed. Although arguably problems initially began surfacing over a year earlier, in August after months of denials, governments, regulators and banks started to admit that the financial system was in serious trouble and that a painful economic downturn was on the cards.

With this admission, the remaining liquidity in the wholesale money markets evaporated as financial institutions lost confidence in their peers –forcing central banks’ hand. EU banks started to issue large profit warnings as their exposure to troubled US housing and credit markets became apparent—and shareholders reacted by jettisoning bank stocks. Houses prices started to fall in many EU countries, unemployment ramped-up and production ground to a halt. Lehman Brothers’ failure a month later ratcheted the crisis up to a new level: an apocalypse that threatened the global economy. In terms of the banks, the emperor had permanently lost his clothes: problems of poor risk management practices, thinly capitalised balance sheets and misaligned funding patterns came to light at many institutions.

We are still experiencing the fallout of these events and their aftermath on a daily basis. The cost of bailing-out failed banks has been enormous. Between October 2007 and the end of 2011, EU governments injected €440 billion into their teetering banks and provided guarantees of €1.1 trillion. Add in the costs in terms of lower economic production and the loss of householder wealth, and the true cost of the financial crisis runs into the trillions. Politicians felt they had little option but to bail-out feckless banks because after the Lehmans collapse, it was clear that no-one knew what would happen if governments didn’t act. Size was an obvious concern: certain banks, whose assets equated to multiples or large percentages of national GDP were just too-big-to-fail from a global, regional or national perspective. Others were too embedded in the financial system overall: these were too-interconnected-to-fail. Public bail-outs proved necessary, sparking deep public anger which has persisted, fuelled by subsequent banking scandals.

Handling systemically important institutions remains an ongoing, and difficult, process in the EU as elsewhere -– we still have many firms that are too-big-to-fail (TBTF) or too interconnected. EU attempts to address these problems have many interconnecting strands - from structural reform, enhanced supervision to capital buffers. The EU reforms also include a requirement for financial institutions to develop recovery and resolution plans to make any failure less disruptive and to ensure that taxpayers no longer foot the bill. This requirement was laid out for all EU banks and designated investment firms in the Bank Recovery and Resolution Directive (BRRD). In July HMT, PRA and the FCA all issued consultations setting out their approach to implementing the BRRD. The FCA’s paper is particularly important given that it is requiring the investment firms that it regulates to prepare these plans for the first time - large UK banks have been required to prepare recovery and resolution plans since 2011. Most investment firms (82%) will be eligible to apply the simplified obligations and approach, which should be less arduous and time consuming.

Amongst other things, BRRD forces troubled banks to bail-in creditors using contingent convertible instruments (CoCos) or similar instruments. CoCos are automatic bail-in hybrid debt securities which have grown in prominence and popularity since the financial crisis. ESMA issued a warning in July that CoCos may not be appropriate for retail investors because they require “a sophisticated level of financial literacy and a high risk appetite”. ESMA’s announcement was followed in August by the FCA’s first use of its temporary product intervention powers to ban the distribution of CoCos in the UK to retail investors from 1 October 2014. The FCA plans to introduce changes to its Handbook over the next year to formalise this ban.

In July, the FCA also focused on consumer credit, announcing plans to cap the amount that payday lenders can charge their customers. The proposals include caps on the daily interest rate, on default fees and on total interest and charges. In short, the measures would make sure that no-one pays back more than twice what they borrowed. The FCA’s own research indicates that the cap will force some market exits because firms will find it uneconomic to serve some customers.

Over the summer, insurers should start to think about getting approval of their internal models under Solvency II. For those firms that choose to go down this route, it provides essential groundwork for implementing Solvency II. But it remains a daunting challenge for firms. Our blog on this issue will help insurers understand some of the key considerations involved.

We have two feature articles this month. In our continuing focus on MiFID II we look at dealing commissions – the FCA issued a discussion paper to look at how the market is performing in line with current expectations and the changes MiFID II might make to the dealing commissions rules. For asset managers and investment banks this issue is critical. We also focus on the continuing benchmark reform, where July saw a number of publications looking at how developed these reforms are and how well administrators are performing in their new roles.

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