Half Time score on EU short selling regulation: Common sense 1, Poltical motives 1

Pardon for this uncharacteristically jargon-heavy blog-post...

Following our event on the proposed EU regulation of short selling in March, we expressed our concerns that political motives were trumping common financial sense at that point in the negotiations (based on the European Parliament’s proposal). It looked as if certain EU politicans had got one over on the markets (or so the politicans would like to present it) with a proposed ban on uncovered credit default swaps (CDS) and extending a ban on naked short selling to the sovereign debt markets.

Now, having examined the latest proposal to come out of the recent meeting of EU finance ministers, its looks as if the common sense is slowly gaining some ground back.

For starters, they’ve left CDS largely alone, apart from a clause which allows CDS activities to be temporarily banned in exceptional circumstances if all national regulators agree (which gives the FSA an effective veto).

The proposal still bans naked short selling (as it was ultimately designed to do), including sovereign debt, but this can be rescinded if it is seen to harm liquidity in sovereign debt markets. Interestingly, short selling of sovereign debt is allowed if it is seen as hedging against a corresponding long position. The European Securities Market Authority (ESMA) is mostly given a coordination role, it can attempt to rescind or extend the ban on an EU-wide basis but, again, it requires the consent of national authorities to do so.

The transparency rules are still included, stating that any investor with a significant net short position in shares must disclose it to regulators and to the markets if above a certain threshold. Importantly, this has been watered down in reference to sovereign debt so that no public disclosure is necessary. Public disclosure of short positions isn't uncomplicated but ultimately its impact will depend on the exact threshold levels and the format in which it is disclosed, both details which are yet to be announced.

Clearly, the Council's proposal is better than what some countries, such as France, had pushed for, particularly in relation to sovereign debt. It looks as if, at least in this round of the negotiations, the common sense approach - not least in terms of avoiding cutting off sources of liquidity for struggling eurozone countries - has been taken to heart. However, the negotiations are far from over, with the European Parliament still pushing for its far tougher proposal.

Member states and MEPs will now have to try to find a compromise between their respective proposals (with some member states no doubt using those negotiations trying to win back concessions that they horse-traded away - that's the nature of co-decision and Qualified Majority Voting).

So while this is pretty good news, it's only the half-time score.

Wrestling with a Greek restructuring

The talk of a Greek restructuring has resurfaced again, following Wolfgang Schauble’s seeming acceptance that one might be necessary in the near future. It looks like he’s back tracked today, claiming he was ‘misinterpreted’, but the damage was already done - Greek cost of borrowing has already hit new highs and the euro weakened significantly.

As we’ve noted on this blog many times (here and here, for example) and in our Greece paper, a debt restructuring is unavoidable, Greece is essentially insolvent. It’s been trying hard to enact the necessary austerity but the evidence is against the government – tax revenues have barely increased, spending cuts are proving hard to enact and the population is already fed up with austerity in all its forms.

There are a couple of points which have been raised with us recently on the negatives of a Greek debt restructuring: it will take down the Greek banking sector and there is significant moral hazard. Undoubtedly, it is a risky proposal but from what we can see, there are few other options to tackle the long term (and in this case short term) problems.

On the risk to the banking sector, there is no doubt that Greek banks hold huge amounts of Greek sovereign debt but that just serves to underline that they’re unsustainable. All the large Greek banks need to be restructured and recapitalised. Combining this with a sovereign debt restructuring is just good sense. They may need some capital injection and a lot of ECB help, they may even need to be nationalised while all this takes place but in the end the newly streamlined banks will serve the economy far better than the bloated inefficient current ones ever could.

As for the moral hazard, it is a valid concern that it could encourage other nations to seek debt relief but unfortunately we’re now in the realm of lesser evils. With bailouts or fiscal transfers you get a double moral hazard – firstly to the governments, who are not being reprimanded for their profligacy, and secondly to banks, who took huge risks which they could not cover – at least a restructuring shares the burden between the two.

It looks like Greece is coming to the end of the road, a decision needs to be made otherwise a chaotic default could be on the cards before 2013 and nobody wants that. Greece is priced out of the markets for the foreseeable future, the public is fed up with austerity and taxpayers across Europe are tired of paying to support ailing economies; what more is there to lose from a debt restructuring?

EU wise guys always centralise

Former Central Banker Alexandre Lamfalussy was yesterday holding court at a debate in Brussels, looking at EU financial regulation, and in particular the creation of the three new EU authorities for 'micro-prudential' supervision and their sister organisation, the new European Systemic Risk Board, for the macro-prudential side of things.

We've looked at this issue in detail before, but let's have another go.

Lamfalussy is an EU "wise man" - belonging to an exclusive group of men (they're almost always men and have usually seen too many winters) whose services are called upon when Europe is need of a game-changing policy that will solve all its problems overnight.

Lamfalussy certainly has an impressive CV. He was the chair of the Committee of Wise Men on the Regulation of European Securities Markets (which is a ridiculous name - why not go for the Fellowship of the Ring while they're at it?), having also served as first President of the European Monetary Institute, predecessor to the ECB, and Director General of the Bank for International Settlements.

It was also Lamfalussy's committee that proposed the so-called Lamfalussy process - the EU's method for deciding and implementing financial regulation (Zzzzz).

Speaking at the debate, Lamfalussy labelled the recent makeover of the EU's financial supervisory architecture a "quantum leap", saying he was particularly pleased with the fact that "the level 2 committees [in the Lamfalussy process] have become authorities now", which in plain English means that more powers have now been given to the EU. As Lamfalussy put it, the three supervisors - charged with overseeing banks, insurance and securities - are now equipped with proper "decision-making powers" (how that is legal under the EU treaties is open to debate, but that's for another time).

He wasn't as happy about the limited mandate of the European Systemic Risk Board, which has more of an advisory role at the moment. He said that "it should get decision-making powers as soon as possible" since "the absence of a macro-prudential supervision component [which is meant to be the ESRB's area] did play a major role in the crisis."

Warming to his subject, he then went on to argue that "the problem with the people now in charge [i.e. the three EU supervisors] is that they haven't been trained or mandated" for their task, adding that "the three should instead have direct and frequent access to the bankers." In other words, the supervisors need to get closer to the people/level that they are meant to be regulating.

Right, so let's recap. Mr Lamfalussy says that 1) financial supervisors failed to spot/address the crisis and 2) the people working for the EU's new financial supervisors aren't trained properly and 3) we need to regulate closer to the ground but 4) we need to concentrate more supervisory powers at the hands of EU regulators - micro as well as macro - at the expense of experienced national authorities which, naturally, are closer to the ground.

Hmmm, something doesn't seem to add up here. Indeed, as someone once noted, "the problem with wise men is that there aren't enough of them." They tend to have an inherent bias towards whatever option they're commissioned to write about, with no one there to take a contrary view.

Judging from Lamfalussy's comments - which of course should be seen in light of his entire speech - it's not entirely clear to us whether he's making the argument for more EU supervisory powers -or less, i.e. devolving powers to a level closer to the firms that are being regulated and where the expertise also lies.

In addition, it remains unclear to us why EU supervisors would do a better job spotting bubbles and systemic risks than their national counterparts (an issue which we look at here).

Having said that, we do see potential in the European Banking Authority (on stress tests, cross-border banking wind-downs and solving host-home country conflicts) and the ESRB (to serve as a forum for exchanging information on systemic risk and keep up with new developments, such as the rise of "shadow banking" for example.)

But surely, an EU wise man must be able to put up a stronger case than this?

A fight breaks out in a bar...

Last week we organised a debate in London on the EU's proposed short-selling rules (a summary of the event can be found here). With four excellent panellists, we covered lots of ground and managed to get into the crucial details without losing track of the bigger picture (always a challenge with what is, after all, a highly technical piece of financial legislation).

The proposal is currently gridlocked in negotiations between MEPs, member states and the Commission.

As it stands, the proposed short-selling regulation is a mixed bag - some much needed transparency measures are welcome, but some provisions on the table could be counterproductive and hurt weaker European economies . In particular, MEPs want to impose a blanket ban on short-selling of "uncovered" Credit Default Swaps on sovereign debt, to counter "speculation" against weaker eurozone economies. That the Commission, and virtually everyone else, has pointed out that there is no evidence that short-selling drives up borrowing costs for governments, seems not to matter.

MEPs insistence on a blanket ban is all about political games - it has nothing to do with economic realities. As MEP Syed Kamall (who's opposing the ban) noted at the debate - and others have noted as well - when a fight breaks out in a bar, you don't hit the guy that started the fight, you hit the one you always wanted to hit (see picture - we'd like to say that the two guys sitting down chilling are representative of the UK's approach to Europe but that might be a bit harsh, at least in this case).

We take a closer look at the proposal and state of the negotiations over on Public Service Europe. We acknowledge that,

The overarching goals of the European Union's new short-selling regulations are supposed to "create a harmonised framework for coordinated action at European level, increase transparency and reduce risks". These are commendable aims, which are also widely accepted by those within the industry.

But on the proposed CDS ban, we note

In fact, in many cases, the ability to "go short" increases investments in struggling economies since it serves to reduce risks involved in that investment – while offsetting the exposure investors may have to long positions elsewhere. Take away this form of insurance, and fund managers will grow increasingly reluctant to invest in the very economies that are in need of cash inflows.

For example, take an investor who considers putting his money into a project or enterprise in one of the eurozone economies, which is struggling to cope with large levels of debt at the moment. Naturally, he will want to have a way to hedge or insure himself against potential losses, in what is a risky economic environment. One way of doing this is to take a short position on the sovereign debt of this country in order to offset some of the risk. An excessive ban on CDS short-selling activities would reduce the flexibility of markets to respond to these kinds of risks, which in turn increases the cost of capital and reduces investments in - and lending to - struggling eurozone economies.

Alluding to the "fight in a bar" analogy, we conclude,

The biggest problem with this proposal is, therefore, that it is driven by a narrow political agenda rather than economic evidence, best practice and common sense. It is easier for politicians to accuse "speculators" - a vague group of people that is never really defined - for carrying out an evil conspiracy, than to deal with the real problems facing the EU economy. Such as low growth, an undercapitalised banking sector, an unsustainable single currency and governments spending money they do not have.

Unfortunately, in this fight it seems as if, rather than improving financial regulation, struggling European countries will be hit the hardest

Gamble

Open Europe published a new briefing earlier this week, looking at the creation of three new EU supervisors to oversee the insurance, banking and securities sectors. The proposal also paves way for the creation of a so-called European Systemic Risk Board - which would be charged with scanning the markets for threats to overall financial stability. On Tuesday, EU finance ministers, including the UK's George Osborne, endorsed the proposal.

The three new EU supervisors would be given binding powers over national regulators in seven different areas, and have the right to interpret, apply and even enforce provisions in over 20 separate directives. So this involves a clear shift in supervisory powers from the national level to the EU.

But putting the power shift aside, from a crude, national interest point of view, will this benefit the UK and the City of London? The short answer is, it could - but that assumes that the UK will stamp its mark on the new supervisory structure (for the long answer - read the full report).

Problem is that relative to its share of the EU's financial markets, the voting system within the supervisors is heavily biased against Britain - most decisions will be taken by a simple majority in the board of the supervisors (consisting of one representative from each member state), which will leave the UK in an unusually weak position to block proposals it disagrees with.

This graph is pretty illustrative:


Irrespective of the merits of the proposal, somehow we doubt that France would sign up to a supervisor with the power to, say, decide the level of farm subsidies by a simple majority vote or that Spain would agree to be part of an EU body which determined fishing quotas by simple majority (both the Multiannual Financial Framework which decides the distribution of farm subsidies, and the Common Fisheries Policy are protected by a veto).

There is a clear need to establish forums for regulators, central bankers and governments to exchange information. The supervisors can also play a useful role in mediating between national supervisors in cases where large cross-border retail banks expose depositors and taxpayers in several different countries to risks.

But the new supervisors will do much more than that - and could well extend their powers incrementally. Interestingly, following the agreement on Tuesday, objections to the new structure did not come from the UK, but from the Czech Republic.

According to the Prague Daily Monitor, Czech Finance Minister Miroslav Kalousek was not entirely happy about being left hanging by his British colleague at the EU meeting. "Great Britain shared our view until yesterday [Monday] and thus has offered an extraordinary show of pragmatism", he said, warning that the new EU supervisors could cause problems in future. He said,

"I have reason to fear that problems may occur sometime in five-six years. One of these [pan-European] agencies will make a wrong decision and will cause harm. This can lead to very complicated discussions about who will pay for it."

We hope he's wrong.