Regulation of Financial and Capital Markets Petr Gapko

Regulation of Financial and Capital Markets Petr Gapko

What are Financial and Capital Markets? • Financial markets in economics are markets, where participants can trade securities, insurance, money, commodities and other fungible items at low transaction costs. • We divide financial market as follows: – – – Money Market Capital Market (Primary and Secondary) Insurance Market Derivatives Market Forex Market Other Markets

What do we need to regulate? • • Financial intermediates – BANKS, brokers, … Flow of money Financial risks Information Behavior Participants Debts • The toughest regulation - LICENCES

Who regulates? • Supervisor of Financial markets – Central Bank – Regulates banks on the basis of Basel II – In CR – Czech National Bank (CNB) • Supervisor of Capital & Securities markets – Securities Exchange Commission (SEC) – Uses the Mi. FID framework – In CR SEC is a part of CNB – Supervises whole markets and intermediates • Supranational supervision: EU Commission, ESMA, European Banking Authority (EBA) – EU Commission develops the framework – CNB has a real domestic regulatory function – EBA performs the EU-wide regulation institution

Who regulates? • Banking Regulation – 1 st level of regulation: National regulator (CNB) • Regulates intra-market entities (banks in the Czech Republic) – 2 nd level of regulation: Supranational regulator (EBA) • Regulator of regulators (supervises national forms of regulations) – 3 rd level of regulation: Legislative regulator (European Commission, European Parliament) • Regulator of the law (sets up the rules) • Capital & Securities Markets – 1 st level of regulation: National regulator (CNB) • Regulates intra-market entities (banks in the Czech Republic) – 2 nd level of regulation: Supranational regulator (ESMA) • Regulator of regulators (supervises national forms of regulations) – 3 rd level of regulation: Legislative regulator (EC, EP) • Regulator of the law (sets up the rules)

Who regulates? • But…what about a bank with HQ in Austria and operating activities in the CR? ? ? – Home vs. host regulator principle • • Home regulator of the Austrian bank is always an Austrian regulator Host regulator is then the Czech regulator Co-operation between the home and the host regulator Regulation on the individual and consolidated basis • What if the bank operating in the CR has been established in a non-EU country? – Only that part of the bank operating in the EU can be regulated – Czech regulator acts as a home regulator for the part of the bank operating in the Czech Republic

“Mi. FID” Directive • The Markets in Financial Instruments Directive (Mi. FID) goal: – to complete the process of creating a single EU market for investment services – to respond to changes and innovations which have occurred in securities markets – to protect investors by making markets deeper, more competitive and more robust against fraud and abuse • Replaces the Investment Services Directive (Directive 93/22/EEC) • Mi. FID is the cornerstone of the European Commission's Financial Services Action Plan

“Mi. FID” Directive – Key aspects • • Authorisation, regulation and passporting Client categorisation Client order handling Pre-trade transparency Post-trade transparency Best execution Systematic Internaliser

Mi. FID - Authorisation, regulation and passporting • Firms covered by Mi. FID will be authorised and regulated in their "home state" (broadly, the country in which they have their registered office). Once a firm has been authorised, it will be able to use the Mi. FID passport to provide services to customers in other EU member states. These services will be regulated by the member state in their "home state" (whereas currently under ISD, a service is regulated by the member state in which the service takes place).

Mi. FID - Client categorisation • Mi. FID requires firms to categorise clients as "eligible counterparties", professional clients or retail clients (these have increasing levels of protection). Clear procedures must be in place to categorise clients and assess their suitability for each type of investment product. That said, the appropriateness of any investment advice or suggested financial transaction must still be verified before being given.

Mi. FID - Client order handling • Mi. FID has requirements relating to the information that needs to be captured when accepting client orders, ensuring that a firm is acting in a client's best interests and as to how orders from different clients may be aggregated.

Mi. FID - Pre-trade transparency • Mi. FID will require that operators of continuous ordermatching systems must make aggregated order information on "liquid shares" available at the five best price levels on the buy and sell side; for quotedriven markets, the best bids and offers of market makers must be made available.

Mi. FID - Post-trade transparency • Mi. FID will require firms to publish the price, volume and time of all trades in listed shares, even if executed outside of a regulated market, unless certain requirements are met to allow for deferred publication.

Mi. FID - Best execution • Mi. FID will require that firms take all reasonable steps to obtain the best possible result in the execution of an order for a client. The best possible result is not limited to execution price but also includes cost, speed, likelihood of execution and likelihood of settlement and any other factors deemed relevant.

Mi. FID - Systematic Internaliser • a Systematic Internaliser is a firm that executes orders from its clients against its own book or against orders from other clients. Mi. FID will treat Systematic Internalisers as mini-exchanges, hence, for example, they will be subject to pre-trade and post-trade transparency requirements

Basel II – need for capital soundness • Issued by the Basel Committee on Banking Supervision • Transposed to the EU law by a CRD (Capital Requirements Directive) • The purpose is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face • Claims that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold • Main aims: – – – Ensure that capital allocation is more risk sensitive; Separating operational risk from credit risk, and quantifying both; Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

Basel II – need for capital soundness • Based on three pillars: – (1) minimum capital requirements (addressing risk) – (2) banks’ own internal capital requirements assesment and supervisory review – (3) market discipline – to promote greater stability in the financial system • Biggest difference between Basel I and Basel II: – In the first pillar, only credit risk was dealt with in Basel I. Market risk was an afterthought and operational risk was not dealt with at all – Second and Third pillars were not dealt with in Basel I at all

Basel II – The First Pillar • The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. Other risks are not considered fully quantifiable at this stage. • The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB stands for "Internal Rating-Based Approach". • For operational risk, there are three different approaches basic indicator approach or BIA, standardized approach or STA, and advanced measurement approach or AMA. • For market risk the preferred approach is Vaule-at-Risk

Basel II – The Second Pillar • The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as – – – – systemic risk pension risk concentration risk strategic risk reputation risk liquidity risk legal risk

Basel II – The Second Pillar • Bank should identify all potentially material risks it faces and develop appropriate methods to measure them • Bank should construct a forward looking (at least) three year capital plan and stress it • Bank should maintain appropriate risk governance structure, create an independent risk function and allocate sufficient sources for sound risk management • The bank’s process of risk management together with main numeric outputs is reported to the regulator once a year in an ICAAP report • Regulators should audit on a regular basis the bank’s risk management process: SREP (supervisory review and evaluation process)

Basel II – The Third Pillar • The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately. • Each bank should regularly (quarterly) publish quantitative as well as qualitative information such as exposures, capital requirements, positions in derivatives, ownership structure, governance structure, financial results… • All the information have to be reported not only to the regulator, but also should be publicly available (i. e. bank’s web site)

Basel II – The Future • Work is apparently already finished on Basel III. The goals of this project are to refine the definition of bank capital, quantify further classes of risk and to further improve the sensitivity of the risk measures. • Basel III will impose further rules on especially liquidity management and capital adequacy • Bsel III document ready, split into CRR and CRD. • Readings: – http: //www. bis. org/publ/bcbs 164. htm – http: //www. bis. org/publ/bcbs 165. htm

Basel III main enhancements New definition of capital Capital buffers Liquidity requirements Leverage ratio Counterparty credit risk Bank resolution framework

Basel III regulation vs. directive CRD IV Capital buffers, Corporate governance, Sanctions, Regulation Practice CRR IV Capital requirements, Liquidity requirements (LCR 2015? , NSFR 2018? ), Leverage ratio (Pillar II 2015? , Pillar I 2018? ), Counterparty credit risk Enforcement CRD/CRR IV implementation in 2019 planned from 2013, full

CRR: Capital Definition Capital Requirements Regulation capital definition: - Tier 1 + Tier 2 (no Tier 3) Tier 1 further decomposed into: - Core Tier 1 (shareholders’ equity ) - Additional Tier 1 Core Tier 1 requirements: 3, 5 % by 31. 12. 2013 4, 0 % by 31. 12. 2014 4, 5 % by 31. 12. 2015 Tier 1 requirements: 4, 5 % by 31. 12. 2013 5, 5 % by 31. 12. 2014 6, 0 % by 31. 12. 2015

CRD: Capital buffers Conservation buffer - Created from the Core Tier 1; can be breached, but in case of breach limitations on dividend repatriation - Applied from 1. 1. 2016 - From 1. 1. 2016 by 31. 12. 2016 max 0, 625 % - From 1. 1. 2017 by 31. 12. 2017 max 1, 25 % - From 1. 1. 2018 by 31. 12. 2018 max 1, 875 % - From 1. 1. 2019 max 2, 5 % Countercyclical buffer - Specific for individual countries, EU regulatory body creates methodology, applied by regulators in individual countries - Can be applied for specific institutions - Calculated quarterly, based on the deviation of a ratio of loans to GDP from a trend and other macroeconomic indicators - Enforcement the same with conservation buffer but can be extraordinarily higher

Capital requirements in summary

Globally Systemically important financial institutions(G-SIFI) Too big to fail 2009 Second meeting of G 20: We want more regulation to prevent the systemic risks 2010 Financial Stability Board (FSB) developed a policy framework (final implementation 2019) Incorporated according to size, complexity and systemic interconnectedness

Policy measures • Recovery and resolution planning • Powers for regulators • Higher capital requirement (1% - 3. 5%) • More intensive supervision

G-SIFI • 2011 Basel Committee on Banking Supervision – methodology for banks (will be extended to nonbanks) • International Association of Insurance Supervisors – methodology for insurance companies (31. 6. 2012) • 2011: 29 banks (17 Europe, 8 America, 4 Asia) (revision in November) • Starting November 2014 (FSB)/ Report by EU Commission December 2014

G-SIFI in 2011 (based on 2009 data) Belgium: Dexia China: Bank of China France: Banque Populaire, BNP Paribas, Crédit Agricole, Société Générale Germany: Commerzbank, Deutsche Bank Italy: Unicredit Japan: Mitsubishi, Mizuho, Sumitomo Mitsui Netherlands: ING Spain: Santander Sweden: Nordea Switzerland: Credit Suisse, UBS UK: Barclays, HSBC, Lloyds, Royal Bank of Scotland US: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, State Street, Wells Fargo

Recommended literature • BASEL II – The New Basel Capital Accord (Downloadable from: http: //www. bis. org/publ/bcbsca. htm) – Marc Saidenberg, Til Schuermann: The New Basel Capital Accord and Questions for Research (Downloadable from: http: //fic. wharton. upenn. edu/fic/papers/03/0314. pdf) • Mi. FID – COMMISSION DIRECTIVE 2004/39/EC (Mi. FID Level 1) – COMMISSION DIRECTIVE 2006/73/EC (Mi. FID Level 2) – COMMISSION REGULATION (EC) No 1287/2006

Thank you for your attention… …Any questions? • My contact details for consultations: – Petr Gapko (petr. gapko@seznam. cz)