Financial Regulation in the EU (eBook)

Raphael Douady is a French mathematician and economist.  He holds the Frey Family Endowed Chair of Quantitative Finance at Stony Brook University (SUNY), and is also the International Representative (and former Academic Director) of the Laboratory of Excellence on Financial Regulation (Labex ReFi, a joint initiative of Paris 1-Sorbonne University, ESCP-Europe, CNAM and ENA) and is affiliated with the French National Centre for Scientific Research (CNRS).  He co-founded fin-tech firms Riskdata (1999) and Datacore (2015).  He has more than twenty years of experience in the banking industry and thirty-five years of research in pure and applied mathematics.  His current research focus is systemic risk and the anticipation of financial market crises. His background in pure mathematics is in dynamical systems, chaos theory and symplectic geometry. He studied at Ecole Normale Supérieure in Paris and earned his PhD in mathematics in 1982 from the University of Paris 7.Clément Goulet graduated from Paris 1 Panthéon-Sorbonne University, France, in Applied Mathematics. He is now a Doctoral Researcher with LabEx RéFi, working on forecasting techniques in finance. He lectures at Paris 1 Panthéon-Sorbonne University, France, where he also runs a doctoral seminar. Pierre-Charles Pradier is a Lecturer at Paris 1 Panthéon-Sorbonne University, France. He has been the Dean of the Economics Department, before serving as Vice-Provost, then Dean of the National School of Insurance (ENAss/CNAM). He joined LabEx RéFi in 2010 to coordinate teaching programmes. He lectures on applied microeconomics, financial economics and statistics.

Contents 5
List of Figures 8
List of Tables 11
1: Introduction 13
References 17
Part I: Supervision of Member States’ Budgets 18
2: Political Economy of the European Monetary Institutions and Reform Proposals 19
2.1 Introduction 19
2.2 EMU Institutional System and Fiscal Policy: Theory and Historical Overview of the Reforms 21
2.2.1 Fiscal Policy in the EMU: Theory 21
2.2.2 The “Original” Stability and Growth Pact 23
2.2.3 The Fiscal Reforms Accomplished as a Consequence of the Crisis 24
2.2.3.1 The Reform of the SGP 26
2.2.3.2 The European Semester 29
2.2.3.3 The Euro Plus Pact 30
2.2.3.4 The Fiscal Compact 30
2.2.3.5 Financial Facilities to Allow Member States to Benefit from Financial Assistance in Case of Distress 31
2.3 The ECB and Monetary Policy Since the Creation of the EMU 33
2.3.1 Mandate and Structure 33
2.3.2 Phases of the ECB Monetary Policy 34
2.3.3 Extension of the ECB’s Tasks 36
2.4 Review of the Different Proposals for a New Economic Governance in the EMU 38
2.5 Conclusions 45
2.6 Annex 46
References 50
3: Fiscal Sustainability and Fiscal Rules in a Monetary Union: Theory and Practice in Europe 53
3.1 Introduction 53
3.2 Why (and How) Does Fiscal Policy Need to Be Constrained? 55
3.2.1 Public Debt Sustainability and Fiscal Policy Rules 56
3.2.2 Fiscal Discipline Within a Monetary Union 61
3.3 European Fiscal Rules: Too Tight? Too Loose? Or Both? 66
3.3.1 Are European Fiscal Rules Ensuring the Sustainability of Public Finance? 67
3.3.2 Procyclical Bias in European Fiscal Policy Rules 70
3.3.3 Was the European Debt Crisis the Result of Irresponsible Fiscal Policies? 73
3.4 Conclusions 74
References 75
4: The Composition Effect of New Fiscal Rules in the Euro Area 79
4.1 European Total Expenditures, by Country and Function 80
4.2 A Brief Literature Review of the Economic Impact of Public Investment 84
4.3 Deficit of Public Investment and the Juncker’s Investment Plan 88
References 91
5: The Banking Union Revisited 95
5.1 Background 96
5.2 Benefits of Banking Union 97
5.3 The Single Supervisory Mechanism 99
5.3.1 The Three Pillars and Their Sequencing 99
5.3.2 The Central Role of the ECB 100
5.3.3 The Necessity of Coordination 101
5.3.4 Micro- and Macroprudential Measures 102
5.3.5 Potential Conflicts within the ECB 103
5.4 The Single Resolution Mechanism 104
5.4.1 The Legal Basis for Bank Resolution 104
5.4.2 The Basic Ingredients of Bank Resolution 105
5.4.3 Organizing Bail-in Procedures 105
5.4.4 Governance, Funding and Fiscal Backstop 106
5.5 Deposit Insurance 107
5.6 Other Structural Issues 108
5.6.1 The Ins and the Outs 108
5.6.2 The Separation of Bank Activities 109
5.6.3 CMU and the Financing of the Real Economy 110
5.7 Concluding Remarks 112
References 113
Part II: Supervision of Financial Entities 114
6: Regulatory Capture in Financial Supervision 115
6.1 The Concept of Capture 116
6.1.1 Materialist Capture 117
6.1.2 Non-Materialist Capture 118
6.2 The Normalization of Capture 121
6.2.1 Institutionalization 122
6.2.1.1 Rationalization 122
6.2.2 Socialization 123
6.3 Are Financial Supervisors Insulated from Capture? 124
6.3.1 Materialist Capture 124
6.3.2 Non-Materialist Capture 126
6.4 The Limits of the Concept of Capture 127
6.5 Concluding Remarks 128
References 128
7: The Challenges of Regulation of Derivatives 131
7.1 Introduction 131
7.2 Structure of Derivatives 132
7.3 Collapse of Bretton Woods and the Rise of Hedging 134
7.4 Transformation of Hedging into Arbitrage 135
7.5 Speculative Capital 140
7.6 Characteristics of Speculative Capital 141
7.7 Forwards and Forward-like Derivatives 143
7.8 Options and Option-like Derivatives 145
7.9 Synthetic Derivatives 150
7.10 Conclusion 156
References 156
Books 156
Newspapers and Online 157
8: The challenges and implications of the Markets in Financial Instruments Directive (MiFID) and of its revision (MiFID II, MiFIR) on the efficiency of financial markets 158
8.1 Introduction 158
8.2 Context in which MiFID was implemented and its first objectives 160
8.3 The efficiency of financial markets 162
8.3.1 Informational efficiency and the Efficient Market Hypothesis (EMH) 162
8.3.2 Operational efficiency or the microstructure research area 163
8.3.3 Allocative efficiency 164
8.4 The challenges and the key regulatory contributions of MiFID 166
8.4.1 Challenges around the competitiveness and the efficiency of financial markets 167
8.4.2 Challenges around the investor protection 168
8.4.3 Challenges around transparency and the quality of markets 169
8.4.4 Challenges around the supervision and the enforcement of the financial regulation 170
8.5 A first assessment of MiFID with the remaining challenges for MiFID II and MiFIR 170
8.6 The implications of MiFID and MiFID II/MiFIR on the efficiency of financial markets 173
8.6.1 Developments in market structures: The implications of the suppression of the national order flow concentration rule and of the introduction of alternative venues (MTFs, SIs and OTFs) on the liquidity 173
8.6.2 Developments in the design rules: The implications of the Best Execution policy and financial innnovations on price formation and the price discovery process 178
8.6.2.1 Developments in the design rules and the Best execution policy 178
8.6.2.2 Developments in design rules and financial innovations 179
8.6.3 Information and disclosure: The implications for the transparency and the quality of markets 181
8.6.4 Market microstructure interfaces with the other areas of finance 184
8.7 Conclusion: United in diversity after the Big Bang and the crisis of 2008 ? 184
8.8 Appendix 186
Bibliography 203
9: The Evolution of Insurance Regulation in the EU Since 2005 206
9.1 Introduction 206
9.2 Market Regulation 207
9.2.1 Price Regulations 208
9.2.2 Consumer Protection 210
9.3 The Solvency II Process 212
9.3.1 Objective and Features of the Solvency II Package 212
9.3.2 Positive Interpretation 215
9.3.3 Criticism 218
9.3.3.1 Accounting-Capital Requirements Feedback Loop 219
9.3.3.2 Long-Term Financing and Asset Concentration 220
9.3.3.3 Very Low Predictive Power 222
9.4 Systemic Risk Regulation 225
9.4.1 From Academic Evidence to Enhanced Supervision of GSII 225
9.4.2 The Insurance Business Is Not Systemic 226
9.4.3 Is the Bank Metaphor Fully Justified? 227
9.5 From Private to Social Costs 228
9.5.1 How Many Costs? 228
9.5.2 The Cost to the Insurance Sector (See Also Appendix 9.2) 230
9.5.2.1 Sector-Wide Costs 230
9.5.2.2 Individual Level Costs 231
9.5.3 From Costs to Concentration and Uniformization 233
9.6 Rationale for Regulation and Future Agenda 238
9.6.1 Addressing Transition Costs and “Regulatory Avalanche” 240
9.6.2 Toward Focused Supervision 241
9.6.3 From (Infinite) Layer Cake to Fitness Menu 243
9.7 Conclusion 243
Appendix 9.1: Relative Insurance Prices in EU28 245
Appendix 9.2: Cost of Insurance Regulation in EU28 246
Appendix 9.3: Insurance Core Principles 248
Insurance Core Principles (ICP) 248
Common Framework for International Groups and Capital Standard 251
Additional Supervision Requirements for G-SIIs 252
Bibliography 252
10: The Impact of Basel III on the Operations of Retail Banks 259
10.1 Improving the Reliability and Safety of Financial Institutions 261
10.1.1 The Progressive Increase in Capital Equity Required by Regulators 261
10.1.2 The Reduction in the Risk Exposure 263
10.1.2.1 The Consequences in Terms of Credit Risk Policies 265
10.1.2.2 When Retail Banks Develop Internationally 266
10.1.3 Raising Equity Capital and the Capacity to Absorb Losses 268
10.1.4 Strengthening Liquidity 271
10.2 Improving the Control of Financial Institutions 274
10.2.1 The Strengthening of Financial Institutions’ Governance 274
10.2.1.1 Regulatory Requirements in Terms of Governance Quality 275
10.2.1.2 Consequences for the Recruitment of Directors 277
10.2.2 Clearer Organization and Responsibilities 278
10.3 Conclusion 280
References 281
11: The Knowns and the Known Unknowns of Capital Requirements for Market Risks 282
11.1 Introduction 282
11.2 Market Regulation 283
11.2.1 Higher Solvency Ratios (CET1/RWA) 284
11.2.2 A More Restrictive Notion of Prudential Equity Capital (CET1) as the Numerator of Solvency Ratios 285
11.2.3 Improved Monitoring of Counterparty Risks 286
11.2.4 Leverage Ratio Acting in Principle as a Backstop 286
11.3 The Reasons for Overhauling the Calculation of Risk Weighted Assets on Trading Books 287
11.4 The Present State of Reforms in the Calculation of Risk Weighted Assets on Trading Books 292
11.4.1 The Rise of Standardized Approaches 293
11.4.2 The Reformulation and Supervision of Internal Models 297
11.4.3 Differentiated Liquidity Horizons and the Limits to Benefits from Diversification 297
11.4.4 Default Risks in the Trading Book 298
11.5 Future Trends 300
11.6 Rethinking Banks’ Capital Markets Activities 302
11.7 Conclusion 305
Bibliography 309
12: Reforming Rating Agencies 313
12.1 Rating Activity’s Characteristics 313
12.1.1 Rating Agencies Give Information to Investors About the Credit Risk of Issuers 313
12.1.2 Issuer Paying System 314
12.1.3 Rating Through the Cycle 315
12.1.4 The International Credit Rating Sector Is an Oligopoly 316
12.2 Criticisms Towards the Activity of Rating Agencies 318
12.2.1 Conflict of Interest 318
12.2.2 Sluggishness 319
12.2.3 Toughness 319
12.3 The Utility of Rating Agencies 319
12.3.1 Credit Rating Agencies Have a Certification Function 319
12.3.2 Credit Rating Agencies Have a Stabilizing Effect on the Bond Market and Give a Profit Opportunity to Informed Investors 320
12.4 Improving Bond Market Regulation 321
Bibliography 322
13: The Regulation of Alternative Investment Funds in Europe: The Alternative Investment Fund Managers Directive 324
13.1 Introduction 324
13.2 The Difficulties in Approving the AIFMD 327
13.3 The Creation of a Residual Category 334
13.3.1 The Notion of “Alternative Investment Funds” in the AIFMD 334
13.4 Further Specifications by ESMA 338
13.5 The AIFMD as a Model of Direct Regulation 342
13.6 Authorization 344
13.7 Information To Be Provided 345
13.8 Initial Capital and Own Funds 347
13.9 Operational Requirements 348
13.10 Leverage 351
13.11 Critical Remarks 352
13.12 Conclusions 355
14: The Regulation of CCPs in Europe: The European Market Infrastructure Regulation (EMIR) 357
14.1 Introduction 357
14.2 Definition of Market Infrastructure and CCPs 359
14.2.1 The Functions of CCPs 362
14.3 Pros and Cons of CCPs 365
14.3.1 Benefits of Clearing Houses 365
14.3.2 Negative Effects 367
14.4 An Overview of EMIR 370
14.4.1 General Elements 370
14.5 The Provisions of EMIR for CCPs 372
14.5.1 Corporate Governance of CCPs 374
14.6 Prudential Requirements for CCPs 378
14.7 Critical Considerations 382
14.8 Conclusions 384
Part III: Funding Innovation, Financing Growth 385
15: The Impact of Regulatory Capital Regulation on Balance Sheet Structure, Intermediation Cost and Growth 386
15.1 Novelties of Basel III (CRD IV/CRR) and Their Anticipated Effects on Lending 389
15.1.1 Capital Requirements 389
15.1.2 Overall Leverage 391
15.1.3 Liquidity Ratios 391
15.1.3.1 Short-Term Liquidity 392
15.1.3.2 Long-Term Liquidity 392
15.2 Regulatory Impact on Financing Businesses 392
15.2.1 Interest-Rate Reliant Impact Studies 393
15.2.2 New Theoretical Developments 394
15.3 What Is the Binding Constraint? 396
15.3.1 Unpalatable Empirical Facts 396
15.3.2 Theoretical Explanations 397
15.3.3 A Narrative Since the Crisis 399
15.4 From Prevision to Recommendations 400
15.4.1 Plausible Next Months 401
15.4.2 Tuning Regulation to Trigger Growth 401
15.5 Conclusion 402
References 403
16: Higher Quality Securitization 405
16.1 Introduction 405
16.2 Securitization 407
16.3 European Commission Proposal 2015/0226 (COD) 409
16.3.1 Rationale, Concerns and Incentives 410
16.3.2 General Rules for all Securitizations 411
16.3.3 Additional Rules Specific to STS Securitizations 414
16.3.4 Issues Arising from the Regulation 415
16.4 Case Study: CLO: High Yield Corporate Financing 420
16.4.1 CLO Characteristics 420
16.4.2 Level of Risk Retention Capital 423
16.4.3 International Convergence 428
16.5 Insolvency Law Reform in Europe 430
16.5.1 Firms of Significant Size (Debt Could be Securitized) 432
16.5.2 Small and Medium Businesses 433
16.6 Conclusion 433
16.7 Annex 434
17: Essay on the State of Research and Innovation in France and the European Union 436
17.1 Introduction 436
17.2 The Tools of Innovation and Economic Growth 438
17.2.1 The Legal Framework of Innovation 438
17.2.1.1 Public Research and Innovation Structures 438
17.2.1.2 Private Research and Innovation Structures 441
17.2.1.3 Business and Research Clusters (“Pôles de Compétitivité”) 443
17.2.2 A Flawed System: Comparison with Other Developed Countries 444
17.3 The Financing of Innovation in Enterprises 446
17.3.1 Public Financing 446
17.3.2 Private Financing 450
17.3.2.1 Companies That Have Access to the Stock Market 450
17.3.2.2 Companies That Aren’t Listed on the Stock Market 454
17.3.2.3 The Case of the Start-Up Companies 459
17.3.3 European Financing 463
17.3.3.1 European Programmes 463
17.3.3.2 The European Investment Bank (EIB) 464
17.4 Conclusion 467
References 470
Name Index 472
Subject Index 477