EU maze

Outside of Brussels, little is known about how financial regulation is made. Like all regulatory processes it is complicated and fraught with political and other tensions; but it may surprise the uninitiated in its openness and transparency. Some are concerned, however, that the European institutions responsible may be creaking under the weight of the huge raft of regulation which they are committed to implementing.

Looking at the EU's financial regulatory process, perhaps any regulatory process, is a bit like taking the Rorschach test: when asked what they see in the inkblot, everybody sees something different. Where one person sees openness and access, another sees pernicious influence. Where some see debate and deliberation, others see self interest and petty point scoring. What some call advocacy, others call lobbying.

How the EU's regulatory process works – and whether it delivers sound regulation – has never been a hotter topic. In the wake of the financial crisis, Europe’s financial regulatory frameworks are being almost wholly redefined. A huge raft of regulation is in process, and it is being done at speed: the EU has committed to the G-20 regulatory agenda and a 2012 end-date for implementation.

It has never been more important or more difficult to get it right. Banks and financial markets lost credibility in the crisis and politicians are keen to be seen giving a robust response. Some believe this is a poor environment for good rule making; in the push to be seen to both punish and strengthen banks, critics fear that politicians and regulators have lost sight of the benefits of financial markets and risk damaging economic growth. They also worry that a silo approach to regulation, where each bit of the puzzle is looked at separately, means an appreciation of the cumulative effects of individual rules is lost.

Banks and trade bodies have sounded warnings that some regulation could backfire in the real economy. Many see these comments as self-serving, but criticism has also come from a source closer to home. Sharon Bowles, for example, a member of the European Parliament (MEP) for the UK's Liberal Democrat party and chair of the Economic & Monetary Affairs Committee (ECON) – the influential committee responsible in parliament for financial regulation – has been a vocal critic of some aspects of the recent regulatory push.

In a speech to the commission in April 2011, for example, she said: “I read our markets financial regulation agenda and weep.” She went on to list the inadvertent or macroeconomic effects of a host of regulations, including Solvency 2, the Alternative Investment Fund Managers Directive (AIFM), the European Market Infrastructure Directive (EMIR) and the review of the Markets in Financial Instruments Directive (MiFID 2).

Safety versus impact

Ms Bowles says that in the wake of the financial crisis, the EU principles of better regulation have been lost in pursuit of safety. But this does not always make for better regulation, she says, citing the 5% retention requirement for securitisations, which she argues fails to distinguish between good and poor securitisation.

 “[The principle of] better regulation used to be based on the efficient functioning of markets. Now the pursuit of safety and stability has become an obsession to which all else must be subordinated. This means that regulations do not always take into account their macroeconomic impact. For example, a recovery in the securitisation market – the bulk of which is done well and is necessary for funding – has been lost because of the constant rehashing of measures in the Capital Requirements Directive [CRD].”

Others, however, counter that the regulations being passed may be painful, but they are necessary steps to avoid another financial crisis. The EU must strike a balance between economic cost and stability, says Olivier Guersent, head of cabinet for Michel Barnier, the commissioner responsible internal markets and services.

“We came close to a real disaster last time and we cannot risk another one; therefore we have to equip ourselves with a new toolkit,” he says. “We estimate that CRD4, for example, will require banks to raise an additional €460bn of capital. We estimate that this will cost 0.01% of [European] GDP but will reduce the likelihood of another crisis by 70%.”

European (and other) legislators are treading a difficult line between creating safety and stability in the financial system at the same time as trying to encourage economic growth. How the various institutions of the EU – the European Commission, the European Parliament and the Council of the EU – work together, and how they interact with market practitioners, is critical in formulating regulations that fulfil these twin objectives.

How does it work?

So how are European financial regulations made? At its most basic, the process is similar to what happens on a national basis. The executive (in this case the commission) puts forward a  proposal. This is scrutinised and amended by parliament; if the council approves the parliament's version, the legislation is passed; if not, a trialogue ensues (between representatives of the commission, parliament and council) until consensus is reached, the final proposal is signed off by both parliament and the council, and a formal piece of legislation is passed. This is in the form of a regulation, which supersedes national law, or a directive, which leaves room for interpretation in a national context.

What is less understood is what goes on before and inbetween these key stages. Outside the corridors of Brussels, few people know where the ideas for legislation come from; who is involved in the consultation processes; who lobbies whom; or who makes up the working groups and committees that shape the structure of debate and the legislative outcome.

The commission is the only body within the EU with right of legislative initiative. Currently, however, most of its time is spent translating the G-20 regulatory agenda into EU legislation. Commission insiders say that more than 80% of the EU's regulatory pipeline over the past year or more has been related one way or another to G-20 commitments.

The commission does not work in a vacuum. Ideas for proposals stem from discussions with member states, the parliament and central banks, which are key contributors to the legislative debate. Discussions in think tanks, such as Brussels-based Bruegel, are sometimes used to float ideas, say some. But proposals “rarely get out of the starting gate if there is too much opposition from the member states”, says one MEP.

Consultation stage

Before a proposal is written, the commission gathers views from member states, EU bodies and industry participants using green papers. These aim to ask whether the commission should act on a particular topic and to gather relevant information that will feed into the proposal and therefore put an issue into context. According to commission staff, these can generate hundreds, or even several thousand, of responses, which must be analysed and incorporated (or not) into the formal proposal that will be put before the parliament and the council.

Increasingly, banks, trade bodies and lobbyists are trying to intervene at this 'upstream' stage. They hope to influence debate or ensure that commission staff and MEPs start from an informed position.

Deutsche Bank has a reputation in Brussels for being both proactive and effective. For example, when the US passed the Volcker Rule – which prevents US banks from doing proprietary trading or from sponsoring or investing in hedge funds and private equity – Deutsche Bank asked DG Markt (the Internal Market and Services Directorate General) if its staff would like to understand more about how the rule worked and the impact it would have. Deutsche took a team of bankers to Brussels and found virtually the entire director-general's staff waiting to listen.

Similarly, when someone in Deutsche's regulatory affairs team read a transcript of an ECON committee meeting and saw one MEP's comment, “I don't know what dark pools are, but they sound ominous,” they called the MEP concerned and asked if they would like a briefing about how dark pools worked. The MEP was delighted.

“We try to see early signs of concern and act upon them. Some of these issues are very technical, so the industry is in a good position to offer some insight into how they work,” says Andrew Proctor, a former head of enforcement at the UK's Financial Services Authority who is now head of government affairs at Deutsche Bank.

Industry participants often complain that consultation periods are too short for them to digest often hundreds of questions or topics, and to consider all the potential ramifications of a proposal.

For example, the consultation for the MiFID review was published in mid-December 2010 with the deadline for comment on February 2, 2011. Many bankers were cynical about its launch just before Christmas and the plan to have a formal proposal by the second quarter, leaving little opportunity for the commission to consider comments on what had turned into a wholesale reassessment of market structures in the EU. "The tight timescale suggests that the proposals are set, and that the review only pays lip-service to the notion of industry consultation," one market participant told The Banker at the time.

The commission's Mr Guersent says this timescale was not typical, and thinks the banks protest too much. “It is difficult to pity them. They typically have a few months and usually have more resources than us, including the best lawyers in town. Only half of DG Markt works on financial services – which means that we have less than 300 people, including the mailman, working on every piece of financial regulation [under way].”

Scrutiny in parliament

When the proposal moves to parliament it is passed to a relevant committee, which will draft the opinion that forms the basis for debate and voting by MEPs in plenary. In the case of financial legislation, this is ECON. Committee meetings are many, long and arduous. Debate can be robust and proposals are often subject to significant change. The EMIR proposal comprised 80 pages and garnered 900 amendments by MEPs; AIFM was 80 pages, with 1800 amendments. “CRD4 is 1000 pages long, you can imagine how many amendments parliament is likely to make,” says one MEP's assistant.

It is in parliament that politics enters the fray. Who chairs and sits on the committees, and who is appointed rapporteur (the author of the draft opinion and the MEP who leads a piece of legislation through parliament) can play a pivotal role in the formation of policy positions. The process can involve significant political horse-trading.

All MEPs (736 in the current parliament) are supposed to sit on two committees; one main committee and one on which they are a substitute. An attempt is made to appoint the MEPs to the committees they request, but this has to be balanced with the need to reach a national and political balance on each committee that reflects the political balance of the house.

Here is where the trading begins, with each political group pitching for the committees it thinks most important and having to give way on others. “For example, ALDI [the Alliance of Liberals and Democrats for Europe] is under-represented by one person on the ECON committee; presumably that is because at some point we traded it for something else,” says Ms Bowles, a member of ALDI.

Specialist expertise may or may not play a role in MEP selection. MEPs tend to ask for committees in their area of interest (the ECON committee has had a lot of economists, former finance ministers, and former financial markets participants, for example) but it is not a given that they will do so, or that they will get what they want.

The rapporteur and shadow rapporteurs for any given piece of legislation are appointed by the parliament's political group coordinators together with the chair and vice-chairs of each committee. Again, this involves negotiation based on the political strength of each party and what other rapporteurships they have been awarded.

Ms Bowles says that if some coordinator negotiations are "genteel", the subject matter means that ECONs are "cut-throat and political". She says the committee prevents the two biggest parties – the European People's Party and the Progressive Alliance of Socialists – from cherry picking the most important rapporteurships by allocating them in batches. “We wait until we have a chunk of rapporteurships to distribute. In this way, we've been able to give some of the rapporteurships on significant issues to some of the smaller groups,” she says. 

The rough and tumble of politics notwithstanding, Ms Bowles is at pains to point out that the parliamentary process generally works well. “Of course there are politics involved; we're politicians. But 90% of what we do is about getting it right; making sure that the technical and legal aspects are correct.”

Lobbying or advocacy?

It is when the proposal has been passed to parliament and the council that lobbying becomes most intense. Given the amount of financial regulation in process, banks and trade bodies have recently beefed up their efforts along with their regulatory affairs departments. Most have a representative in Brussels, and former regulators are in strong demand.

One MEP says: “I can't turn around in the parliament building without falling over the representative of one bank or another.”

Olivier Guersent

Olivier Guersent

Many MEPs agree that when lobbying is done well it plays a crucial role in the legislative process, providing important technical and contextual information, and helping them to see an issue from a practical perspective. However, many also say that tactics can be heavy-handed. “Threatening to take your business out of the EU is not a persuasive argument,” says the MEP.

Other commentators agree. “Coming in late with a purely defensive position is seen as self-serving in Brussels. What is needed is early, insightful help, and a coherent argument for why a particular financial activity is good for Europe,” says Malcolm Levitt, an economist who has worked at the UK Treasury, the Organisation for Economic Co-operation and Development and the European Commission, and last year published a report for the Centre for the Study of Financial Innovation in London called Getting Brussels Right.

Industry bodies try to reduce the 'noise' of lobbying by putting together industry-wide position papers and building productive relationships with commission staff and MEPs. Much of this is about shedding light on how markets really work. In the context of MiFID, for example, the Association for Financial Markets in Europe (AFME) took key MEPs' assistants onto a trading floor and sat each one next to a trader for a day.

Providing research-based evidence is also key. In relation to whether foreign exchange (FX) should be included in EMIR – the main aim of which is to push standardised over-the-counter (OTC) contracts onto exchanges and into central clearing – AFME partnered with consultancy Oliver Wyman to identify exactly what risk FX markets present. The research showed that the main risk in FX is around settlement, which accounts for about 92% of risk in transactions up to six months, while counterparty risk, which is what EMIR addresses, accounts for only 5% to 9% of the risk in a transaction.

AFME used this research as part of the financial industry's case that FX should be exempt from the scope of EMIR. Both the council and the parliament versions of the draft EMIR legislation now refer to the difference between settlement and counterparty risk with regard to FX. According to Gerry Cross, head of advocacy at AFME, this creates a good basis for discussion when EMIR gets sent to the European Securities Market Authority (ESMA), which will finalise the related technical standards and be in charge of implementation and supervision. 

“This kind of fact-based approach helps to correct misunderstandings and show how markets work in practice. This is crucial for getting the calibration of regulations right,” says Mr Cross, who was formerly deputy director of regulatory affairs in Washington, DC, for the Institute of International Finance, and who also spent eight years at the UK's Financial Services Authority, during which time he was seconded to the commission as coordinator of the CRD.

Too much influence?

Many argue that lobbying by the financial industry gives firms too much influence over the regulatory process and that banks and other entities spend millions of pounds on advocacy not to educate but to water down regulations. Earlier this year, Benjamin Fox, parliamentary adviser to the Socialist group's vice-chairman of the ECON, wrote in an article for UK magazine, Tribune, that financial lobbyists are a "malign" influence on the European parliamentary process.

“Many of the amendments to financial directives are drafted, not by politicians, but by financial sector lobbyists. In my role as an adviser to an MEP, I have seen draft amendments that have been sent to me by lobbyists being tabled, in identical form, by other MEPs – often several times... Similarly, when it comes to a vote, politicians can expect to receive detailed voting lists telling them how they can help the respective lobbyists… [This] is hardly democracy in action.”

MEPs and commission staff say this is a cynical interpretation of what happens, and argue that they are capable of separating the self-serving from the good suggestions. Others say that amendments are there to be debated. “Just because an amendment is put in does not mean that it will pass,” says Ms Bowles. “Parliament works on the notion that it is better to put ideas on the table for discussion.”

Impact of the council

In the council, the debate inevitably takes a national turn. The council is made up of one person from each member state and the presidency of the council rotates every six months to reduce the influence of one member state in the development of any single policy.

The presidency sometimes flexes its muscles. In March this year, for instance, Hungary, which was leading negotiations on the text on behalf of the council at the time, issued a revised draft of the EMIR text, which included both listed and OTC types of derivatives. This set in train a contentious debate in parliament which has helped to delay the final version of the legislation.

Council meetings are arranged by subject matter, with different national ministers attending depending on the topic under discussion. Meetings are also attended by the respective department members from the commission, who not only answer questions but indicate which amendments they will accept or not accept and therefore can have a significant impact on council negotiations.

There are a number of sub-committees and working groups; the most important for financial regulation is the Economic and Financial Affairs Council, composed of the economics and finance ministers of member states. Its role covers policy areas such as economic policy coordination and surveillance, budgetary and public finances, the euro, and financial markets and capital movements. Its decisions are mainly reached by qualified majority, with the exception of fiscal matters, which have to be decided by unanimity.

Critical to the council's work is the Committee of Permanent Representatives (Coreper), which prepares items for discussion in the council. This is split into two levels: Coreper I comprises deputy ambassadors and is responsible for issues such as environment and social affairs; Coreper II is the more important, and is made up of ambassadors from the member states' permanent representations in Brussels. It works on more contentious issues such as economic and financial affairs, justice and home affairs, and external relations. Both committees meet at least weekly and usually instruct working groups to carry out preparatory work.

The working groups and Coreper are extremely influential; it has been estimated that 70% to 90% of the council's decisions are clarified at this preparatory level and adopted by the council without further discussion. So powerful are they, that in a paper presented to a pan-European conference on EU politics in Portugal in June last year, Ingvild Olsen, from the department of political science at Aarhus University in Denmark, asked whether such groups are advisers or de facto decision makers.

This makes them a key target for lobbyists. AFME, for example, holds public policy committee meetings on a monthly basis, visiting a different city every month. In this way it is able to meet key officials from each central bank, finance ministry and the local supervisory authorities. It also has roadshows on specific topics. For CRD4 and MiFID, for example, AFME has held briefings in Paris, Berlin, Warsaw, Budapest, Rome and Copenhagen. Spending time with the upcoming council presidencies is also important, says Mr Cross.

“It is important that we build relationships with each of the participants in the process. The key personnel in finance ministries, central banks and regulators, for example, meet in working groups in the council and in the new European supervisory authorities, and therefore play a central role in the decision-making process,” says Mr Cross.

Hammer out in trialogue

When the council and parliament fail to agree, a trialogue ensues, where they and the commission must hammer out a deal. This can be a tortuous process. The AIFM directive, which aimed to regulate hedge funds and private equity for the first time, is a case in point. National interest collided with parliamentary disagreement. The UK felt its financial services would be disproportionately damaged because of the concentration of hedge funds in London, while in parliament, the directive overlapped two committees (ECON and JURI, the Legal Affairs Committee) sparking a competency battle over whose amendments should prevail.

Sharon Bowles

Sharon Bowles, MEP, chair of Economic and Monetary Affairs Committee

Ms Bowles says that the trialogue process for AIFM took at least 30 meetings lasting three-hours each before agreement could be reached. In total, it took more than 18 months to make its way from proposal to directive.

“If a piece of legislation becomes a nightmare, such as AIFM, it turns into a political football,” says another Brussels insider. “It looks like EMIR will follow a similar route.”

For EMIR, the disagreement centres on access to central counterparties (CCPs) and clearing. One stumbling block is the proposal that every CCP should allow everybody to connect to their services on a non-discriminatory basis. This is a serious issue for vertical silos, which often allow only their own platforms to connect. There is also disagreement on whether EMIR should cover listed as well as OTC derivatives. Following the amendment by the Hungarian presidency, many in the EU have agreed that it should. Others, such as Werner Langen, the conservative German MEP, who is EMIR's rapporteur in ECON, say this veers too far from the G-20’s original mandate for derivatives market reform, which focused purely on clearing standardised OTC contracts.

Critics say Mr Langen's position is more about protecting the interests of a national champion than adhering to the G-20 mandate. If exchange-traded derivatives were to fall under EMIR, Europe’s largest derivatives exchange, Eurex, owned by German exchange operator Deutsche Börse, would have to allow rival venues and clearing houses to access its vertically integrated trading and clearing silo. Mr Langen was on summer recess and was not available for comment. 

As a result of the fraught negotiations, the parliament's final vote has been delayed until September. So far, it has failed to get unanimous agreement with the council, and the issue has had to be handed over to the Polish presidency, which begins after the summer break. 

“When there are three or four areas which cannot be agreed, then legislation becomes very political and protectionism a real issue. This is where a good process can break down,” says the Brussels commentator. 

The presidency of the council can play a crucial diplomatic role at such times, says Godfried De Vidts, Brussels-based director of European affairs at interdealer broker ICAP. When the AIFM directive was mired in controversy, it was the central role of the Belgium presidency, particularly finance minister Didier Reynders, which enabled the trialogue to strike a deal. “Through hard work in council meetings and in trialogue with the parliament, Didier Reynders succeeded in getting the AIFM directive through,” says Mr De Vidts. “He helped to create an acceptable compromise that the industry can live with and the parliamentarians were prepared to vote for.”

Politicised post-crisis?

Regulation is by its nature a political process. But many suggest that it has become more politicised since the financial crisis, as fear about the stability of the banking system has rumbled on into its fourth year. Moreover, the eurozone sovereign crisis has revealed fault lines in the European project and responses at an EU level are leading to electoral unrest at a domestic level.

Politicians are therefore keen to demonstrate to their electorate that they are coming down heavily on the banking industry and over-powerful markets. This undermines the ability to be objective about contentious subjects such as commodity speculation or short-selling. One source says that when Germany introduced a ban on short-selling last year, the instruction to do so came directly from chancellor Angela Merkel's office, even though German treasury officials told the government that it was a pointless exercise.

The head of one Brussels-based trade body says that many MEPs see being tough on banks as a way to "reconnect" with a distant electorate. “They can go back to their constituencies and say: 'Look, we have clamped down on the evil bankers who caused our economic problems.' It as an easy way to score political points.”

At the commission, Mr Guersent says politicians are clearly more involved, but does not think this is necessarily negative. “If by politicised you mean that politicians are taking a keener interest in regulations, and have decided that many of the issues should not be decided by technocrats, that is certainly correct. Are they playing populism? Maybe. But there are plenty of other reasons for [the EU] to be tough on the financial sector,” he says.

If EU and US financial services have been characterised in the past decade or so by deregulation, since the financial crisis they have entered an era of re-regulation. According to David Doyle, an EU policy adviser for financial services regulation, there is expansion in scope and scale. “The new EU approach is that everything that constitutes risk should be regulated and supervised. The net has been widened dramatically both in terms of the financial instruments that should be covered and the actors who should be included,” he says.

This is coupled with the game-changing introduction of the three-pronged pan-European supervisory architecture, comprising the European Securities and Marketing Authority, the European Banking Authority and the European Insurance and Occupational Pensions Authority. This means all-change for everybody in the value chain, says Mr Doyle. “As well as giving the new supervisory authorities powers of intervention, it signals that Europe is now working towards a 'single rule book' for banking, insurance and securities regulation.”

The result will be fewer directives and more direct regulation; and this means less room for interpretation (or delay) at a local level. With regulations emerging in set rather than interpretable form, the pressure on all the participants in the legislative chain to get it right can only increase.

A gargantuan task

The process can clearly break down. AIFM is an example of what can go wrong when this happens. Similarly, there is sometimes a sense that the bits do not fit together because there is a lack of a holistic view. For example, there is no 'read across' between CRD4 and Solvency II; banks are being asked to go and raise lots more capital at the same time as insurance companies – major investors in banks, and subject to Solvency II – are being told not to invest in banks.

It is also a symptom of the gargantuan task faced by European legislators. There are currently 32 legislative bills on the table – and they have an accelerated timeline for execution because of the commitment to the G-20's 2012 deadline. Many would argue that speed, volume and good regulation are not happy bedfellows. Particularly as many suggest that legislators are ill-equipped to deal with this onslaught.

“The commission is understaffed and parliamentarians have very little support for what is an increasingly heavy workload. How can they give the necessary time to digesting each of these hefty proposals. Just the proposal for CRD4 is 1000-pages long, and its ramifications are huge. I have four people working on that single proposal full time,” says one head of regulatory affairs at a bank. “This must increase the capacity for error.”


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