European Financial Regulation

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Definition: European Financial Regulation

Full Definition of European Financial Regulation

On November 1, 1993, the Maastricht Treaty went into effect, creating the European Union (EU) and establishing EU citizenship, which included rights to vote and to run for office. For decades, Europeans had worked towards political union and a European common market. These efforts had produced a number of legal entities that survived the Maastricht Treaty, including the Council of Ministers, the European Parliament and the European Community (EC). The Maastricht Treaty granted the EC authority to set policy in many areas, including education, public health, consumer protection, the environment, economic union and technology research. The EC would also have responsibility for monetary policy, as national currencies were replaced with a common European currency called the euro. The euro was launched for use by institutions in 1999. Notes and coins first circulated in 2002. Most member nations of the EU adopted the euro. The United Kingdom was one of a handful of nations that did not. It still retains the pound as its currency.

Of European financial legislation prior to 1993, little survives. An exception is the 1985 Undertakings for Collective Investment in Transferable Securities Directive (UCITS) establishing rules for pooled investment vehicles. Funds established in accordance with these rules can be sold throughout the EU, subject to local tax and marketing laws.

Until the 1980s, the United Kingdom enforced no statutory separation of banking and securities industries but distinguished between them as a matter of custom. The Bank of England supervised banks, while securities firms—firms that broker or deal in securities—were self-regulating. The UK’s 1986 Financial Services Act changed this, establishing a separate regular for securities firms.

Germany had a tradition of universal banking, which made no distinction between banks and securities firms. Under German law, securities firms were banks, and a single regulatory authority oversaw banks. France and the Scandinavian countries had similar regimes. Accordingly, Europe supported two alternative models for financial regulation:

  • the Continental or German model of universal banking, and
  • the Anglo-Saxon or British model of separate banking and securities activities.

As the nations of Europe moved towards integrating their economies, the two models of financial regulation came into conflict. New European laws needed either to choose between or somehow blend the two approaches.

This was addressed with the 1993 Investment Services Directive (ISD), which largely left it to individual nations to maintain their own legal and regulatory frameworks for financial services. Financial firms were granted a “single passport” to operate throughout the EU subject to the laws of their home country. Home country regulators would supervise compliance with home country laws and regulations, but host countries were to specify rules of conduct and supervise compliance. This formula allowed a bank domiciled in an EU country that permitted universal banking to conduct universal banking in another EU country that prohibited it. With France and Germany committed to universal banking, the single passport model effectively opened all of Europe to universal banking. It also permitted Britain to maintain a separate regulatory framework for its non-bank securities firms.

Since the securities operations of Germany’s universal banks would be competing with Britain’s non-bank securities firms, there was a desire to harmonize capital requirements for the two. The solution implemented with the 1993 Capital Adequacy Directive (CAD) was to regulate functions instead of institutions.

The CAD established uniform capital requirements applicable to both universal banks’ securities operations and non-bank securities firms. A universal bank would identify a portion of its balance sheet as comprising a “trading book.” Capital for the trading book would be held in accordance with the CAD while capital for the remainder of the bank’s balance sheet would be held in accordance with the 1988 Basel Accord, as implemented by Europe’s 1989 Solvency Ratio Directive. Bank capital was conservatively defined according to the 1989 Own Funds Directive, but local regulators had the discretion to apply more liberal rules for capital supporting the trading book.

A bank’s trading book would include equities and fixed income securities held for dealing or proprietary trading. It would also include equity and fixed income OTC derivatives, repos, certain forms of securities lending and exposures due to unsettled transactions. Foreign exchange exposures were not included in the trading book but were addressed organization-wide under a separate provision of the CAD.

A minimum capital requirement for the market risk of a trading book was based upon a crude value-at-risk (VaR) measure intended to loosely reflect a 10-day 95% VaR metric. This entailed separate “general risk” and “specific risk” computations, with the results summed. The measure has come to be known as the “building-block” approach.

Europe developed the CAD at the same time that the Basel Committee was developing an amendment covering market risk for its 1988 Basel Accord. The two initiatives influenced each other. Essentially, Europe was pursuing locally what Basel was pursuing globally. European regulators had hoped that both initiatives could be completed simultaneously, but this was not to be. The EU had set a deadline of 1992 for reaching agreement on all significant single-market legislation. The Basel Committee’s work continued until 1996. Accordingly, the CAD was passed three years before the 1996 amendment to the Basel Accord was complete.

In 1993, the CAD and proposals for the Basel amendment were very similar. Both calculated capital requirements for a trading book based upon a building-block VaR measure. By 1996, the Basel amendment had evolved. It retained a building-block VaR measure as one option for calculating market risk capital, but it also allowed banks, under certain circumstances, to use their own internal (and presumably more sophisticated) VaR measures. Because CAD did not provide for the use of internal VaR measures, European banks were potentially at a competitive disadvantage compared to banks outside of Europe. To address this issue, Europe rushed passage of an update to CAD, called CAD II. This was somewhat of a stopgap measure. It allows European banks to base capital requirements on internal VaR measures, but it remains inconsistent with the 1996 Basel amendment in other respects. A new CAD III will implement the Basel II Accord.

In 1999, The European Commission released a Financial Services Action Plan for updating European financial regulations to address a number of developments during the 1990s:

  • The new euro currency had been adopted by the majority of member states, opening the door to further integration of financial services.
  • Trading had increased in a variety of instruments inadequately addressed by the 1993 ISD, including credit derivatives, securitizations, weather derivatives, emissions and contracts linked to freight.
  • The trading landscape was being transformed, with long-established exchanges merging or issuing stock to become public corporations while facing competition from emerging electronic trading facilities not covered by ISD.
  • Financial institutions were increasingly entering the business of offering investment advice, raising issues of moral hazard.
  • Experience with the 1993 ISD had fallen short of expectations. Financial markets remained fragmented, with a patchwork of host country regulations preventing most firms from operating on a truly pan-European basis.

The Financial Services Action Plan spawned a number of directives on issues such as market abuses, capital raising and transparency. By far the most significant new directive was the 2006 Markets in Financial Instruments Directive (MiFID). This replaced the 1993 ISD, so it was called ISD II for a time, but that name has fallen out of use.

MiFID retained the single passport mechanism with modifications. Supervision was left fully to home countries, but additional provisions promote harmonization of regulations across borders. Stock exchanges were stripped of privileges, placing them on more of an equal footing with alternative trading systems and dealers. An important (and controversial) provision requires best execution of client trades. Firms must do whatever is reasonable to ensure that client trades receive the best possible execution with regard to price and other relevant factors, such as transaction costs, speed of execution, likelihood of execution and likelihood of settlement. There are provisions requiring pre- and post-trade transparency and various client protections. Other provisions cover management of financial institutions, conflicts of interest, disclosures and record keeping.

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Definition Sources

Definitions for European Financial Regulation are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 16th April, 2020 | 0 Views.