Malta: Being Better Informed: FS Regulatory, Accounting And Audit Bulletin - December 2012

EXECUTIVE SUMMARY

Welcome to this edition of "Being better informed", our monthly FS regulatory, accounting and audit bulletin, which aims to keep you up to speed with significant developments and their implications across all the financial services sectors.

The FSB led the surge of Shadow Banking policy recommendations published in November, which we summarise in this month's Feature.

The FSB also looked at how shadow banking has grown globally in is its shadow banking monitoring report. At this time assets in the aggregate shadow banking system are about half the size of assets in the traditional banking system.

In Europe, a number of legislative initiatives are delayed until 2013. On the insurance front, a further delay to Solvency II implementation now seems inevitable. But in Laying the foundations for the future of insurance reporting we make a case for adopting both sets of requirements now, to minimise the expense and disruption that would occur later.

In the UK, the FSA published its first consultation to implement AIFMD.

In 2013, many of areas of regulation will take shape as European regulators finalise key legislative initiatives and the UK launches its new regulatory regime.

• For the banks, it's about improving their culture and rebuilding profitability, while at the same time coping with new capital requirements under CRD IV. Banks will also need to adopt the new supervisory approaches presented by the EU banking union and the launch of the PRA, and continue clean-up efforts on prior misdeeds.
• Insurers will be hoping that their work on Solvency II doesn't go stale during the hiatus, and will look more closely at investor disclosure and conduct issues.
• Asset managers will be grappling with more strict MMF regulation, UCITS changes and the new alternative investment fund regime, while trying to work out what the FCA wants from them on the competition front.

We'll take a closer look at the 2013 regulatory landscape next month. We wish you all the joys of the holiday season and a Happy New Year, from all of us in the PwC Regulatory Practice.

Laura Cox
FS Regulatory Centre of Excellence

SHADOW BANK OF THE FUTURE?

FSB introduces global regulatory structure

After a mid-year lull, international regulators and policy setters released more than half a dozen shadow banking proposals in November. The FSB led the way by publishing four documents, with IOSCO contributing a report on Global Developments in Securitisation Regulation and the FSB releasing its second annual Global Shadow Banking Monitoring Report.

The FSB published two consultations which set out the foundations of a new global shadow banking regime. An Integrated Overview of Policy Recommendations presents the FSB's overall approach to shadow banking issues, while the Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities introduces a high-level policy framework for regulators to assess and mitigate bank-like systemic risks posed by most shadow banking entities. The FSB also released a further consultation, Policy Recommendations to Address Shadow Banking Risks in Securities Lending and Repos, putting forward 13 suggestions to enhance transparency, strengthen regulation of securities financing transactions and improve market structure. The three consultations close on 14 January 2013.

This article outlines the key FSB proposals and findings from the Global Monitoring Report, explains the international work streams' structure and summarises the status of each initiative as at the end of November 2012. We also touch on recent activity in Europe from the EP and from the FSOC in the US.

Getting on top of Shadow Banking

The financial crisis exposed the deep interdependence of the banking sector with non-bank entities which also undertake forms of credit intermediation and are dubbed 'shadow banks'. Therefore regulators are seeking to appropriately regulate the non-banking sector, when involved in such activities. "You cannot tackle systemic risks unless you tackle things other than banks." said Vikram Pandit, former Citigroup CEO.

After agreeing Basel III capital and liquidity reforms, G20 leaders tasked the FSB with developing proposals to strengthen the oversight of the shadow banking system. At the Cannes Summit in November 2011 G20 leaders endorsed the FSB's initial recommendations to make the shadow banking system safer.

The FSB then delivered its detailed proposals to the G20 Central Bank Governors and Finance Ministers at the Mexico City Summit on 5 November 2012. The Communiqué from the meeting called for the FSB to produce final policy measures for the St Petersburg G20 summit in 2013.

The FSB has organised its shadow banking work into five work streams:

1. interaction between banks and shadow banking
2. MMFs
3. other shadow banking entities (excluding MMFs)
4. securitisation and
5. securities lending and repos.

The Basel Committee is reviewing the interaction between banks and shadow banking, and IOSCO is managing the work streams on MMFs and securitisation. The FSB is leading the work streams exploring other shadow banking entities' and securities lending and repos.

Improving monitoring and data reporting on agenda

The FSB's second annual Global Shadow Banking Monitoring Report surveys 25 countries (the 24 FSB countries and Chile), 11 more countries than last year. The report aims to look at the big picture on shadow banking activity, examining national flows of funds across all types of non-bank intermediation. It found that:

• Shadow banking grew rapidly before the crisis, rising from $26 trillion in 2002 to $62 trillion in 2007. The system declined slightly in 2008 but then reached $67 trillion in 2011.
• Shadow banking's share of total financial intermediation has decreased since the crisis. It remained at 25% in 2009-2011 after peaking at 27% in 2007. The aggregate size of the shadow banking system is around half the size of the banking system's assets.
• The US had the largest shadow banking system with $23 trillion in 2011, followed by the euro area ($22 trillion) and the UK ($9 trillion).

The FSB believes that although regulators have improved the monitoring process - increasing its scope and data granularity - they need to do more to reach a satisfactory level of supervision. The FSB recommends that regulators use additional analytic methods based on market supervisory practices and gather more data. They should aggregate better international data to provide an accurate assessment of the potential risks posed by shadow banking. The FSB observes that they have insufficient for countries such as Russia, China and Saudi Arabia, and believes that large international financial institutions should be providing more data.

Progress on the work streams

Work Stream 1: Banks' interaction with shadow banks

Since the crisis, the Basel Committee has been considering possible rules to better manage banks' exposures to shadow banking entities beyond Basel III. Building on its July 2012 interim report, the Basel Committee will put forward detailed policy recommendations by mid-2013 on:

• Scope of consolidation: additional guidance to improve the international consistency of the scope of consolidation for prudential regulatory purposes. The guidance will clarify how banks should consolidate their shadow banking
• exposures, with rules drafted to limit regulatory arbitrage opportunities.
• Large exposures: developing a large exposure regime that takes into account risks typically arising from the shadow banking system, such as interconnectedness and opacity.
• Banks' investment in funds: introducing a more consistent and risk sensitive international capital treatment for bank investment in funds to better reflect the funds' underlying investments and leverage.

The Basel Committee also considered capital requirements relating to banks' short- term liquidity facilities to shadow banking entities (e.g. MMFs), but decided to take no further action. The Basel Committee was concerned that there could be unintended adverse affects, such as reducing the sensitivity of capital regimes to risk. Further, Basel III liquidity requirements were considered sufficient in addressing this risk.

Work Stream 2: MMFs

Following consultation, IOSCO published its Policy Recommendations for Money Market Funds in October 2012. The FSB endorsed IOSCO's paper as an effective framework in its entirety. The FSB particularly supports the Recommendation 10 requirement that stable NAV MMFs should be converted into floating NAV where possible. Where that is not possible, the FSB recommends that measures to safeguard MMF's resilience against runs should be functionally equivalent to the bank capital and liquidity requirements which protect against runs on deposits.

The US, which has the largest MMF market, has been wrestling with MMF reforms for some time. The FSOC published Proposed Recommendations Regarding Money Market Mutual Fund Reform on 13 November 2012. The FSOC argues that even a small threat to a MMF can start a run, because MMFs cannot absorb losses in their holdings without depressing the market value of their shares. The FSOC's recommendations follow proposals put forward by SEC Chairman Mary Shapiro in February 2012, which the SEC did not adopt. Chairman Shapiro called for a floating NAV or a tailored capital buffer of less than 1% of a fund's assets. The FSOC will send its final recommendations back to the SEC to take action.

The FSOC's proposals build on Chairman Shapiro's proposals:

1. Floating NAV: removing an accounting exemption that allows MMFs to maintain a stable NAV would encourage most MMFs would move to a floating NAV.
2. Stable NAV with NAV buffer and 'minimum balance at risk': MMFs would hold a buffer of up to 1% of assets to absorb daily fluctuations, to enable them to achieve a stable NAV. The buffer would be paired with a requirement for MMFs to hold an amount equal to 3% of a shareholders' highest account value, in excess of $100,000, available for redemption on a delayed basis. If an MMF suffers losses that exceed the NAV buffer, the losses would be borne first by shareholders who had recently redeemed - creating a disincentive to redeem and protecting remaining shareholders.
3. Stable NAV with NAV buffer and other measures: MMFs would hold an NAV buffer of 3% to provide "explicit" loss absorbency, combined with other measures such more stringent investment diversification requirements, increased minimum liquidity levels and more robust disclosure requirements.

The FSOC stresses that the proposed recommendations are not mutually exclusive. The consultation closes on 11 January 2013.

Work stream 3: Other shadow banking entities

The FSB proposes a package of diagnostic and policy tools to manage the risks presented by 'other shadow banking' entities. Once those are agreed, the FSB will map relevant non-bank financial entities into one five economic functions and assess the viability of the policy tools for each entity. The framework will provide the structure under which an annual monitoring exercise will be conducted, as well as assisting authorities in determining whether to extend the regulatory perimeter. The policy framework should eventually become a FSB membership commitment, subject to peer reviews.

Work stream 4: Securitisation

IOSCO published Global Developments in Securitisation Regulation on 16 November 2012. IOSCO notes that securitisation markets can play a role in supporting economic growth by providing an alternative source of funding for the banking sector. However, it believes that a complex range of factors will determine the return of investor confidence to these markets.

The paper provides 10 recommendations, including a roadmap for international convergence and the implementation of risk retention requirements. IOSCO indicates that more work needs to be done to standardise asset level disclosures and recommends other means to support sustainable securitisation markets, including the relative prudential treatment of securitisation products and certain accounting issues, such as consolidation.

IOSCO published Principles for Ongoing Disclosure for Asset Backed Securities (ABS) on 27 November 2012 as a guideline for regulators designing or reviewing their ASB disclosure regimes. The 11 disclosure Principles complement the Disclosure Principles for Public Offerings and Listings of Asset-Backed Securities that IOSCO issued in 2010, and are consistent with other IOSCO disclosure principles.

Work stream 5: Securities lending and repos

In its Policy Recommendations to Address Shadow Banking Risks in Securities Lending and Repos, the FSB notes that this system can provide a valuable alternative to bank funding and supports real economic activity. It says that shadow banking regulation should ensure securities lending and repos are subject to appropriate oversight and regulation but should not hinder sustainable non-bank financing models.

The FSB strongly believes that regulators should impose minimum standards to limit reductions to haircuts in benign market conditions, and possibly to agree to binding numerical haircut floor to limit procycliality. Such a framework would need to be carefully designed and calibrated to avoid unintended consequences and further proposals will be the subject of a public consultation.

Disclosure to markets and regulators should be expanded and improved. Financial institutions should work with international standard setting bodies to improve current disclosure practices for securities lending, repo and wider collateral activity. Financial intermediaries should disclose re-hypothecation practices to clients so they can understand their exposure in the event of counterparty failure, while fund managers should improve the level of information that they provide to end-investors.

Regulators should develop more detailed regulatory reporting, with the long term goal of reporting to trade repositories as the most effective approach to data collection. However, market-wide surveys are suggested as an initial step.

The FSB believes that more needs to be done to manage collateral. Regulators should develop minimum standards to limit the risks associated with cash collateral investment and develop standards for collateral valuation and management, and to endorse the use of central clearing where appropriate.

Finally, policy makers should adopt changes to the treatment of repo and securities lending transactions in insolvency.

EP reports on shadow banking

The EP published an Own Initiative Report on Shadow Banking on 8 November 2012, responding in part to the EC's March 2012 Green Paper on Shadow Banking. The EP supports the EC's proposals, which are broadly in line with the FSB proposals. It also stresses the value of the shadow banking system, stating that "contrary to what the term might suggest" shadow banking is not necessarily an unregulated or illegal part of the banking sector.

The EP made a few key suggestions:

• The EP believes that the EBA's remit should include the shadow banking sector, arguing that the reports of
• the ECON Committee on CRD IV represent an important step in tackling shadow banking.
• The EP calls on the EC to submit a review of the UCITS framework, with particular focus on MMFs, in the first half of 2013. Like the FSOC recommendations, the EP believes that regulators should either require a conversion to a floating NAV or introduce appropriate safeguards to protect a stable NAV MMF's resilience.
• The EP also invites the EC to adopt measures by the beginning of 2013 to increase transparency for clients in the securities lending and repo market.

Next steps

The FSB work stream owners will refine their policy proposals following consultation and plan to publish final policy recommendations by September 2013. They will suggest implementation timetables for each set of recommendations.

The EC is expected to issue legislative proposals on shadow banking in 2013. These proposals may come earlier than previously anticipated, given the timelines set out in the EP's report.

The FSOC will finalise its recommendations on MMFs once the current consultation period closes and then pass these back to the SEC to implement. We expect the SEC to consider these recommendations early in the new year.

With all this activity, 2013 looks set to be a significant year in the regulation on shadow banking. The proposed regulatory changes for securities lending, repos, MMFs, etc have important implications for many firms' business models. Firms will need to play an active role in shaping this new regulation, to help ensure that regulators understand how these changes will affect the industry and the wider economy. Given the significant role that non-bank credit intermediation played in getting us through the financial crisis, we all have a vested interest in ensuring its continued viability.

To read this Bulletin in full, please click here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.