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Part Two: Unintended consequences? In Part I, my starting point was the Investment Services Directive (No. 93/22/EEC) and how EU measures aimed at creating a competitive and consumer friendly market for investment services caused a number of unintended consequences by failing to deliver on its intentions. In this the second and concluding part of my analysis into the unintended consequences of EU financial regulation, I have chosen the Capital Adequacy Directive (93/6/EEC), the Market Abuse Directive (2003/6/EC) and the Deposit Guarantee Schemes Directive (94/19/EC) and ask, could these directives have unwittingly aided and abetted the 2007 financial crisis? Banking compromise or compromised? Beginning with the Capital Adequacy Directive (CAD) its intention was to ensure that investment banks had enough capital reserves in the event of a financial crisis. Henceforth investment banks across the EU were required to have adequate reserves to cover their position risk, requirements for debt, equities settlement and counterparty risk, as well as foreign exchange risk and other large exposures. Traditionally, up until the CAD, retail banks and investment banks had been governed by different regulatory regimes reflecting the differences in their business models. According to Dale, this opening up of EU financial markets to competition presented European regulators with two problems. First, host countries needed to ensure banks operating or delivering services in their territory were doing so under proper regulatory standards of prudence. Secondly, there was a business and policy concern that these very same prudential standards did not discriminate between different types of financial firms leading to an unfair competitive climate. The CAD represented an attempt by the Commission to achieve a competitive environment across the EU between retail banking and investment banking but in doing so it created a number of unintended consequences and failed to deliver 18 WMA JOURNAL
on its promise. The resulting negotiated compromise between the retail and investment banking interest groups meant that the CAD had three major flaws. The first was that the capital adequacy requirements called for by the CAD represented the minimum requirement, as imposing higher requirements was deemed to dilute the solvency protection traditionally afforded to retail banks. At this stage, national authorities could ‘gold-plate’ the directive by imposing higher requirements when transposing the directive into national regulation. However, by doing so they would run the risk of undermining their competitiveness . The second was that retail banks could now use their deposit base to fund investment banking operations such that the ‘moral hazard’ problem was amplified. Thirdly, the CAD conferred upon investment banks the same credit standing as that accorded to retail banks. This implied that governments would, if faced with a defaulting investment institution, act as a lender of last resort, arrangements which had traditionally been reserved for retail banks. More ominously, however, the CAD, in seeking to establish a level competitive playing field, may have provided the seeds of the 2007 financial crisis. Dale put forward the proposition that; given that retail banks would now have a much higher capital reserve requirement for bank loans than those applicable to securitised debt, bearing the same equivalent risk value and maturity date (a factor of no less than times 32 for short-term securities loans) post CAD, banks would have a powerful incentive to shift business away from traditional lending to securitised lending. Clearly a case of an unintended consequence as he so aptly stated at the time. The logic and simplicity of Dale’s argument in his 1994 article appears, with the benefit of hindsight, prophetic, for this has been the root cause of the 2007 global financial meltdown. Conventional wisdom places the cause of the 2007 global financial crisis on the somewhat nefarious activities of the US sub-prime lending market.
However, had it not been for the fact that EU banks were finding it more advantageous to create value, via securitised as opposed to traditional loan debts, perhaps the severity of the crisis could have been averted. A prime example of a financial institution which based its business model on securitised debt and became sadly enmeshed in the US sub-prime loans crisis was the UK’s Northern Rock Bank. The next section provides further perspectives on how EU directives aimed at ensuring fair competition and ethical trading may have indirectly contributed to the resulting run on this Bank in late 2007. The case of the Northern Rock run According to Hall , the run on the Northern Rock, caused by the spillover effects of the US sub prime crisis, demonstrates, how an amalgam of EU measures to facilitate competition, by limiting state asset relief to institutions in financial trouble, as well as, the EU’s 2005 Market Abuse Directive, combined to exacerbate a liquidity crisis into the first full blown run on a UK bank in 140 years. In the past, when a bank had faced a liquidity crisis, the Bank of England would intervene and either act as a lender of last resort or more commonly, put together a ‘rescue’ package, by effectively ‘brokering’ a takeover, as happened during the Barings collapse. However, during the House of Commons’ Treasury Select Committee hearings into the affair it emerged, according to senior Northern Rock executives, that the Bank of England wanted to extend a liquidity lifeline to a potential takeover candidate (generally believed to have been Lloyds TSB Bank). That being the case, the executives argued, Northern Rock could have survived saving untold costs to the tax-paying consumer, albeit under new ownership. However, the Bank of England had subsequently issued a statement that Lloyds TSB required a loan of up to £30 billion for a period of up to two years. Consequently, the Bank of England was caught by the EU rules on state aid. Rules which had been designed to ensure fair competition in a single market. The reasoning being that by giving favoured www.thewma.co.uk
treatment to some businesses, it would harm business competitors, distorting the normal competitive market and hindering the longterm competitiveness of the community. Additionally, the Bank of England was caught in a labyrinth of enabling legislation, such as the Takeover Code, given a legislative footing in the Companies Act 2006, the EU’s 2005 Market Abuse Directive (which prevents secret takeovers), the insolvency provisions of the Enterprise Act, as well as the Financial Services Compensation Scheme which is the UK’s transposition of the Deposit Guarantee Schemes Directive (94/19/EC). This EU directive also attempted to facilitate competition by placing restrictions on the use of deposit insurance information in advertisements in order to avoid competitive
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All these measures conspired to turn a bad situation into a catastrophic run on the Northern Rock distortions in the EU marketplace. In doing so it failed to define the risk adjustment of premium contributions and set the maximum period for depositor compensation at three months. Hall identifies three base flaws. First, very few consumers in the EU were aware of the deposit protection until the crisis hit and once it hit, given the limited protection, they had every incentive to take their money from the bank. The second flaw we have already covered in our discussion of the CAD and relates to cross subsidies and failure to prevent moral hazard. While the third flaw was brought about by the enforced wait provisions giving investors every incentive to demand the return of their deposits causing a run. All these measures conspired to turn a bad situation into a catastrophic run on the Northern Rock. Conclusion In the first instance it is suggested that there is compelling evidence that the CAD aided and abetted the 2007 financial crisis. Ironically this directive was aimed at ensuring that investment banks had adequate capital reserves in the event of a financial crisis. Yet we have seen how, following www.thewma.co.uk
the implementation of the CAD, banks had a powerful incentive to shift business away from traditional lending to securitised lending, the latter being the root cause of the 2007 financial meltdown. Was this not a foreseeable consequence? Did Dale not warn about the dangers as far back as 1994? Had not the 1929 Crash taught us the lesson that retail and investment banking had to be separate? Had this not resulted in the passing of legislation aimed at separating retail banking operations from investment banking operations? Were Brussels policy makers unaware of these historical events? Unfortunately my research cannot provide definitive answers to these questions but, if we were to apply ‘the reasonable person’ test, one would be hard pressed not to conclude this was a foreseeable consequence. The evidence presented by Hall in the case of the Northern Rock provides further evidence of “unforeseen consequences” although maybe not so much as ‘unforeseen’ as foreseeable where it concerns the CAD. The passing of the CAD made securitised lending more attractive to banks than traditional lending. Northern Rock had availed itself of this apparent growth opportunity and made its core business the provision of securitised lending. This left it dangerously exposed to the securitised lending defaults that began to spread across the Atlantic around 2006. Their predicament was compounded when their main recourse, The Bank of England, was blocked from taking remedial action by the EU’s Market Abuse Directive as well as the Deposit Guarantee Schemes Directive. Admittedly the purpose and intention of these directives was not to cause the demise of banks. Could this have been foreseeable? Given the evidence that I have presented over the course of these two articles, I conclude that there is both compelling as well as persuasive evidence that the resulting spillovers, could have been foreseen. Moreover, given the failures of EU financial regulation, to create a single European market for financial instruments, this European project continues to be at best a work in progress. Given this track record and the continuing drive by Brussels to regulate our sector I have no doubt that further unintended consequences will occur. Whether these will turn out to have been foreseeable is a matter for conjecture and further debate. A.L.Danino M.Res LLB, Peterevans WMA JOURNAL 19
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