Abstract
Modern regulators are much concerned with systemic risk, or more generally with the stability of the financial system or its disturbance. In practice, it has become the major regulatory issue superseding other regulatory concerns like those with depositors and investors who for their protection must look towards depositors and investors protection schemes in the case of an insolvency of their bank or other financial intermediary. Even concerns about conduct of business, notably miss-selling of financial products or giving poor investment advice, recede into the regulatory background and are left to private law action even if civil recourse may be reinforced. Concern with stability then also tends to surpass the concern with financial irregularities, the third prong of public concern in the financial area.
To meet stability concerns, regulation commonly imposes licensing or similar requirements setting conditions. In this manner, it attempts to improve the health of financial institutions as a whole and to provide a better protection of the public against system collapse. This regulation, which largely centers on capital adequacy requirements, the fit and proper test for management, and the need for proper systems, is embedded in legal norms and administrative law protection or judicial review as far as the so regulated financial institutions are concerned. This is also referred to as micro-prudential supervision.
Although rule-based in principle, supervision of this nature raises in particular the issue of regulatory discretion complicating the legal position of licensed and supervised intermediaries in terms of judicial review. In the UK, the introduction of principle-based and judgment-based micro-prudential supervision leads here to further uncertainty. The more direct justification was the avoidance of a box ticking mentality in regulators but after a financial crisis there is always public indignation that regulators did not do more to prevent it, which may lead to even greater demands for ad hoc powers of intervention. The result is likely more regulatory discretion and conceivably (further) intrusion into the daily management of individual banks or other financial intermediaries. As such, the English approach will be explored by way of example, especially since the financial regulation in the UK remains leading in sophistication in Europe and as such an important guide within the EU, even though it may be cogently argued that the UK attitude to finance and more generally to risk is different from that of many other EU countries.
Increased regulatory discretion now also derives from so-called macro-prudential supervision, another new idea after the 2008 financial crisis, and the emergence and operation of financial policy or stability committees like in the UK the Financial Policy Committee (FPC), in the EU the European Systemic Risk Board (ESRB), and in the US the Financial Stability Oversight Council (FSOC). It seeks to enhance the already existing focus on the stability aspect of financial regulation and supervision. Although it still raises the question of its true meaning, focus and task, the relationship to micro-prudential supervision, and its legal structure and framework, it poses even more the question of legal recourse for affected parties against this type of prudential supervision.
In international transactions, there is the additional issue of regulatory jurisdiction in all regulatory matters and the applicable administrative law. This is in the EU in principle resolved through the balance of competences between home and host regulators with emphasis on the powers of the former and the mutual recognition principle concerning such powers throughout the EU on the basis of the harmonization of the basic regulatory structure. An important new aspect is here the Single Supervisory Mechanism (SSM) agreed in 2013 for euro-zone banks, which introduces the idea of a single banking regulator in the Eurozone of the EU, further supported in 2014 by the Single Resolution Mechanism (SRM) and the operation of the European Central Bank (ECB) with a multitude of powers: monetary policy, lender of last resort, micro-prudential supervisor of the major euro-zone banks, macro-prudential supervision of those banks at least in the area of counter cyclical capital standards, and initiator of their resolution in the case of crisis. To this may be added the role in the payment system of the central banks being part of the ECB system, and now the increasing tendency in the ECB to provide liquidity at random, even to governments thus influencing macro-economic policy.
These overlapping functions potentially complicate further the issue of the applicable regulatory frame work and legal recourse of banks and other financial institutions. The independence of central banks has become an important theme and there is therefore little democratic accountability even though it would still be right to distinguish here between the different functions they exercise, but there is a tendency to ignore these differences. The consequence is that there is little supervision and therefore also little legal accountability left at the level of the ECB which has potentially a further debilitating effect in matters of legal recourse of affected parties. It requires us to explore in how far we still have a rule-based system of regulation.
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Notes
- 1.
In the crisis of 2008, it became better understood that investment institutions may also contribute to systemic risk, especially when they face a liquidity crisis. The secondary banking system may also become involved if it starts suffering from similar problems. These important aspects will not be here discussed any further except to say that, in the event, the Lehman collapse did not have the systemic effect that was first feared and it is possible that in times of crisis the fear of systemic collapse becomes exaggerated. In other words, the system might be more robust than is often thought in times of panic and too much may be made of the instability scenario, then often used to enhance ad hoc regulatory powers and emergency measures. There was and is still much of this in the re-regulation scenario after 2008. The invocation of systemic risk to justify more regulation may then be self-serving and is often misplaced.
- 2.
Cf. e.g. Schwarcz (2008), p. 193. Systemic risk thereby becomes primarily a liquidity issue but it may not cover the full picture. In any event, competitive pressures may keep interest rates down and allow the truth to be revealed much later. See further also Schwarcz (2012), p. 816; and Anabtawi and Schwarcz (2011), p. 1349.
- 3.
In the Regulation (EU) No 1092/2010 on the European Macro Prudential Oversight establishing the European Systemic Risk Board (ESRB), in Preamble no 9, some key criteria are given to help identify the systemic importance of markets and institutions and therefore attempts to indicate which institutions should be watched but it says nothing about when such risks are triggered. The criteria were considered to be (a) size (the volume of financial services provided by the individual component of the financial system), (b) substitutionability (the extent to which other components of the system can provide the same services in the event of failure), and (c) interconnectedness (linkage with other components of the system). These criteria were supplemented by a reference to (d) financial vulnerabilities and the capacity of the institutional framework to deal with financial failures which should consider a wide range of additional factors such as, inter alia, the complexity of specific structures and business models, the degree of financial autonomy, intensity and scope of supervision, transparency of financial arrangements and linkages that may affect the overall risk of institutions. Especially this last addition makes for a judgmental approach and does not provide sufficient legal criteria that can be objectively applied. It also impacts on micro-prudential supervision and raises the issue of the relationship between both especially when it comes to recourse.
- 4.
This may not be limited to the plight of shareholders and creditors (bond holders and depositors) in a resolution when for the first the valuation of assets taken to a “good” bank and for the latter the pari passu treatment with other creditors when some liabilities are transferred to that bank may become an issue. Short of full resolution, various participants or stakeholders may also suffer from demands for capital increases or other actions that inhibit activity or profitability. In all these cases, there would be a need for at least some minimum legal protections. Resolution authorities are here no more than bankruptcy trustees and should not hide behind a superior status which in other context they may well have.
- 5.
Note that depositors and investors for the most part do not derive from it a direct cause of action against misbehaving financial intermediaries, see also text at nt 6 below. Only under conduct of business and product supervision rules, they may be given special (civil) recourse against their financial intermediaries e.g. in the case of missselling or other tactics but this civil protection does not automatically follow from a breach of license conditions. In the absence of a direct (private) cause of action, some horizontal effects might, however, still derive from regulation when expressing more general protection principles, expanding in this manner private recourse, but it is rare as we shall see. Regulators in the US have also used their powers to fine banks in part to compensate damaged mortgagors, who could not otherwise find compensation. It concerned here the protection of borrowers rather than investors or depositors. It is rare, but one may think of prospectus liability of issuers in the capital markets and now also of the liability of rating agencies under the Regulation (EU) No 513/2011, OJL 145/30 (2011), as amended in Regulation (EU) No 462/2013 OJL 146/1 (2013) and Directive 2013/14 OJL 145/1 (2013). It concerns specific statutory authorisations. For the rest, horizontal effect would appear to depend on whether regulatory rules enunciate a fundamental protection principle. Regulators’ rule books may help, however, more directly when supporting duties of care. Regulators tend to have here broad discretion also in conduct of business matters and may impose further duties which may strengthen private recourse against intermediaries and may help investors in particular in formulating a private cause of action, see further also the comments in Sect. 2 on the principle-based approach. These important issues will not here be further discussed, except to say that in the US under Dodd-Frank a special consumer regulatory agency was created more directly to intervene as regulator in the protection of clients in the area of conduct of business, mainly the miss-selling of financial products and giving poor investment advice. It may be is extended to product transparency and supervision. In the EU in MiFId II and MiFIR there is also greater emphasis on these powers, but even in the US it is not clear under Dodd Frank in how far regulators may also engage in suing privately on clients’ behalf beyond imposing and redistributing fines.
- 6.
The House of Lords in Three Rivers District Council and Others v Governor and Company of the Bank of England [2000] 2 WLR 1220, seemed less concerned with depositors but accepted—absent bad faith—the prevailing statutory restrictions on liability for banking supervisors as an adequate defence. In the UK, this defence is more extensively interpreted than elsewhere; in France, for instance, administrative courts accept in this connection faute simple as sufficient ground for civil liability, therefore conceivably leaving more room for depositors’ protection; see Cour Administrative d’Appel de Paris, 30 March 1999.
In Three Rivers, even reasonable policy objectives and considerations connected with systemic risk or the smooth operation of the financial system did not seem to figure large. They were in any event not weighed against the statutory requirements of depositors’ protection as laid down in s 3 of the UK Banking Act 1987. It was assumed that the EU First Banking Directive of 1977 (77/780/EEC), now largely superseded by the Credit Institution Directives of 2000 and 2006, even though clearly concerned with depositors, did not give depositors extra rights in this connection. No guidance from the European Court of Justice was sought; see further M Andenas, ‘Liability for Supervision’ [2000] Euredia 379.
- 7.
See Thomas Pringle v Government of Ireland, ECJ Nov. 27 2012, Case C-370/12.
- 8.
See also B Eichengreen, “Euro Area Risk (Mismanagement)”, in E Balleisen et al., Eds, Recalibrating Risk: Crises and Regulatory Change (2014).
- 9.
The first question was one of legality: to what extent did the Financial Services and Markets Act (FSMA 2000) allow for this newer approach especially to protect smaller investors? As it left much to the FSA—the UK financial regulator of those days—and to its rule-making authority, this was not considered a substantial hindrance, not therefore either in further defining and providing private recourse, but there remains an issue in terms of express provisions, see also Loosemore v Financial Concepts [2001]Lloyd’s Report 235; Seymour v Caroline Ockwell & C0 [2005] PNLR 758; Barnes v Black Horse Ltd [2011] EWHC 1416 (QB) and there has to be some translation into breach of fiduciary duty or contractual or the commission of a tort. It also remains true that mere breach of principle could inhibit private law sanctions in courts of law for not being sufficiently precise. The result could be and fear then is that regulators and investors, in their eagerness, more readily find some breach of principle by intermediaries. That could then also go to the supervision aspect and fit and proper test. There had therefore to be some reasonableness test and some reliance on reasonable predictability in outcome.
In this connection, the following basic principles or rather areas of principal concern were identified in the UK: integrity, due skill and care, adequate financial resources, proper market conduct, treating customers fairly (now commonly referred to as TCF, it often being perceived as the key principle), proper use of financial promotions, avoidance of conflicts, suitability of advice, protection of client assets, and active interacting with regulators. In several succeeding FSA reports, the notion of TCF indeed became a central theme whilst the whole concept of conduct of business was in the process of being recast.
The emphasis thus shifted to the better protection more especially of investors. The idea was that consumers should be comfortable with the culture of their intermediaries, that the products and services were designed to meet their requirements, that advice was suitable, that they got what they had been led to expect, were kept properly informed before, during and after a sale or purchase, and did not face unreasonable post-transaction barriers. There was also the idea that regulation should look at the various stages of a relationship from product design, through promotion, quality of research and advertising, transaction including suitability and best execution, after-transaction care including complaints, and systems and controls including paper trails and internal sales incentives. It could also apply to bank customers/borrowers. In this approach, wholesale was basically left to its own devices.
- 10.
This newer approach seemed undisturbed by the crisis of 2008 and may particularly be used to challenge intermediaries more intensely on how they ensure continuing compliance with the principles, whether they regularly review the consequences of their decisions, but also whether they adequately consider the potential for risk crystallisation and new risks when moving their business forward. This may then go beyond the mere protection of clients and move into the licensing requirements as part of the fit and proper test. Principle-based regulation may then also enter the world of judicial review in respect of affected intermediaries when licenses are amended or revoked as a consequence.
- 11.
It is one of the innovations brought by the Financial Services Act 2012 that introduced in the UK a new supervisory structure, operative as of April 1 2013. Promoting confidence and transparency in financial services was the professed aim. The new structure is also given a strong mandate to promote competition. This is all very laudable, but it is politics devoid of much of a legal compass, see further also RM Lastra, “Defining forward looking, judgment based supervision”, 14 JBR, 221 (2013).
- 12.
See S Schwarcz, “Systemic Risk and The financial Crisis: Protecting the Financial System as a ‘System’” (forthcoming). The term macro-prudential supervision has been used for some time, in the BIS since the 1970s but its popularity is much more recent—see for its early use C Borio, “Implementing a macroprudential framework: Blending boldness and realism”, BIS Working Paper July 22 2010. See for is early use in legal discourse Andenas and Panourgias (2002), p. 130.
- 13.
See Gordon and Muller (2011), p. 156.
- 14.
A Part 1A was added to the Bank of England Act 1998 on the Financial Stability Strategy of the Bank and new Exhibit 2A was added concerning the appointment and removal of members of the Financial Policy Committee.
- 15.
E.g. from a letter of the Governor of the Bank of England to the Chairman of the Treasury Committee of the House of Commons of Nov. 22 2013, it is clear that identifying bubbles e.g. in the housing market was a concern. According to the Record of the FPC Committee meeting held on June 17 and 25 2014, it concerned itself also with countercyclical capital buffers for mortgage lenders which was set at 0 but it issued recommendations requiring a stress test of borrowers assuming rates would rise by 3 % and limiting mortgage lending to new mortgagors with a loan to income ratio of more than 4.5.
- 16.
In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act (section 112) provides the legal basis following the G-20 lead. The FSOC has three primary purposes and must (a) identify risks to the financial stability that could arise from material financial distress or failure, or ongoing activities of large interconnected bank holding companies or non-bank financial companies or that could arise outside the financial services marketplace; (b) promote market discipline by eliminating expectations that then US will shield these entities from losses in the event of failure; and (c) respond to emerging threats to the stability of the US financial system. The 2014 Annual Report lauds the finalization of the Volcker Rule, of the bank capital rules, of the supplementary leverage ratio for the largest banks, and the advent of clearing for swap markets. It highlights continuing concerns about money market funds, new financial products, complex connected financial institutions, reference rates (libor etc.), the prospective impact of greater interest rate volatility, operational risks, the impact of financial developments abroad, data gaps and data quality, and housing finance, all important subjects and some inventory of prospective trouble but no answer as to how to deal with them, probably because it is unclear how and in what circumstances they will arise.
- 17.
Regulation (EU) No 1092/2010 of the European Parliament and of the Council of Nov. 24 2010 on the European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board.
- 18.
It is sometimes thought that this concern about large banks is not typical for macro-prudential supervision. Even if there are only small banks, there may still be a lot of risk. It also neglects the time dimension, that is the concern how banking risk evolves over time.
- 19.
Loretta Mester, “The Nexus of Macroprudential Supervision, Monetary Policy, and Financial Stability” Dec. 5 2014 https://www.clevelandfed.org.
- 20.
It may even be questioned whether we want stability at all if it means no more consumer and student loans. There is also the negative effect on growth, probably underestimated, but it is likely to become an ever more important issue if growth does not return. Providing general liquidity to the system by monetary means is hardly a long term substitute.
- 21.
It is well known that the multitude of smaller banks were the major problem in the US during the 1930s financial crisis.
- 22.
There is a lot of empirical evidence supporting this. Kiyotali and Moore (1997) demonstrate this in the housing markets when in good times collateral values increase supporting further borrowing whilst in bad times decreases lead to crises. Brunnermeier and Sannikov (2014) amplify this with respect to increased capital levels in banks in good times allowing further lending. It lowers volatility in asset prices which allows banks to increase leverage, etc.
- 23.
The IMF found mixed results in the use of macro-prudential tools in reducing systemic risk in 49 countries, see C Lim, F Columba a.o, “Macroprudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences”, IMF Working Paper WP/11/238 (Oct. 2011), but these measures where incidental and did not amount to the strategic countercyclical policy here advocated.
- 24.
It should be noted that even though there is now a single regulator, there is as yet no single regulatory regime. The ECB as the new banking regulator for the eurozone banks in many of its activities still operates under the laws of Member States, even if harmonised by Directives and by the drive for a single rule book created by the European Banking Authority (EBA). Even where it operates under Regulations, these may still give local authorities options to fashion their own rules.
- 25.
Council Regulation (EU) no 1024/2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions, OJL 287/63 (2013).
- 26.
Art. 136 of the Treaty on the Functioning of the European Union (TFEU) was amended by adding: “The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required assistance under the mechanism will be made subject to strict conditionality”. “That refers especially to state aid restrictions. It means that the fund (like the SSM) operates within EU law subject to the jurisdiction of the ECJ”.
- 27.
The SRM is embedded in the framework of the earlier EU Directive 2014/59/EU of May 15 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms which covers all Member States, but the Board substantially replaces the national resolutions authorities under that Directive in the eurozone area (see Preamble 86 of the 2014 Resolution).
- 28.
They are the banks whose asset value exceeds € 30 billion, whose assets are more than 20 % of their country’s GDP (unless assets are less than €5 billion, or are the top three banks in their country. The ECB decided which these were in Sept 2014.
- 29.
International relations remain the competency of the Member States, therefore also the licensing of branches of non-EU banks and their supervision (Article 8).
- 30.
EU Regulation No 806/2014 of July 15 2014 OJL 225/1 (2014).
- 31.
The creation and management of the SRF was contentious, also the contributions. It was ultimately decided that banks will make contributions ex ante so that in 8 years after Jan 1 2016 1 % of the projected deposits of all banks in the banking union will be covered and this is estimated to amount to €55 billion. More may be demanded ex post if this proves insufficient. These transfers from national entities towards the SRF as an EU body are regulated under the inter-governmental agreement of Dec. 2013 and not under the Regulation.
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Dalhuisen, J.H. (2016). The Management of Systemic Risk from a Legal Perspective. In: Andenas, M., Deipenbrock, G. (eds) Regulating and Supervising European Financial Markets. Springer, Cham. https://doi.org/10.1007/978-3-319-32174-5_15
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