Will Europe go it alone on financial regulation following Brexit? Don’t count on it

The times are certainly changing.

Following the November election of Donald Trump as U.S. president, an extensive list of long-held governing norms is now up in the air, including everything from immigration policies to trade negotiations to the tax code. The regulatory structure around the financial services industry in this country is also up for review, with potential changes coming to Dodd-Frank and other rules.

But this is not just a U.S. phenomenon. The same populist tide that carried Trump to the White House has been stirring across Europe for the last several years, peaking most recently with the U.K.’s June Brexit vote to leave the European Union.

As a result, rumors have begun circulating that the European Union may soon move to enact its own set of financial regulations, pulling an end run around the existing United States- and United Kingdom-focused structure so that it may exert itself in this new world order.

Deutsche Bank CEO John Cryan said as much to the Wall Street Journal in November, highlighting Europe’s opposition to the new Basel III capital standards rules that, many bankers on the continent have suggested, may limit the freedom of European banks and unduly benefit their American competitors.

“I do think the regulations that we’re facing for the banking sector globally are only for the benefit of the U.S.,” he told the paper. “It’s about time Europe started implementing rules that benefit Europe, [rather than playing] to some policy of global harmonization.”

Banking regulators met in Chile last month to try to hammer out a deal with the European opposition, making what Basel Committee on Banking Supervision chair Stefan Ingves called “good progress,” but returned without a final deal in place.

It all comes down to differing philosophies for dealing with risk. European and Japanese bankers have long relied on their own internal modeling systems when estimating asset risks associated with capital requirements, while their U.S. counterparts are more skeptical, preferring industry-wide standards.

It has created an impasse that seems unlikely to budge anytime soon.

Mulling a split

But is a diversion from Basel III, and the entire existing financial regulatory system, a real possibility for the European Union?

In a word, yes, says Leonard Ng, co-head of the EU Financial Services Regulatory Group with international law firm Sidley Austin LLP in London.

“Change is likely to occur not only because of the Capital Markets Union (CMU) project, but also obviously because of the U.K.’s expected departure from the European Union in 2019, assuming the Article 50 Brexit notice is given in 2017,” he says. “Setting aside Brexit, the CMU project has already thrown out a couple of new regulatory initiatives, including the new Securitization Regulation which, amongst other things, seeks to introduce a framework for simple, transparent and standardized securitizations, and also a new Prospectus Regulation to make capital raising easier and more efficient.”

“Maintaining or delaying differences and gaps with the approach currently in place in the U.K. and U.S., even if motivated by the specific conditions of the EU financial market, will generate the risk for further inefficiencies. The current level of political integration in the EU makes this risk quite serious.”

Renzo Traversini, Senior Director of EMEA Risk Business Consulting, SAS

At issue, Ng says, is the fact that the EU’s existing financial regulatory structure is mostly a hodgepodge of directives and regulations, 40 in all, that were put in place following the financial crisis in an effort to prevent future meltdowns. These actions date back to 2009, and much of the implementation has yet to be completed.

So, when the European Commission put out a call for evidence in early 2016 related to its Capital Markets Union project, it encountered an environment that was and is looking for a stronger footing. This latest effort is driven by the recognition that, although the existing regulatory framework was put in place in order to prevent future financial crises—and has done so to date—regulatory change is also needed to encourage innovation, jobs, and economic growth among the EU’s member countries.

In short: The continent is moving in the right direction in terms of financial regulation, but there is more work to be done.

Ng even calls the Securitization Regulation and Prospectus Regulation moves that were initiated this year “peripheral in nature,” focusing instead on the big picture for the European Union.

“Bigger projects, including the recent efforts to start on a project to harmonise EU insolvency laws, are far more important in getting to the heart of what the CMU project is trying to achieve,” he says.

Pros and cons

The upsides to an EU transition from the existing regulatory architecture are clear, according to Renzo Traversini, senior director of EMEA Risk Business Consulting at SAS.

CAPITAL MARKETS UNION

The European Commission describes the intent behind the Capital Markets Union plan.
The Capital Markets Union (CMU) is a plan of the European Commission to mobilise capital in Europe. It will channel it to all companies, including SMEs, and infrastructure projects that need it to expand and create jobs. By linking savings with growth, it will offer new opportunities for savers and investors.
Deeper and more integrated capital markets will lower the cost of funding and make the financial system more resilient. All 28 Member States of the EU will benefit from building a true single market for capital.
Stronger capital markets will complement Europe’s strong tradition of bank financing, and will:
Unlock more investment from the EU and the rest of the world;
Better connect financing to investment projects across the EU;
Make the financial system more stable;
Deepen financial integration and increase competition.
The Capital Markets Union is a new frontier of Europe’s single market. Its creation is a key element of the Investment Plan announced by the Juncker Commission in November 2014.
The challenges
Investment in Europe remains heavily reliant on banks
Significant differences in financing conditions between Member States exist
There are differing rules and market practices for products like securitised instruments or private placements
Shareholders and buyers of corporate debt rarely go beyond their national borders when they invest
Many SMEs still have limited access to finance
The objectives
Develop a more diversified financial system complementing bank financing with deep and developed capital markets
Unlock the capital around Europe which is currently frozen and put it to work for the economy, giving savers more investment choices and offering businesses a greater choice of funding at lower costs
Establish a genuine single capital market in the EU where investors are able to invest their funds without hindrance across borders and businesses can raise the required funds from a diverse range of sources, irrespective of their location
Source: European Commission

An independent European financial regulator will have the authority to develop and achieve more coherent regulatory requirements across all EU countries, ensuring a more stable and efficient financial sector on the continent. What’s more, the organization would be able to design such a system to better fit the norms of business in Europe, avoiding the conflicts that are currently stalling Basel III adoption and levelling the playing field for all in the industry.

The trouble, he says, will come in the form of uncertainty.

By its very nature, regulatory uncertainty throws the brakes on business growth. In the face of changing and unclear regulations, firms are left to wonder about what investments they should make or what new lines of business they should enter. When everything is up in the air, no one in the market knows exactly what’s going on or what’s coming next.

As a result, most usually do nothing.

“The creation of a new entity like an EU financial regulator will allow potential space for disagreements and discussions on a global level, with the other regulator in the U.K. and U.S.,” Traversini says. “Maintaining or delaying differences and gaps with the approach currently in place in the U.K. and U.S., even if motivated by the specific conditions of the EU financial market, will generate the risk for further inefficiencies. The current level of political integration in the EU makes this risk quite serious.”

Left unchecked or opaque for too long, this type of uncertainty could do serious, long-lasting damage to Europe’s financial sector as well as its overall economy.

And this is to say nothing of the costs associated with such changes. Significant financial and human resources need to be deployed in order to manage regulatory change, making it potentially more expensive for businesses in the financial sector to be profitable over time. This could also raise new barriers to entry to the sector, potentially limiting the market and constraining financial innovation among EU member states.

“At a time when less regulations are expected in the United States and United Kingdom, implementing a stringent framework in the EU that is not aligned with the two main financial centers mentioned above would create a strong competitive disadvantage that could hammer the European financial industry,” argues Axel Pierron, managing director of Opimas, a capital markets consulting firm in Paris specializing in market structures and fixed income.

Not so fast

But regulatory change in the European Union, as in any political system, comes slowly.

Even if European officials decide a change is needed, it will likely take years for any such transition to actually happen.

First, in order to realize any change, the organization must reach consensus among its member countries, all of which have their own markets and domestic concerns to worry about. That process, by design, can take years, as each of the 28 member states mulls through the issues and decides on a course of action. And then, after all that, one “no” can be enough to kill the issue. Even if the process were to begin today and nothing actually becomes law for two, three, or four years, it’s almost a non-issue because so much has changed in the European Union in the last year that’s there’s already a lot of uncertainty about the future. A lot of people are being cautious right now.

Secondly, European regulators have limited expertise with financial market operations outside of cash equity markets, which explains why the European Union has often looked across the Atlantic or the Channel for inspiration for its regulatory structures, according to Pierron.

But the single biggest obstacle to fundamental change to EU financial regulations is the simple fact that it may not be necessary, explains Professor John James, chairman of the Center for Global Governance, Reporting, and Regulation at Pace University in New York City.

“I would be more interested in the why,” he says. “Is it to tighten up the enforcement procedures? Because they’re still pretty light compared to some of the member states. Why would they want to change it, to go away from the U.K. and U.S.? This could be another area of government reacting against the EU establishment. In other words, the populist bug has gone from the population to the local government and from the local government to the EU overseers, but we’ll have to wait and see.”