Regulating Financial Services/Banks

In the EU, uniform regulation across Europe applies for Central Securities Depositories (CSDs).⁴¹ Article 26 of Regulation 909/2014 expects CSDs to implement effective policies and procedures to ensure compliance with the said regulation, maintain and operate effective written organizational and administrative arrangements to identify and manage any potential conflict of interest, and be subject to independent audits. The regulation expects a great degree of transparency, and the CSDs’ internal governance and conduct of business rules will be reviewed. If there are no independent directors on the board, CSDs will be expected to appoint at least two and will need to ensure that measures are in place against conflicts of interest. These are just a few of the regulatory measures outlined by Belghazi (2013). Furthermore, Article 27 of the regulation expects the remuneration of the board of CSDs to not be linked to the business performance of the entity.

Likewise in the United States, government financial regulations were designed to ensure the stability and safety of depository institutions, which include banks, savings and loan associations, and credit unions (Meier 1985, 37), and to ensure financial soundness of depository institutions and the general safety of consumers at large. Meier (1985) and Liou (2013) have expressed the view that the regulatory framework developed after the Great Depression in the United States was gradually reformed due to computer technology, high interest rates, entrepreneurial innovations, political ideologies and powers, and domestic and international financial environments. Liou (2013, 213) summarized the reforms in the United States and indicated that they included new legal cases and legislation that changed usury laws (e.g., Marquette National Bank v. First of Omaha Service Corp. in 1978), removed interest rate ceilings, allowed banks to offer adjustable-rate mortgage loans, and finally repealed important restrictions emphasized in the Glass—Steagall Act. The repeal of Glass—Steagall restrictions in 1999 was critical because it reduced the separation between commercial banks and investment banks and allowed financial institutions to combine banking, securities, and insurance operations (i.e., the formation of mega banks). Furthermore, the financial regulation policies were complex (US Government Accountability Office [GAO] 2012; Peretz and Schroedel 2009), the regulated system had some structural problems (Peretz and Schroedel 2009, 610), and complex investment products were developed that challenged the regulators, while investors and consumers did not fully understand their contents. Thus, a regulatory gap played a contributory role in the financial crisis (Rivlin 2008).

In the United Kingdom the regulatory framework for financial services, which had developed over the course of the twentieth century, has been described as “complex and fragmented” (McMeel 2013, 600). There were multiple regulators; the governing legislation and regulatory requirements were embodied in various legislations, codes, and regulations; and overall the consumers and practitioners were confused. In an effort to improve prudential and supervisory arrangements, a Prudential Regulatory Authority (PRA) and a Consumer Protection and Markets Authority (CPMA) were established by the Financial Services Act in 2012⁴² in place of the FSA. The PRA is part of the Bank of England with the aim to oversee macro-prudential policy, while the CPMA is responsible for “conduct of business regulation for both retail and wholesale firms” (McMeel 2013, 602).

As previously mentioned, and drawing on Gambacorta and van Rixtel (2013), structural measures were introduced in several countries to separate “commercial” and “investment” banks in the wake of the financial crisis. These measures were intended to minimize the contagion effect from risky activities and decisions within and between banking institutions and also to protect certain categories of financial activities considered vital for the national economy or significant in terms of consumer/depositor protection from riskier but less significant activities. In the United States, the Volcker Rule since 2012 allows market-making activities on behalf of customers but has done away with proprietary trading, while having several exemptions for transactions for such instruments as US Treasury and agency securities. It does, however, restrict such trading and banking activities in different subsidiaries within the same group (p. 2). The Volcker Rule also prevents banks from investing in and sponsoring entities trading in hedge funds and private equity funding because it would expose them to the same risk as those entities.

The 2011 Vickers Commission in the United Kingdom concluded there were difficulties in applying Volcker’s distinction between proprietary trading and hedging activities, and it proposed a narrow definition of activities that would be permitted within a ring fence but with a recommended higher level of capital (in the main domestic deposit taking and lending to households and small- and medium-sized enterprises [SMEs]). Consequently, the Commission proposed ring-fencing the country’s banks without completely separating commercial from investment banks.

In response to the global financial crisis in continental Europe, a High- Level Group, under the Chairmanship of Mr. Jacques de Larosiere, was tasked by the European Commission (2009a) to examine how best to strengthen the European supervisory arrangements to better protect EU citizens and restore trust in the financial system. The group’s conclusions emphasized the importance of ensuring the stability of the financial system as a whole and not simply focusing on the supervision of individual firms. In December 2010, two EU Regulations⁴³ establishing the European Systemic Risk Board⁴⁴ (ESRB) entered into force as part of the ESFS and with the purpose of ensuring macro-prudential supervision of the EU’s financial system. In addition to the ESRB, the ESFS consists of

• • the European Banking Authority⁴⁵;
• • the European Insurance and Occupational Pensions Authority⁴⁶;
• • the European Securities and Markets Authority⁴⁷;
• • the Joint Committee of the European Supervisory Authorities (ESAs); and finally,

• the competent or supervisory authorities in the member states as specified in the legislation establishing the three ESAs.

In addition, the European System of Financial Supervisors (ESFS), which is the framework of financial supervision in the EU, has existed since 2011. It was first proposed by the European Commission in 2009, in response to the 2008 financial crisis, and it replaced the Committees of Supervisors with ESAs. The ESFS has the task of supervising individual financial institutions, that is, so-called “micro-prudential supervision.”

In February 2012, the European Commission established a High-Level Expert Group to examine the structure of the EU’s banking sector. Modeled after the United Kingdom’s Independent Commission on Banking, the group produced a report in October 2012 (the Liikanen Report⁴⁸) that separated “proprietary trading and all assets, liabilities and derivatives positions incurred from other banking activities” (Gambacorta and Van Rixtel 2013). It was proposed that, with certain exemptions, the former activities should operate on a stand-alone basis and be assigned to a separate legal entity. Hedging and special investment vehicles together with private equity investment would also be assigned to a separate trading entity, which would not be allowed to fund itself with deposits or provide retail financial services. One restriction recommended in the Liikanen Report was an upper limit of 15—20 percent of a bank’s total trading assets; otherwise, a second stage of examinations would be imposed on the bank (p. 24).

As one might expect, the idea of a single European Banking Supervisor attracted some opposition⁴⁹ on the grounds that (a) such an entity would create political problems since it would be in a position to overrule national regulators, (b) taxpayers would fear that the deposit insurance fund could be used to transfer funds from countries with adequate banking systems to those with deficient banking systems, and (c) it would require a system of burden sharing (Booth and Morrison 2012, 26). After three years in operation, the challenge for researchers is to evaluate the performance of the European Banking Authority.

Finally, at the international level, an article in New Scientist revealed that 147 interconnected entities control the network of global capitalism (Aron 2015). As a consequence, if one of those entities (not necessarily a large organization) had a problem, the rest of the interconnected entities could experience a significant adverse effect. Concern about the vulnerability of the interconnected entities to a ripple/domino effect led the Financial Stability Board⁵⁰ to publish a list of 29 systemically important financial institutions (SIFIs). If SIFIs fail, the world’s economy would be jeopardized. To safeguard themselves against collapse, these organizations are required to hold a significant proportion of their capital as collateral, despite the effect on their profitability (Aron 2015, 10). An entity is designated as SIFI on the basis of three criteria: its size, interconnectedness, and complexity. However, a company’s SIFI designation can and has been legally challenged because there is no agreement on how the three defining criteria interact to define a company’s importance worldwide. As a result, the regulation of SIFIs will be gradually eroded.