Student Number: 09132031

Module: EU Banking Regulation

Module Number: LAW 30340
Word Count: 3,511

EU Banking Regulation Assignment

The global economic crisis in which our society finds itself enveloped in was brought about

by a number of key contributing factors. It is widely accepted that the origin of the global

crisis can be found in the banking practices prevalent in the United States over the past

decade, or as U.S. treasury secretary Paulson described as “bad lending practice by banks”.1

The roots of this crisis go back decades. Years without a serious economic recession in the

United States bred complacency among financial intermediaries and investors. Financial

challenges such as the near-failure of Long-Term Capital Management and the Asian

Financial Crisis had minimal impact on economic growth in the U.S. This created

exaggerated expectations about the resilience of their financial markets and firms. Rising

asset prices, particularly in housing, hid weak credit underwriting standards and masked the

growing leverage throughout the system. Risk management systems did not keep pace with

the complexity of new financial products and market discipline broke down as investors

relied heavily on credit rating agencies. Compensation practices in effect throughout the

financial services industry rewarded short-term profits at the expense of long-term value.

Households saw significant increases in access to credit, but those gains were overshadowed

by pervasive failures in consumer protection, leaving many Americans with obligations that

they neither understood nor could afford.2

An Evaluative Analysis

To provide an insight into the key contributing factors of the global crisis it is necessary to

reflect on the actions of the then Federal Reserve Chairman Alan Greenspan in the aftermath

1 Sheran Dang, “SIVs, Bank Leverage and Subprime Mortgage Crisis”, (2008), available at SSRN
http://ssrn.com/abstract=1319431
2
http://www.financialstability.gov/docs/regulatoryreform/executive_summary.pdf
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

of the collapse of the technology equity bubble and the terrorist attacks on September 11,

2001.

His response to those events involved injecting an enormous amount of liquidity into the

U.S. monetary system, which lowered short-term lending rates to 1 percent by 2003.

The low interest rate environment had two significant consequences:

(1) An explosion in credit; and

(2) Low returns on traditional investments, which likely fuelled the boom in hedge funds and

private equity.

The adverse consequence of introducing such low interest rates was a reduced return on risk-

free assets such as U.S Treasuries. As a result, investors reallocated their portfolios towards

more lucrative but riskier assets, while another method used to generate higher returns in a

low interest rate environment required an extreme use of leverage.

To feed the appetite of investors and bankers alike, banks began to pursue an "originate -to -

distribute" (OTD) strategy, an innovative process that enabled banks to expand their lending

business without violating the lending limits placed by regulators.3 The process involved;

i) originating consumer and corporate loans,

ii) packaging loans into asset-backed securities (ABS) and collateral debt

obligations (CDOs)

iii) creating over the counter (OTC) derivatives whose values were derived from

loans

iv) distributing the resulting securities and other financial instruments to investors4

3
Arthur E.Wilmarth Jr., “The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime
Financial Crisis”, 2009, Connecticut Law Review, Vol 41, No.4.
4 Ibid.
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

However, by separating the originator of a loan from the bearer of its ultimate default risk,

the OTD model began to dilute the screening incentives of the originating banks.5 Ultimately

OTD loans were of inferior quality and banks that were stuck with these loans in the post-

disruption period had disproportionately higher borrower defaults.6

The Subprime Mortgage Collapse

The subprime mortgage crisis largely came about due to the excessive use of complex

financial instruments such as securitization by the Banks and the availability of innovative

mortgage options which allowed buyers to purchase houses for which they could not sustain

the mortgage payments in equilibrium.7

Securitization

The process of securitization involved the pooling of cash flows and the issuance of securities

backed by underlying assets.8 In the majority of cases mortgages had been bundled into

securities which were then rated and sold to various investors. Securitization allowed banks

to leverage up in tranquil times while the unforeseen result was that it concentrated risks in

the banking system by inducing banks and other financial intermediaries to buy each other‟s

securities with borrowed money.9

The initial appeal of securitisation was that risk could be diversified.

The Bank offloaded bundles of loans to an investor via a special purpose vehicle (SPV).

Pooled mortgages were resold in tranches that had different seniority and the investors could

5
Amiyatosh Purnanandam, “Originate-to-Distribute Model and the Subprime Mortgage Crisis”, AFA 2010 Atlanta meetings
paper. Available at SSRN: http://ssrn.com/abstract=1167786
6 Ibid at page 3.
7
Luigi Zingales, “The Causes and Effects of the Lehman Brothers bankruptcy”, (Oct 8, 2008), Before the Committee on
Oversight and Government Reform, United States House of Representatives, found at
http://www.scribd.com/doc/11096014/Causes-and-Effects-of-the-Lehman-Brothers-Bankruptcy

8
http://www.membersocieties.org/srilanka/linked%20files/Securitisation.pdf
9
Hyun Song Shin, “Securitisation and Financial Stability”, (2009) at http://www.voxeu.org/index.php?q=node/3287
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

select „tranches‟ with preferred return-risk combinations.10. By using the historical record of

defaults, the senior tranches were considered extremely safe; but historical records did not

factor in the probability of a significant drop in real estate prices at the national level as such

a depreciation in the value of property had not occurred since the Great Depression.11

In knowing that they would not bear the ultimate risk of default; many mortgage originators

further relaxed their lending standards.12 Thus the consumer was offered what was in

essence, free money.

The investor for his part would receive in return, monthly payments from the SPV with

interest.

However, instead of dispersing the risk, which was the intention behind securitization, many

academic commentators argue that in reality, securitization undermined financial stability

by concentrating risks within the banking sector.13

Default in Mortgage Repayments

The extent of securitization went largely unknown. As a result, when the housing market

collapsed and mortgagors defaulted on their repayments, many institutions holding these

securities panicked and the short term financing market abruptly froze.14

As liquidity evaporated and mortgage rates escalated the banks were forced to take assets

onto their books. Thus, many investors no longer wished to invest in the SPVs and the banks

were forced to take more assets onto their balance sheet.

While the subprime mortgage collapse in the U.S was undoubtedly the fundamental cause of

10
Paul Mizen, “Understanding the Financial Crisis 2007-2009”, Center for Finance and Credit markets, University of
Nottingham.
11
Luigi Zingales, “The Causes and Effects of the Lehman Brothers bankruptcy”, (Oct 8, 2008), Before the Committee on
Oversight and Government Reform, United States House of Representatives, found at
http://www.scribd.com/doc/11096014/Causes-and-Effects-of-the-Lehman-Brothers-Bankruptcy
12
Ibid.
13
Ibid.
14
Sheran Dang, “SIVs, Bank Leverage and Subprime Mortgage Crisis”, (2008), available at SSRN
http://ssrn.com/abstract=1319431
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

the global financial crisis, the collapse of one financial institution in particular triggered a

system-wide crisis of confidence in banks across the globe.

The Fall of Lehman Brothers

In September 2008, Lehman Brothers was pronounced bankrupt.15 The demise of Lehman

Brothers is widely attributed to overleverage which in 2007 was almost 30x.16

Its collapse sent the financial markets plummeting, resulting in a massive exodus from

private capital to safe Treasury securities, which paralyzed capital markets, froze lending,

and sent risk premiums on corporate and personal debt to record highs. These convulsions

in the credit markets directly contributed to the global economic downturn in which the

World now finds itself in.17

Underlying Reasons for the Banking Crisis

Bad regulation has been cited as a major flaw in the structure of the banking system.

The globalised economy of the twenty-first century appears to have diminished the capacity

of national authorities to exercise effective regulatory control and oversight over global

markets.18

An issue that has been cited as being problematic was the minimum reserve requirements set

out by the banking regulations19. Deposits with the central bank or cash that was held to

meet the minimum reserve requirements did not provide the banks with a reserve that it

could use when there was an unexpected shortfall of cash inflows. These funds only served to

15
Andrew Clark, “How the Collapse of Lehman Brothers Pushed Capitalism to the Brink”, (2009), at
http://www.guardian.co.uk/business/2009/sep/04/lehman-brothers-aftershocks-28-days
16 2007 SEC filings – Lehman Brothers Holdings INC
17
Jeremy J. Siegel, “The Lehman Crisis: An Unhappy Anniversary”, (2009), Found at
http://www.businessweek.com/investor/content/sep2009/pi20090918_770685.htm
18
Michael Longo, “The Global Financial Crisis: Causes and Implications for Future Regulation Part 2”, (2010), Journal of
International Banking Law and Regulation
19
Report on Enhancing Market and Institutional Resilience (April 2008) at page 12, found at
http://www.financialstabilityboard.org/publications/r_0804.pdf?noframes=1.
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

meet the regulatory requirement.20 Similarly, the equity capital that was held to meet the

capital adequacy requirements provided the bank with an imperfect buffer against

unforeseen losses. The Financial Stability Board (FSB) have recommended for an assessment

to be made regarding the impact of the Basel II implementation on banks‟ capital levels and

will decide whether additional capital buffers are needed21.

The credit rating agencies (CRAs) have also been credited for their role in the current

worldwide financial crisis22. Financial institutions such as investment banks and broker

dealers use credit ratings to determine the aggregate riskiness of their capital structure.

However, it has been said that the CRAs suffered from a conflict of interest, particularly in

the area of structured financial products. Corporations planning to issue structured financial

products customarily would solicit the opinion of credit rating agencies while the securities

were being structured.23

Companies sought to issue securities that had the highest credit rating possible on the

securities being issued. The conflict issue arises when the same CRA that had been consulted

on the creation of a structured financial product goes on to rate that same product during the

underwriting process and, putting its stamp of approval on it for the use of prospective

investors. As a matter of practicality, it would be difficult for a CRA in such a position to turn

around and issue a lower rating than the rating sought by the issuer based on advice received

previously when the same CRA may have served as a consultant.24

The lack of transparency presented further difficulties. Because of systemic

interdependence, the individual bank‟s risk exposure could not be ascertained by just looking

at the bank‟s assets and liabilities, on balance sheet and off. If the bank‟s asset position

20
Martin Hellwig, “Systemic Risk in the Financial Sector: An Analysis of the Sub-Prime Mortgage Financial Crisis”, (2008),
found at SSRN
21
Report on Enhancing Market and Institutional Resilience (April 2008) at page 32, found at
http://www.financialstabilityboard.org/publications/r_0804.pdf?noframes=1.
22
Ibid at page 32.
23
Tom Hurst, “The role of credit rating agencies in the current worldwide financial crisis”, (2009), Company Lawyer at 61
24
Ibid
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

involves a certain risk and the bank has hedged this risk by contracting with a third party,

the effectiveness of the hedge depends on the third party‟s ability to fulfil its obligations

when needed. If the positions of other market participants like the contracting party are not

known, there is no way the supervisor can correctly assess the bank‟s exposure to such

systemic risk just by looking at the bank‟s balance sheet.25

The Plan for Reform

Experience of the financial crisis has exposed important failures in financial supervision, both

in particular cases and in relation to the financial system as a whole. In Europe, President

Barroso therefore requested a group of high level experts, chaired by Mr Jacques de

Larosière, to make proposals to strengthen European supervisory arrangements, with the

objective of establishing a more efficient, integrated and sustainable European system of

supervision.26 Similarly, on a more international stage the Financial Stability Forum (FSF)

undertook an analysis of the causes behind the turmoil and set out recommendations for

increasing the resilience of markets and institutions going forward27.

In January 2009, the Commission took action to strengthen the “Lamfalussy level 3

Committees” which covered the areas of Banking Supervision, Securities Regulation and

Insurance and Occupational Pensions. It was then recommended that the three committees

be transformed into European Authorities with increased powers. The function of these

authorities would be to

25
Martin Hellwig, “Systemic Risk in the Financial Sector: An analysis of the Subprime-Mortgage Financial Crisis”, (2008),
Found at SSRN
26
Proposal for a Directive of the European Parliament and the Council found at
http://ec.europa.eu/internal_market/finances/docs/committees/supervision/20091026_576_en.pdf
27
Report on Enhancing Market and Institutional Resilience (April 2008), found at
http://www.financialstabilityboard.org/publications/r_0804.pdf?noframes=1.
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

 Co-ordinate the work of national supervisors,

 Arbitrate between national supervisors in supervisory colleges in cases of

disagreement on supervisory issues regarding a cross-border financial institution;

 Take steps to harmonise national regulatory rules and move towards a common

European rulebook;

 Directly supervise certain pan-European institutions which are regulated at EU level,

such as Credit Rating Agencies.

This was followed by legislative proposals in September 2009.28

The proposals were for a regulation establishing a European Banking Authority. The

proposals provided for the establishment of the European System of Financial supervisors

(ESFS) and for the development of a single rule book which would ensure uniform

application of rules in the EU and thus contribute to the functioning of the internal market.

The ESFS would consist of a network of national financial supervisors working in tandem

with new European Supervisory Authorities (ESAs), created by transforming the existing

European supervisory committees into a European Banking Authority (EBA), a European

Insurance and Occupational Pensions Authority (EIOPA), and a European Securities and

Markets Authority (ESMA).

A European Systemic Risk Board (ESRB) would also be established, to monitor and assess

potential threats to financial stability that arise from developments within the financial system

as a whole. The ESRB would provide an early warning of system-wide risks that may be

building up and, where necessary, issue recommendations for action to deal with these risks.

The task of the ESAs is to assist the national authorities in the consistent interpretation and

application of the Community rules.29

28 http://ec.europa.eu/internal_market/finances/committees/index_en.htm
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

However, the focal point for day-to-day supervision will remain at the national level, with

national supervisors remaining responsible for the supervision of individual entities. The

proposals are thus said to be in accordance with the principles of subsidiarity and

proportionality.30

And on an International level, the ESAs could serve as helpful contact points for supervisory

authorities from third countries. In this context, they may, without prejudice to the

competences of the European Institutions, enter into administrative arrangements with

international organisations and the administrations of third countries.31

In October 2009, an “Omnibus” Directive was proposed by the European Parliament and

Council in order to develop the single rule book which would ensure uniform application of

rules in the EU. To achieve the single rule book, amendments to the various financial

services sectoral Directives require being made and in their place, one single directive would

be established.

The Commission itself has proposed a broad range of measures to tackle the financial and

banking crisis via the issuing of Communications. Such measures include;

 Initiatives to increase transparency and ensure financial stability in derivatives and

other complex structured products.

 Legislation to increase the quality and quantity of banks' prudential capital and to

tackle complex securitisation and to address liquidity risk and excessive leverage.

This is intended to reinforce capital requirements for trading book activities and

29 Proposal for a regulation of the European Parliament and of the Council Establishing a European Banking Authority , Found
at http://ec.europa.eu/internal_market/finances/docs/committees/supervision/20090923/com2009_501_en.pdf
30
Ibid.
31
Proposal for a Directive of the European Parliament and the Council found at
http://ec.europa.eu/internal_market/finances/docs/committees/supervision/20091026_576_en.pdf
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

upgrade capital requirements for complex securitisations in banking and the trading

book as well as mitigating any excessive pro-cyclicality of existing capital

requirements.

 Strengthening its 2004 Recommendation on remuneration of directors

 Legislative proposals to simplify and harmonise the national laws regarding

securities holding and transaction in the EU.32

In response to such proposals for reform, it might be said that the banking crisis is as much

about the supervisors' imperfect understanding and enforcement of the existing rules as it is

about those rules having had inherent defects that warrant regulatory readjustments.33 And

the national supervisors‟ weaknesses were only compounded by their reliance on flawed

credit ratings.34

As mentioned above, the credit rating agencies have been criticised for their role in the global

financial crisis.

In light of their flaws some meaningful steps have been taken to improve the functioning of

the credit rating agency industry. In July 2009, the Council adopted a regulation

introducing a legal framework for credit rating agencies.35 It provides for a legally-binding

registration and surveillance system for credit rating agencies issuing ratings that are

intended for use for regulatory purposes.

It is also aimed at:

 ensuring that credit rating agencies avoid conflicts of interest in the rating process,

or at least manage them adequately;

 improving the quality of methodologies used by credit rating agencies and the

32
Tony Ciro, Michael Longo, “The Global Financial Crisis: Causes and Implications for Future Regulation: Part 2”, (2010),
Journal of International Banking Law and Regulation.
33
Phoebus Athanassiou, “The role of regulation and supervision in crisis prevention and management: a critique of recent
European reflections”, (2009), Journal of International Banking Law and Regulation
34
Ibid
35
Regulation (3642/09)
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

quality of their ratings;

 increasing transparency by setting disclosure obligations for credit rating.36

The Commission's raft of proposals reflects many of the recommendations proposed by the

FSB but also testifies to the EU's long-standing commitment to harmonisation and

institution-building. However, the EU's current legitimacy crisis after the original rejection

of the Lisbon treaty, raises some doubts as to whether it can generate further impetus for

integration.37And the United Kingdom may be less sanguine than Germany, France, Italy and

some of its other partners in the EU on the nature and extent of reform necessitated by the

Global Financial Crisis, in fearing a consequential diminution of London's financial power.38

This author is of the opinion that one nation solutions are not sufficient to counter the effects

of the Global Financial Crisis and that significant strengthening of EU level control is

appropriate in these circumstances. However, while it would be thought that an

international approach to reform of banking regulation and supervision would be superior to

reform simply on a European level, the proposals of the FSB continue to allow for national

supervision and regulation, when clearly more integrated regulatory reforms are required in

the current globalised banking environment. While such proposals are welcome, certain

difficulties remain.

36
Brussels, 27 July 2009, 12380/09 (Presse 234) at http://register.consilium.europa.eu/pdf/en/09/st12/st12380.en09.pdf
37
Tony Ciro, Michael Longo, “The Global Financial Crisis: Causes and Implications for Future Regulation: Part 2”, (2010),
Journal of International Banking Law and Regulation.

38
Ibid.
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

Conclusion

The European Union and FSB have been active in their research of the deficiencies within

the banking system which led to the systemic failure of the banks. In having researched the

causes, they have amply responded with proposals for reform, with the intention of

preventing a recurrence of a similar crisis. However, it is evident that the proposals made

are in response to the global banking crisis, and may be criticised for implementing

regulations retroactively without sufficiently thinking ahead. One aspect of the proposed

regulations that may be criticised is the lack of dialogue over the national aspects of

supervision. While the proposals for regulation may be sound, as the de Larosière Report

itself acknowledged, a substantial cause of the banking crisis was due to “real and important

supervisory failures”.39 In light of such criticism, national supervisors have appeared

incapable of living up to their national supervisory tasks, yet the de Larosière report

advocates that supervision should remain at the national level.40 The proposals for banking

supervision seem somewhat confused. While the de Larosière report states that supervision

should remain at the national level, it also expects the enhanced Lamfalussy Level 3

Committees to bridge any differences by “developing common approaches to supervision”,

“binding technical standards” and “interpretative guidelines” or by settling disputes between

national supervisors, as proposed in the Commission Communication.41

Thus, within the proposal there are conflicting suggestions which may prove problematic if a

non-national body possessed of “binding mediation powers” were to instruct, as part of a

mediation process, national supervisors to act ultra vires their responsibilities under their

39
De Larosière Report, The High-Level Group on Financial Supervision in the EU, Report, February 25, 2009, Brussels paras
152-162.
40
De Larosière Report, The High-Level Group on Financial Supervision in the EU, Report, February 25, 2009, Brussels paras
172, 180.
41
European Commission, European Financial Supervision, Communication, May 27, 2009, Brussels, COM(2009) 252 Final, 9-
10.
Student Number: 09132031
Module: EU Banking Regulation
Module Number: LAW 30340
Word Count: 3,511

respective national legal framework.42

It is evident that there is a need for unified regulation and supervision throughout Europe

and indeed on a global scale. However, while the regulation of the Banks may be deemed

satisfactory, it is the supervision that will prove somewhat more difficult. The EU is faced

with the option of conflicting with the national supervisors and facing the question of

legitimacy; or, maintaining the status quo and “building upon existing structures”43 which

may compromise the efficiency of the proposed supervisory architecture.

Personally, I would sooner give the EU greater competence over banking supervision, both

cross-border and domestic rather than risk a repeat of our current financial plight.

42
Phoebus Athanassiou, “The role of regulation and supervision in crisis prevention and management: a critique of recent
European reflections”, (2009), Journal of International Banking Law and Regulation
43
European Commission, European Financial Supervision, Communication, May 27, 2009, Brussels, COM(2009) 252 Final,
available on the website of the European Commission 12.