Wednesday, May 16, 2012

Chief of German Federal Financial Regulator Sees Importance of Regulating Shadow Banking and Derivatives

The new head of the German Federal Financial Supervisory Authority (BaFin), Dr. Elke König, emphasized the urgency of completing the regulation of shadow banking and derivatives in an interview with the BaFin Quarterly. She also said it was imperative to establish cross-border resolution authorities for systemically important financial institutions. Noting that her objective is for BaFin to be regarded as a benchmark both in Europe and international bodies, Dr. König said that Germany, as a major financial market, must participate closely in the shaping of EU and global regulatory standards.

There is no alternative to the recently introduced European System of Financial Supervisors, she posited, adding that Europe is a common economic area which will in due course need a common rule book. This is also in the interests of the German financial industry. She pledged that BaFin will assist the work of the banking and securities supervisory authorities and the European Systemic Risk Board, participating in working groups developing technical standards, but will also keep a critical eye on the new authorities. The BaFin President noted that the EU Commission will present a first experience report on the activity of the authorities in early 2014. Their founding Regulations might then have to be improved upon here and there, she predicted.

The regulation of the shadow banking system is one of the biggest challenges facing EU authorities, said Dr. König, and regulators must not get bogged down on this or else they will face a situation where banks are regulated while risks are being created next door in the shadow banking sector. Noting that various Financial Stability Board working groups have been gathering the facts on shadow banking, the BaFIN head said that the next step will be to make the connections between regulated banks and shadow banks transparent and then regulate these connections if need be, while simultaneously pushing ahead with the regulation of shadow banks themselves. That is the only way dangerous arbitrage can be stopped.

Dr. König has an uneasy sense that the enthusiasm for regulating shadow banking is waning as national interests begin diverging again. Unfortunately, many countries appear to be focusing more on short-term market advantage than on long-term stability. Regulating shadow banks must proceed apace because if significant progress is not made soon, she cautioned, it is only a matter of time before the financial markets are hit by unpleasant surprises from this area.

Similarly, Dr. König said that the international regulation of derivatives trading is making slower progress than 
hoped for. She believes that this is due, firstly, to the fact that derivatives regulation is enormously complex. More and more very different players are involved in derivatives transactions. Secondly, the industry must be given the chance to implement everything that is agreed, she said, and there the devil is in the details.

She emphasized that derivatives regulation is urgently needed. There is simply no alternative, she stressed, while acknowledging that there will never be a completely watertight solution. Derivatives regulation raises entirely new questions, such as what happens if a Central Counterparty fails or how can regulators be given access to data available on global transactions registers. Transparency in the derivatives market, which is closely linked with the shadow banking sector, is absolutely imperative.

Turning to the resolution of systemically important financial institutions (SIFIs), the BaFin chief described the subject of cross-border restructuring as a very complicated one. Although the German Restructuring Act means that Germany does not need to fear comparison at the moment, the effect of national legislation simply ends at national borders, which is a problem when it comes to SIFIs.

For that reason, in October 2011 the Financial Stability Board adopted principles to facilitate the orderly resolution of such institutions. A significant component of the FSB requirements is recovery and resolution plans. The FSB is keeping a very close eye on whether national authorities have been presented with such plans for their SIFIs.

The question of burden-sharing is also playing a prominent role. National interests very quickly manifest themselves at the international level, noted the official, since every country wants to protect its taxpayers and its depositors.

In order to deal with the situation, the EU is planning a Crisis Management Directive. Consideration is being given not only to implementing the FSB requirements and introducing a burden-sharing scheme, but also a creditor loss-sharing scheme, commonly referred to as debt write-down. By the time such a Directive is in place, she averred, the recovery and resolution of financial institutions should be easier to plan and manage, for the European area at least.