Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law Volume Volume 6: Financial Regulation 9781509949649, 9781509949670, 9781509949663

Volume 6 of this new edition deals with financial regulation of banks and banking activities and products. It critically

203 95 6MB

English Pages [485] Year 2022

Table of contents :
Preface
Contents
Table of Cases
Table of Legislation and Related Documents
Part I. Financial Services, Financial Service Providers, Financial Risk and Financial Regulation
1.1. Financial Services and their Regulation
1.2. International Aspects of Financial Regulation
1.3. The 2008 Financial Crisis and its Effect on Financial Regulation
1.4. The Essentials of Commercial Banking
1.5. Capital Markets. The Essentials of the Investment Securities Business and its Regulation
Part II. International Aspects of Financial Services Regulation: The Effects of Globalisation and the Autonomy of the International Capital and Swap Markets. The Developments in GATT/WTO, the EU and BIS/IOSCO/IAIS
2.1. The Globalisation of the Financial Markets and the Informal or De Facto Liberalisation of Finance
2.2. The Formal Regime for the Freeing of the Movement of Goods, Services, Current Payments and Capital After World War II
2.3. The Creation of the EEC in Europe and its Evolution into the EU
2.4. The Effects of Autonomous Globalisation Forces on Financial Activity and its Regulation in the EU
2.5. Developments in the BIS, IOSCO and IAIS. The International Harmonisation of the Capital Adequacy Regime (Basel I, II and III)
Part III. The EU Regulations and Directives Concerning the Internal Market in Financial Services: Early Action, the European Passport, the 1998 EU Action Plan for a Single Market in Financial Services, and Further Action Following the 2008 Financial Crisis
3.1. Early EU Concerns and Action in the Regulated Financial Service Industries
3.2. The Early EU Achievements in the Regulation of Financial Services
3.3. The European Passport for the Financial Services Industry
3.4. The 1999 EU Action Plan for Financial Services
3.5. The Details of the Third Generation Directives and their Revamping under the 1999 Action Plan. The Period Up to the 2008 Financial Crisis and the Continuation of the Basic Framework
3.6. Other EU Regulatory Initiatives in the Financial Area
3.7. The EU During and After the 2008 Financial Storm
4.1. The European Banking Union
5.1. Summary, Evaluation and Conclusion
Index

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DALHUISEN ON TRANSNATIONAL AND COMPARATIVE COMMERCIAL, FINANCIAL AND TRADE LAW VOLUME 6 Volume 6 of this new edition deals with financial regulation of banks and banking activities and products. It critically reviews micro-prudential regulation, the need for macro-prudential supervision and an independent macro-prudential supervisor, the role of resolution authorities, the operation of the shadow banking system, and the extraterritorial reach and international recognition of financial regulation. The volume considers in particular the fallout from the 2008 financial crisis and the subsequent regulatory responses in the US and Europe, especially in the EU. The complete set in this magisterial work is made up of 6 volumes. Used independently, each volume allows the reader to delve into a particular topic. Alternatively, all volumes can be read together for a comprehensive overview of transnational comparative commercial, financial and trade law.

ii

Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law Volume 6 Financial Regulation Eighth Edition

Jan H Dalhuisen Emeritus Professor of Law King’s College London Chair in Transnational Financial Law Catholic University Lisbon Visiting Professor UC Berkeley Corresponding Member Royal Netherlands Academy of Arts and Sciences Member New York Bar Former ICSID Arbitrator and FCIArb

With the Cooperation of Dr Tracy Maguze Researcher at the Pew Charitable Trusts in Washington DC

HART PUBLISHING Bloomsbury Publishing Plc Kemp House, Chawley Park, Cumnor Hill, Oxford, OX2 9PH, UK 1385 Broadway, New York, NY 10018, USA 29 Earlsfort Terrace, Dublin 2, Ireland HART PUBLISHING, the Hart/Stag logo, BLOOMSBURY and the Diana logo are trademarks of Bloomsbury Publishing Plc First published in Great Britain 2022 Copyright © Jan H Dalhuisen, 2022 Jan H Dalhuisen has asserted his right under the Copyright, Designs and Patents Act 1988 to be identified as Author of this work. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publishers. While every care has been taken to ensure the accuracy of this work, no responsibility for loss or damage occasioned to any person acting or refraining from action as a result of any statement in it can be accepted by the authors, editors or publishers. All UK Government legislation and other public sector information used in the work is Crown Copyright ©. All House of Lords and House of Commons information used in the work is Parliamentary Copyright ©. This information is reused under the terms of the Open Government Licence v3.0 (http://www. nationalarchives.gov.uk/doc/open-government-licence/version/3) except where otherwise stated. All Eur-lex material used in the work is © European Union, http://eur-lex.europa.eu/, 1998–2022. A catalogue record for this book is available from the British Library. A catalogue record for this book is available from the Library of Congress. Library of Congress Control Number: 2022933885 ISBN: HB: 978-1-50994-964-9 ePDF: 978-1-50994-966-3 ePub: 978-1-50994-965-6 Typeset by Compuscript Ltd, Shannon To find out more about our authors and books visit www.hartpublishing.co.uk. Here you will find extracts, author information, details of forthcoming events and the option to sign up for our newsletters.

To my Teachers and my Students

vi

PREFACE The is the sixth and last Volume in this series, dealing with the regulation of financial products and services. Efforts in the Basel Committee and G-20 provided major guidance and led to the discussion of the present implementation in the US, the EU, and the UK. This is an ever more demanding subject and I have been most fortunate to be able to cooperate with Dr Tracy Maguze, Researcher at The Pew Charitable Trusts in Washington DC, who was my PhD student and whose work on macro-prudential supervision will be published shortly by the present publisher. This cooperation is acknowledged on the title page. I am no less indebted to Dr Federico Della Negra, Senior Legal Counsel at the European Central Bank, whose work is also published by Hart Publishing, for having had the patience to go through the text and providing helpful suggestions. The responsibility for the choices made and the final text, of course, remains mine. As with the companion Volumes, other younger scholars and practitioners are invited to contribute to the next edition by writing to me and any contribution will be acknowledged. More can and must be done, even if there is a page limit to what publishers will allow, parts can be rewritten and perhaps shortened. More important is that the text must remain accessible to graduate students for whom this series was always written. To this end, simplification is necessary but within the limits of the narrative remaining meaningful at the graduate and research level. Choices must be made, and this was always the true challenge. They are not immutable and alternatives may be possible. Jan H Dalhuisen Berkeley, February 2022 [email protected]

viii

CONTENTS Prefacevii Table of Cases xvii Table of Legislation and Related Documents xxi Part I Financial Services, Financial Service Providers, Financial Risk and Financial Regulation 1.1. Financial Services and their Regulation 1.1.1. The Recycling of Money. Commercial Banking and Capital Markets 1.1.2. Financial Services and Financial Risks. Financial Stability and Systemic Risk 1.1.3. Types of Banking Risk. The Issues of Banking Illiquidity and Insolvency 1.1.4. Liquidity Management and Management of Balance-sheet Risk 1.1.5. Risk Management, Hedging and the Commoditisation of Risk 1.1.6. The Role of Central Banks as Lenders of Last Resort. Government Support Systems 1.1.7. The Role of Regulation and the Major Regulatory Concerns: Financial Stability, Depositors and Investor Protection (Conduct of Business), and Market Integrity 1.1.8. The Basic Structure of Modern Financial Regulation. The Type of Recourse 1.1.9. Deregulation and Re-regulation of Modern Financial Activity. The Institutional and Functional Approach to Financial Regulation. Monetary, Liquidity and Foreign Exchange Policies Distinguished 1.1.10. The Different Aims of Modern Financial Regulation 1.1.11. Conflicting Regulatory Objectives. Lack of Clarity in Statutory Regulatory Aims 1.1.12. Financial Regulation and the Issue of Moral Hazard. The Operation and Effects of Deposit and Investor Guarantee Schemes. The Issue of Regulatory Capture 1.1.13. The Pro-cyclical Nature of Banking and Micro-Prudential Banking Regulation 1.1.14. Principle-based Regulation and Judgment-based Supervision in the UK. Micro- and Macro-prudential Supervision 1.1.15. Macroprudential Policy. Objectives, Instruments, and Powers 1.1.16. The ‘Too Big to Fail’ Issue 1.1.17. Universal Banks, Conglomerate Risks and the Effect on Regulatory Supervision

1 1 5 10 13 16 19 21 25 30 35 41 46 48 52 60 66 67

x Contents 1.1.18. The Shadow Banking System 1.1.19. Other Ways to Recycle Money. Trading Platforms, Fintech, Virtual Payment and Lending Facilities: Bitcoin and Crowdfunding. The Potential Effect on Commercial Banking 1.1.20. Official and Unofficial Financial Markets. Regulatory Issues 1.1.21. Market Abuse, Insider Dealing, and Misleading Financial Structures. The Regulatory Response 1.2. International Aspects of Financial Regulation 1.2.1. When are Financial Activities International? EU Approach, Home or Host Country Rule between Member States. The EU Passporting 1.2.2. Different Attitudes to Foreign Regulation. The EU Approach to Third Country Activity, Access to the EU, and Export from the EU 1.2.3. Regulation of the Activities of Foreign Banks in the US 1.2.4. The US Regulatory Approach to Issuing Activity and to Investment Services Rendered in the US by Foreign Issuers and Intermediaries 1.2.5. The Basel Concordat Concerning International Commercial Banking Regulation. Efforts to Achieve a Framework for International Financial Conglomerate Supervision. The Joint Forum 1.2.6. The Modern International Financial Architecture. The Advent of Macro-prudential Supervision, the Financial Stability Board (FSB) and its Significance 1.3. The 2008 Financial Crisis and its Effect on Financial Regulation 1.3.1. What Do We Mean by Financial Stability and Systemic Risk? 1.3.2. Financial Crises and Immediate Causes of Regulatory Failure 1.3.3. The Lack of Academic Models and Reliable Information 1.3.4. The Regulatory Picture in 2008. Shortage of Regulation? 1.3.5. Policy Issues 1.3.6. The Modern Credit Culture. The Democratisation of Credit 1.3.7. A New Theme in Public Policy and a New Paradigm in Banking? Modern Monetary Theory (MMT) 1.3.8. Different Attitudes Towards the 2008 Financial Crisis and its Resolution 1.3.9. Problems with the Reform of Financial Regulation and Prudential Supervision After 2008 1.3.10. Areas for Regulatory Reform 1.3.11. Effect of Globalisation. The Lack of an International Safety Net 1.3.12. The US and European Regulatory Responses to the Financial Crisis 1.3.13. The Emergence of the Eurozone Banking Union and the Mutualisation of Banking Debt in the Eurozone 1.3.14. Ways Ahead 1.4. The Essentials of Commercial Banking 1.4.1. Major Aspects of Banking. Supervision and the Role of Banks of Last Resort 1.4.2. Types of Banks and their Operations. Non-banks and the Shadow Banking System 1.4.3. Commercial Banking Products, Unsecured and Secured Loans, Leasing, Repos, Receivable Financing, Syndicated Loans, Trade and Project Finance

70 73 77 80 83 83 87 88 89 92 95 97 97 100 103 105 108 112 115 119 125 127 134 137 142 145 147 147 150 151

Contents xi 1.4.4. Commercial Banking Risks 154 1.4.5. Risk Management in Banks 159 1.4.6. Broad and Narrow Banking. Sharia Banking. Market-based Monitoring of Banks 161 1.4.7. Commercial Banking Regulation and Banking Regulators. International Aspects 164 1.4.8. Intermediation and Disintermediation of Commercial Banks 166 1.4.9. The Banking or Current Account Relationship and Agreement 167 1.4.10. The Democratisation of Financial Services and its Effects. A Human Right to Credit and a Public Function for Banks? 172 1.4.11. Fintech and the Potential Effect on Commercial Banking 174 1.5. Capital Markets. The Essentials of the Investment Securities Business and its Regulation 175 1.5.1. Major Types of Securities. Negotiable Instruments, Transferable Securities and Investments. Book-entry Systems and Securities Entitlements175 1.5.2. Securities Markets and their Organisation. Official Markets 181 1.5.3. Unofficial Markets, Globalisation of Markets, Euromarkets 184 1.5.4. The Primary Market and Security Issuers. International-style Offerings 187 1.5.5. The Secondary Market and its Trading Techniques 188 1.5.6. Internet or Electronic Issuing and Trading. ATSs and MTFs/OTFs. Black Pools, HFTs and Crowd-funding 190 1.5.7. Modern Clearing, Settlement and Custody 195 1.5.8. The Role of Investment Banks as Underwriters and Market-makers 198 1.5.9. The Role of Investment Banks as Brokers and Investment Managers. Investors’ Protection, Fiduciary Duties 201 1.5.10. Insolvency of Securities Brokers. The Notion of Segregation, Tracing and Constructive Trust in Respect of Client Assets 206 1.5.11. Other Activities of Investment Banks. Fund Management, Prime Brokerage, Corporate Finance, and Mergers and Acquisitions. Valuations209 1.5.12. The Risks in the Securities Business. Securities Regulation and its Focus. The European and US Approaches 212 1.5.13. Securities Regulators 214 1.5.14. International Aspects of Securities Regulation 216 1.5.15. Fintech and the Capital Markets 217 Part II International Aspects of Financial Services Regulation: The Effects of Globalisation and the Autonomy of the International Capital and Swap Markets. The Developments in GATT/WTO, the EU and BIS/IOSCO/IAIS 2.1. The Globalisation of the Financial Markets and the Informal or De Facto Liberalisation of Finance 219 2.1.1. Autonomy of the International Capital Markets. Its Extent and Meaning 219 2.1.2. The Eurobond Market and its Main Features. Euro Deposits 221 2.1.3. The Legal Status of Euromarket Instruments and Underwriting Practices225

xii Contents

2.2.

2.3.

2.4.

2.5.

2.1.4. Central Bank Involvement 2.1.5. Development of the Swap Markets, its Main Features and the Clearing 2.1.6. The Legal Status of Swaps, the Applicable Law. Bankruptcy and Regulatory Issues The Formal Regime for the Freeing of the Movement of Goods, Services, Current Payments and Capital After World War II 2.2.1. Cross-border Movement of Goods. GATT 2.2.2. Cross-border Payments and Movement of Capital. IMF 2.2.3. Cross-border Movement of Services. GATS 2.2.4. The WTO The Creation of the EEC in Europe and its Evolution into the EU 2.3.1. The European Common Market and Monetary Union 2.3.2. The EU Institutional Framework and Legislative Instruments 2.3.3. The EU Internal Market: Definition of Cross-border Services. Connection with Free Movement of Goods and Persons and with the Right of Establishment 2.3.4. Early Failure of Full Harmonisation of Regulated Financial Services in the EU and the 1985 Breakthrough: Mutual Recognition of Home Regulation. The European Passport in Finance The Effects of Autonomous Globalisation Forces on Financial Activity and its Regulation in the EU 2.4.1. Effects of the Free Flow of Capital in the EU. The 1988 Directive on the Free Movement of Capital 2.4.2. The 1988 Directive and the Redirection of Savings and Tax Avoidance Issues. The 2003 Savings Tax Directive 2.4.3. The 1988 Directive and the Movement of Financial Products and Services 2.4.4. The 1988 Directive and Monetary and Exchange Rate Aspects of the Free Flow of Capital. The 1997 Stability Pact 2.4.5. The Single European Market for Financial Services and its Relationship to the Euromarkets Developments in the BIS, IOSCO and IAIS. The International Harmonisation of the Capital Adequacy Regime (Basel I, II and III) 2.5.1. The Functions of the BIS, IOSCO and IAIS 2.5.2. The BIS Capital Adequacy Approach for Banks. The Basel I Accord. Criticism. Basel II 2.5.3. Credit Risk, Position Risk, Settlement Risk, and Operational Risk. Liquidity Risk 2.5.4. The Risk Assets Ratio, Risk Weightings, and Qualifying Capital under Basel I. The Minimum Capital Standard 2.5.5. 1993 BIS Proposals for Netting, Market Risk and Interest Rate Risk. The 1996 Amendment. VaR 2.5.6. The Building Block Approach 2.5.7. Capital for Derivatives 2.5.8. Contingent Assets and Liabilities. Off-balance-sheet Exposures. Credit Conversion Factors

225 226 226 229 229 231 232 235 237 237 243 245 250 251 251 252 255 255 256 257 257 259 262 264 265 267 268 269

Contents xiii 2.5.9. Capital Adequacy Calculations under Basel I. The Level Playing Field for Banks and the Effect of a Change in the Minimum Capital Requirement 2.5.10. Criticism of Basel I. The 1999 BIS Consultation Document and the 2001 BIS Proposals. Inclusion of Operational Risk. Basel II (2008) and the American Shadow Committee 2.5.11. Continuing Criticism and the 2008 Crisis 2.5.12. The Situation After Basel II. Basel III. Increased Capital, the Leverage Ratio, a Regulatory Approach to Liquidity Risk and the Macro-prudential Add-on 2.5.13. The New Liquidity Regime in Basel III 2.5.14. Derivatives, Contingencies and Other Off-balance-sheet Exposures After Basel III 2.5.15. Capital Adequacy Calculations under Basel II and Basel III 2.5.16. The Finalised Basel III Accord 2.5.17. Evaluation of the Basel Framework Overall Approach

270 273 278 280 285 287 287 293 294

Part III The EU Regulations and Directives Concerning the Internal Market in Financial Services: Early Action, the European Passport, the 1998 EU Action Plan for a Single Market in Financial Services, and Further Action Following the 2008 Financial Crisis 3.1. Early EU Concerns and Action in the Regulated Financial Service Industries 297 3.1.1. Regulatory Restrictions on the Operation of the Internal Market. The Effect of Home and Host Regulation. The Concept of the General Good 297 3.1.2. Case Law Concerning the Notion of the General Good in Support of Host-country Financial Regulation 300 3.2. The Early EU Achievements in the Regulation of Financial Services 302 3.2.1. Banking 302 3.2.2. Details of the Early Banking Directives and Recommendations 302 3.2.3. Mortgage Credit 304 3.2.4. Capital Markets: The Early Securities and Investments Recommendations and Directives 305 3.2.5. UCITS 307 3.3. The European Passport for the Financial Services Industry 308 3.3.1. The Third Generation of EU Directives. The Development of the Passport 308 3.3.2. The Reduction of the Role of the General Good Supporting Host-country Rule in the Third Generation Directives 311 3.3.3. Division of Tasks. No Single EU Regulator. Regulatory Competition 313 3.3.4. Interaction with GATS 314 3.3.5. The Early EU Reciprocity Requirements. Relation with Third Countries. National Treatment and Effective Market Access 314 3.4. The 1999 EU Action Plan for Financial Services 315 3.4.1. The Main Features 315 3.4.2. The Lamfalussy Report and its Implementation. The Role of Comitology320 3.4.3. The 2005 White Paper on Financial Services 321

xiv Contents 3.5. The Details of the Third Generation Directives and their Revamping under the 1999 Action Plan. The Period Up to the 2008 Financial Crisis and the Continuation of the Basic Framework 323 3.5.1. The Second Banking Directive/Credit Institution Directives (SBD/CIDs): Home Country Rule Reach. Residual Host-country Powers323 3.5.2. Scope of the Banking Passport. Universal Banking and the Procedure for Obtaining the Passport. Home- and Host-country Communications 324 3.5.3. ISD/MiFID: Basic Structure. Background and Scope 325 3.5.4. ISD/MiFID: Home-country Rule, Authorisation, Capital, Prudential Rules. Procedure for Obtaining the Passport. The Concept of the General Good Revisited 328 3.5.5. ISD/MiFID I: Conduct of Business 328 3.5.6. Home or Host-country Authority in Matters of Conduct of Business 332 3.5.7. Regulated Markets, Concentration Principle and Stock Exchange Membership. The Competition of Modern Informal Markets or MTFs. Best Execution and Internalisation 332 3.5.8. Clearing and Settlement, CCP Access After MiFID I 335 3.5.9. ISD/MiFID: Member States’ Committee 335 3.5.10. CARD and the 2003 Prospectus Directive. The Issuer’s Passport 336 3.5.11. The 2003 Transparency Directive 339 3.5.12. The EU Approach to Capital Adequacy 340 3.5.13. The Market Abuse Directive (MAD) and 2014 Regulation (MAR) 341 3.5.14. UCITS and Fund Management 343 3.6. Other EU Regulatory Initiatives in the Financial Area 344 3.6.1. Large Exposures 344 3.6.2. Deposit Protection and Investor Compensation 344 3.6.3. Winding Up of Credit Institutions. The Alternative of an EU Resolution Regime in the Eurozone 345 3.6.4. Pension Funds 345 3.6.5. International Banking Supervision. Basel Concordat, EU Implementation347 3.6.6. Supplementary or Consolidated Supervision. International Co-operation and the 2011 Amendments 347 3.6.7. The E-commerce Directive 349 3.6.8. Long-distance Selling of Financial Products to Consumers 350 3.6.9. The Takeover Bids Directive (TOD) 351 3.6.10. Other Parts of the 1998 Action Plan: Electronic Money, Money Laundering, Settlement Finality, Cross-border Use of Collateral, and Taxation of Savings Income 352 3.6.11. Mortgage Credit 353 3.6.12. Payment Services Directive: SEPA 353 3.6.13. The Consumer Credit Directive 354 3.6.14. EU Activities in the Field of Clearing and Settlement 354 3.7. The EU During and After the 2008 Financial Storm 357 3.7.1. The General Scene 357 3.7.2. The New Committee Structure: The European System of Financial Supervisors (ESFS). The Single Rule Book 365

Contents xv 3.7.3. The Amended Capital Adequacy and Liquidity Regime (CRD 2–3) 368 3.7.4. The New Credit Institutions Directive and the Consolidation of the Capital Requirements for Banks and Investment Firms (CRD 4 and CRR). The 2019 and 2020 Amendments to CRD and CRR (CRD 5 and CRR 2) 368 3.7.5. The 2014 Replacement of MiFID I. MiFID II and MiFIR and the 2016 Commission Delegated Directive 371 3.7.6. The European Market Infrastructure Regulation (EMIR). Clearing and Settlement Issues for Derivatives 374 3.7.7. The Alternative Investment Fund Management Directive (AIFMD) 376 3.7.8. The Securities Law Directive and the Central Securities Depository Regulation (SLD and CSDR). Securities Clearing and Settlement 376 3.7.9. The Regulation on Short Selling and Certain Aspects of Credit Default Swaps (CDS) 377 3.7.10. Other Product Governance Obligations and Product Intervention Powers381 3.7.11. The Issue of Trading in Banks. The Volcker Rule in the EU 383 3.7.12. The Shadow Banking System. The Securities Financing Transactions Reporting Regulation (SFTR) 385 3.7.13. The Credit Rating Agency Regulation (CRAR) 386 3.7.14. The Replacement of the Prospectus Directive (PR3) 386 3.7.15. The Project for a Capital Markets Union (CMU) 387 3.7.16. Orderly Resolution, State Aid, an International Safety Net, and International Co-operation. The EU Bank Recovery and Resolution Directive (BRRD and BRRD2) 388 3.7.17. The New Regime Concerning Relations with Third Countries. The Notion of Equivalence 391 3.7.18. The EU Securitisation Regulation 395 3.7.19. Public Regulation and Private Law Consequences in the EU: The Impact of the EU Regulatory System on Private Law 396 4.1. The European Banking Union 400 4.1.1. Introduction 400 4.1.2. The Single Supervisory Mechanism (SSM) and Resolution Regime (SRM) 401 4.1.3. The Single Resolution Mechanism (SRM), the ECB, the Single Resolution Board (SRB) and the Single Resolution Fund (SRF) 403 4.1.4. The Single Deposit Guarantee Scheme (SDGS) 404 4.1.5. The Commingling of Competences and the Lack of a Robust Legal Framework of Recourse in the Eurozone Banking Supervision and Resolution Regime 405 4.1.6. The Issue of Proportionality in the Application of the EU Financial Regulatory Framework in the Eurozone 410 5.1. Summary, Evaluation and Conclusion 414 5.1.1. The Applicable Regulatory Regime Concerning Banking and Capital Market Activity under the Latest EU Directives and Regulations 414 5.1.2. The Institutional Aspects of the EU Regulatory Framework and Process 416 5.1.3. The Passport and the Technique of Passporting 416

xvi Contents 5.1.4. 5.1.5. 5.1.6. 5.1.7.

The EU Regulatory Involvement in the Market Infrastructure The Aim of Financial Stability and Orderly Markets The Issue of Conduct of Business Protection The Matter of Market Integrity, Including Market Abuse, Money Laundering, and Tax Avoidance or Evasion Issues 5.1.8. Third Country Activity 5.1.9. Evaluation

418 420 421 421 422 422

Index425

TABLE OF CASES Australia Commissioners of the State Savings Bank of Victoria v Permewan, Wright Co Ltd (1914) 19 CLR 457�� 147 European Union Case 9/56 Meroni v High Authority [1957–58] ECR 133�� 380 Case 62/70 Coditel [1980] ECR 881�� 301 Case 2/74 Reyners v Belgian State [1974] ECR 631�� 238 Case 8/74 Procureur du Roi v Dassonville [1974] ECR 837�� 237–38, 248 Case 33/74 Van Binsbergen v Bedrijfsvereniging Metaalnijverheid [1974] ECR 1299�� 238 Case 14/76 De Bloos [1976] ECR 1497�� 247 Case 33/78 Somafer [1978] ECR 2183�� 247 Cases 110/78 and 111/78 Van Wesemael [1979] ECR 35�� 300 Case 120/78 Rewe-Zentral AG v Bundesmonopolverwaltung für Branntwein [1979] ECR 649�� 249, 309, 312 Case 139/80 Blanckaert & Willems 1981] ECR 819�� 247 Case 203/80 Guerino Cassati [1981] ECR 3211�� 238 Cases 286/82 and 26/83 Luisi and Carbone [1984] ECR 377��238, 246 Case 205/84 Commission v Germany [1986] ECR 3755�� 299–300 Case 198/86 Conradi [1987] ECR 4469�� 248 Case C-362/88 GB-Inno-BM [1990] ECR I-667�� 300 Case C-180/89 Commission v Italy [1991] ECR 709�� 301 Case C-340/89 Vlassopoulou [1991] ECR I-2357�� 248 Case C-353/89 Mediawet [1991] ECR I-4069�� 301 Case C-76/90 Saeger v Dennemeyer [1991] ECR I-4221��247, 300 Case C-106/91 Ramrath [1992] ECR I-3351�� 248 Cases C-267/91 and C-268/91 Keck and Mithouard [1995] ECR I-6097�� 248–49, 312 Case C-330/91 Commerzbank [1993] ECR I-4017�� 248 Case C-19/92 Kraus [1993] ECR I-1663�� 248 Case C-1/93 Halliburton [1994] ECR I-1137�� 248 Case C-55/93 Van Schaik [1994] ECR I-4837��301, 312 Case C-384/93 Alpine Investments BV v Minister van Financien [1995] ECR I-1141��247, 301, 311–12, 329 Case C-415/93 Union Royale Belge des Sociétés de Football Association ASBL and others v Jean-Marc Bosman [1995] ECR I-4921�� 248

xviii Table of Cases Case C-439/93; Lloyd’s Register of Shipping v SociétéCampenon Bernard [1995] ECR 1-1961�� 247 Case C-55/94 Reinhard Gebhard v Consiglio dell’Ordine degli Avvocati e Procuratori di Milano [1995] ECR I-4165�� 247–48, 300 Case C-101/94 Commission v Italy [1996] ECR I-2691�� 300 Case C-272/94 Guiot [1996] ECR I-1095�� 301 Case C-222/95, Société Civile Immobilière Parodi and Banque H. Albert de Bary et Cie, ECLI:EU:C:1997:345�� 301 Case C-222/02 Peter Paul ECLI:EU:C2004:606�� 396 Case C-19/11 Markus Geltl v Daimler AG�� 342 Case C-577/11, DKV Belgium SA v Association belge des consommateurs Test-Achats ASBL, ECLI:EU:C:2013:146�� 301 Case C-604/11Genil 48 SL et al v Bankinter SA et al, 30 May 2013�� 399 Case C-270/12, United Kingdom of Great Britain and Northern Ireland v European Parliament and Council of the European Union, ECLI:EU:C:2014:18��142, 380 Case C-62/14 Peter Gauweiler v Deutscher Bundestag, ECLI:EU:C:2015:400�� 411 Case C-312/14, Banif Plus Bank Zrt v Márton Lantos, ECLI:EU:C:2015:794��180, 399 Case C-441/14 Danks Industri (DI), acting on behalf of Ajos A/S v Estate of Karsten Eigil Rasmussen, EU:C:2016:278�� 400 Case C-678/15, Mohammad Zadeh Khorassani, ECLI:EU:C:2017:45�� 180 Case T-733/16, La Banque postale, ECLI:EU:T:2018:477�� 408 Case T-745/16, BPCE, ECLI:EU:T:2018:476�� 408 Case T-751/16, Confédération nationale du Crédit mutuel, ECLI:EU:T:2018:475�� 408 Case T-757/16, Société générale, ECLI:EU:T:2018:473�� 408 Case T-758/16, Crédit agricole SA, ECLI:EU:T:2018:472�� 408 Case T-768/16 BNP Paribas, ECLI:EU:T:2018:471�� 408 Case C-493/17, Heinrich Weiss and Others, ECLI:EU:C:2018:1000�� 411 Case C-208/18, Jana Petruchová v FIBO Group Holdings Limited, ECLI:EU:C:2019:825�� 180 France Cour Administrative d’Appel de Paris, 30 March 1999�� 30 United Kingdom Baring v Corrie 2 B & Ald 137 (1818)�� 208 Bechuanaland Exploration Co v London Trading Bank [1898] 2 QBD 658�� 225 Clayton’s Case (1816) 35 ER 767�� 169 Crestsign v The Royal Bank of Scotland, [2014] EWHC 3043 (Ch)�� 203 Foley v Hill (1848) 2 HCL 28�� 148 Joachimson v Swiss Bank Corp [1921] 3 KB 110��148, 170 Libyan Arab Foreign Bank v Bankers Trust United Kingdom�� 225 Rubenstein v HSBC, [2011] EWHC 2304 (QB)�� 203 SCF Finance Co Ltd v Masri (No 2) [1987] QB 1002�� 148 Three Rivers District Council and Others v Governor and Company of the Bank of England [2000] 2 WLR 1220�� 30

Table of Cases xix United States Elliott v Capital City State Bank 103 NW 777 (Iowa 1905)�� 172 Grants Pass & Josephine Bank v City of Grants Pass 28 P 2d 879 (Oregon 1934)�� 172 Marine Bank v Weaver 455 US 551 (1982)�� 179 Metlife v FSOC, 177 F Supp 3d 219�� 64 Nationsbank of North Carolina v Variable Annuity Life Insurance Co 115 Sup Ct 810 (1995)�� 151 SEC v WJ Howey Co 328 US 293 (1946)�� 179

xx

TABLE OF LEGISLATION AND RELATED DOCUMENTS Canada Charter of Rights 1985�� 172 European Union Accounting Modernisation Directive�� 319 Admission Directive�� 305–7, 319 Art 5�� 306 Art 10�� 306 Art 15�� 306 Alternative Dispute Resolution for Consumer Disputes Directive�� 399 Alternative Investment Fund Management Directive (AIFMD)��73, 85, 141–42, 204, 308, 317, 343, 357, 364, 376–78, 391, 394, 397, 414, 418 Bank Recovery and Resolution Regulation��369, 390 BRRD (Bank Recovery and Resolution Directive)�� 66–67, 143–44, 165, 367, 388–89, 391, 403 Preamble�� 412 Art 27�� 389 Art 31(2)�� 389 Art 32(1)(c)��144, 389 Art 32(5)��389, 412 Art 44(3)��409, 412 BRRD (Bank Recovery and Resolution Directive) (2)��369, 388, 390–91 Capital Adequacy Directive�� 140, 261, 267, 279, 310, 340, 368 Capital Requirements Directive��87, 107, 116, 132, 268, 340–41, 344, 347, 349, 366–69, 391–92, 395, 400, 402, 410, 412, 414–17 Art 74(4)�� 410 Art 77(1)�� 410 Capital Requirements Directive (2)��17, 140, 347 Art 1(30)�� 17 Art 122(a)�� 17 Capital Requirements Directive (3)�� 27

xxii Table of Legislation and Related Documents Capital Requirements Directive (4)��57, 64, 87, 107, 140, 283, 287, 295, 341, 347, 349, 366–72, 395, 415–16 Preamble�� 288 Arts 35-46�� 417 Art 47�� 391 Art 48�� 391 Arts 74-75�� 417 Art 92��410, 412 Art 131�� 283 Capital Requirements Directive (5)�� 287, 341, 368–70, 390, 392 Art 97(4)�� 411 Art 143(1)(c)�� 411 Capital Requirements Regulation (CRR)��57, 64, 286–88, 295, 310, 341, 367, 369–71, 390, 395, 400, 410, 416–17 Capital Requirements Regulation (CRR 2)��286–87, 341, 368–70, 390, 410 Capital Requirements Regulation (CRR) Art 4(1)�� 216 Art 4(1)(a45)�� 411 CARD (Consolidated Admission and Reporting Directive)��184, 253, 305, 307, 319, 336, 339, 353, 414 Art 8��336, 339 Central Securities Depository Regulation (CSDR)�� 376–77, 397 Preamble�� 377 Charter of Fundamental Rights�� 404 Preamble��58, 408 Art 16��409, 412 Art 52�� 241, 409, 411 Collateral Directive 2002/47/EC�� 319, 352, 397 Comitology Decision�� 320 Commission Directive 91/31/EEC�� 261 Commission Regulation (EC) No 809/2004�� 336 Consolidated Accounts Directive��302–3 Consolidated Supervision Directive��302–3 Consumer Credit Directive (87/101), Art 4(3)�� 141, 351, 354 Credit Institutions Directives��30, 44, 94, 165–66, 226, 238, 246–47, 261, 269, 279, 289, 301–2, 310, 315–16, 326, 340, 344–45, 347, 368–69, 388 Preamble�� 323 Art 1�� 147 Art 1(2)�� 327 Art 6ff�� 323 Art 23��315, 324 Art 24�� 324 Art 25(2) and (3)�� 325 Art 26�� 325 Art 26(1)�� 323 Art 27�� 323 Art 28�� 325

Table of Legislation and Related Documents xxiii Art 29�� 323 Art 31�� 323 Art 33�� 323 Art 37�� 323 Art 40�� 323 Art 42�� 165 Art 47�� 315 Art 48�� 315 Art 132�� 165 Art 139�� 165 DCFR (Draft Common Frame of Reference)�� 217 Delegated Regulation (EU) 2017/565, Preamble�� 204 Deposit Protection Directive�� 344 Directive 70/50, Art 3�� 237 Directive 92/121 EEC, Art 6�� 344 Directive 2003/41/EC on the Activities and Supervision of Institutions for Occupational Retirement Provision�� 346 Directive 2006/73/EC�� 330 Directive 2009/138/EC, Art 13(26)�� 180 Directive 2011/61/EU, Art 4(1)�� 180 Directive (EU) 2019/1023 on preventive restructuring frameworks�� 397 Directive on free movement of capital and money 88/361 EEC��252–53, 255, 298 Art 5(6)�� 253 Directive on insider dealing 89/592/EEC�� 314 Directive on money laundering 91/308/EEC�� 314 Directive on tax co-operation 77/799/EEC�� 253 Directive on Taxation of Savings Income 2003/48/EC��253–54 E-commerce Directive��349–50 Art 3�� 195 EBA Regulation Art 9a�� 367 Art 60a��368, 411 EMIR (European Market Infrastructure Regulation)�� 16, 39, 140, 142, 197, 335, 354, 357, 364, 366, 371–72, 374–77, 386, 393–94, 397, 415–16, 420 ESBR Regulation (EU) No 1092/2010��7–8, 60, 365–66, 389 Preamble��8, 60, 67 Art 2(c)�� 7 ESMA Regulation Preamble�� 367 Art 18�� 366 Art 38g�� 367 Art 38h�� 367 Art 38i�� 367 Financial Conglomerate Directive��348–49 First Banking Directive��30, 302–4, 309, 336 Art 1�� 147 Art 4(1)�� 309

xxiv Table of Legislation and Related Documents First Consolidated Banking Supervision Directive�� 94 Fourth Company Directive�� 319 Insider Dealing Directive�� 310 Insurance Directives��238, 301 Investment Services Directive�� 44, 87, 166, 182, 204, 208, 210, 217, 226, 238, 255–56, 261, 300–1, 308, 310–12, 316, 319, 321, 325–27, 330, 332–33, 335, 338, 340, 347, 349 Preamble��44, 166, 329 Art 1(1)�� 325 Art 1(13)�� 333 Art 1(2)�� 325 Art 1(4)�� 180 Art 2�� 326 Art 2(1)�� 326 Art 2(2)�� 326 Art 3�� 328 Art 3(3)�� 328 Art 3(4)�� 328 Art 3(7)(e)�� 328 Art 7�� 315 Art 10�� 329 Art 11�� 44, 328–30, 350 Art 11(2)��328–29 Art 11(3)�� 329 Art 13�� 329 Art 14(3)�� 333 Art 14(4)�� 333 Art 15�� 333 Art 15(3)�� 333 Art 15(4)�� 333 Art 16�� 333 Art 17(4)�� 329 Art 18(2)�� 329 Art 19(2)�� 329 Art 19(4)�� 329 Art 19(6)�� 329 Art 20�� 333 Art 21�� 333 Art 21(2)�� 333 Art 24�� 329 Large Exposure Directive�� 344 Listing Particulars Directive��305–6 Art 24b�� 307 Market Abuse Directive (MAD)��81, 141, 321, 327, 341–42, 372, 414 Preamble�� 44 Art 1�� 82

Table of Legislation and Related Documents xxv Market Abuse Regulation (MAR)�� 82, 341–42, 364, 366, 372, 397, 414, 419, 421 MiFID II Directive��44, 76, 78, 85, 87, 166, 179–80, 190, 204, 226, 239, 301, 310–12, 316, 369, 372–73, 375, 377, 382, 392–94, 397, 400, 415–18, 422 Preamble�� 180, 194, 315, 391, 419–20 Art 2(1)(b)��194, 419 Art 4(1)(20)�� 419 Art 4(1)(38)��194, 419 Art 4(1)(7)�� 419 Art 4(44)�� 180 Art 5(2)�� 420 Art 11�� 420 Art 15�� 420 Art 16�� 371 Art 16(3)�� 381 Art 23��204–5 Art 24��205, 397 Art 24(1)�� 204 Art 24(2)��204, 381 Art 24(4) and (5)�� 204 Art 25�� 204 Art 25(2)�� 371 Art 28�� 421 Art 30(1)�� 204 Arts 39ff��315, 391 Art 69(2)�� 371, 396, 399, 421 Art 75(1)�� 371 Ann I��194, 419 MiFID (Markets in Financial Instruments Directive)�� 44, 85, 87, 141, 165–66, 180, 182, 190, 193, 202, 204–5, 208, 210, 217, 226, 238, 256, 301–2, 310–12, 316–17, 319–21, 327–34, 336, 338–39, 343, 347, 349, 356, 373, 377, 414–15 Preamble�� 326, 331, 333 Art 1�� 326 Art 1(1)�� 327 Art 2�� 326 Art 4(1)(26)�� 332 Art 4(1)(7)�� 327 Art 4(1)(8)�� 327 Art 4(15)�� 327 Art 4(18)�� 180 Art 4(2)�� 326 Arts 5-15�� 326 Art 5(1)�� 194

xxvi Table of Legislation and Related Documents Art 5(2)��327, 334 Art 5(2)`�� 194 Art 9�� 328 Art 11�� 327, 329, 334 Art 12�� 328 Art 13�� 327–28, 334 Art 14�� 327–28, 334 Art 14(1)�� 327 Art 15�� 315, 327, 334 Art 19�� 332 Art 21�� 332 Art 21(2)�� 331 Art 22��332, 334 Art 24�� 335 Art 24(1)�� 327 Art 25�� 332 Art 27�� 331–32, 334 Art 28��331–32 Art 29�� 194, 328, 334 Art 30�� 194, 328, 334 Art 31�� 326 Art 31(2)�� 328 Art 31(5)��194, 334 Art 31(6)��194, 334 Art 32�� 328 Art 32(7)�� 332 Art 33�� 328 Art 34��328, 335 Art 35�� 328 Arts 36ff�� 194 Art 44�� 334 Art 45�� 334 Art 45(5)�� 331 Art 46(1)�� 331 Arts 56ff�� 165 Art 61�� 332 Art 62�� 332 Title III�� 327 Ann I�� 326 MiFIR (MiFID Implementing Regulation)�� 239, 310, 364, 367, 377, 383, 392–94, 415, 420 Preamble�� 190, 315, 391, 421 Art 2(1)(d)��194, 419 Art 3�� 421 Art 4�� 421 Art 4(1)(44)�� 381 Art 5�� 421 Art 8�� 421

Table of Legislation and Related Documents xxvii Art 10�� 421 Art 12�� 421 Art 13�� 421 Art 18�� 421 Art 40�� 381 Arts 40-42�� 381 Art 40(3)�� 382 Art 41�� 381 Art 41(3)�� 382 Art 42��381–82 Art 42(2)�� 382 Art 42(6)�� 382 Art 46(1)��315, 391 Mortgage Credit Directive (MCD)��141, 353 Mutual Recognition Directive�� 305, 307, 336 Own Funds Directive�� 261, 310, 340 Pan-European Personal Pension Product Regulation��346, 397 Payment Services Directive��141, 353 Prospectus Directive�� 38–39, 44, 76, 86–87, 184–85, 188, 199, 213, 256, 305–7, 312, 317–20, 336, 338–39, 364, 386, 394, 414 Preamble�� 336 Art 2(1)�� 185 Art 2(1)(c)(iii)�� 337 Art 2(1)(d)�� 337 Art 2(1)(m)�� 338 Art 2(4)�� 337 Art 2(a)�� 179 Art 3�� 336 Art 3(2)�� 337 Art 3(f)��185, 223 Art 4(1)�� 337 Art 4(2)�� 337 Art 5(1)�� 337 Art 5(2)�� 338 Art 5(2)(d)�� 338 Art 5(3)�� 338 Art 5(4)�� 338 Art 5(5)�� 337 Art 7�� 337 Art 7(2)(e)�� 337 Art 9(1)�� 338 Art 10(4)�� 337 Art 11(3)�� 337 Art 13�� 327 Art 13(1)�� 338 Art 14(1)�� 338 Art 14(8)�� 337

xxviii Table of Legislation and Related Documents Art 15(7)�� 337 Art 16(1)�� 338 Art 17(1)�� 338 Art 19(2)�� 338 Art 19(3)�� 338 Art 20(3)�� 337 Art 21�� 306 Art 21(3)(a)�� 339 Art 29�� 336 Prospectus Regulation 2017��39, 76, 179, 184, 188, 307, 318, 386–87 Art 2(a)�� 179 Public Offer Directive�� 307 Art 14�� 307 Art 15�� 307 Art 20�� 307 Art 21�� 307 Regular Financial Reporting of Listed Companies Directive�� 306 Regulation 17�� 245 Regulation (EC) No 1287/2006�� 330 Regulation (EU) No 575/2013��289, 310 Regulation (EU) No 1093/2010 establishing a European Supervisory Authority (European Banking Authority)�� 367 Regulation (EU) No 1094/2010 establishing a European Supervisory Authority (European Insurance and Occupational Pensions Authority)�� 367 Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority)�� 367 Regulation (EU) No 1286/2014 on key information documents for packaged retail and insurance-based investment products��180, 396 Regulation (EU) No 2015/760 on European long-term investment funds�� 397 Regulation (EU) No 2015/847 on information accompanying transfers of funds�� 367 Regulation (EU) No 2016/1011 on indices�� 367 Regulation (EU) No 2019/2033, Art 62(3)�� 216 Regulation (EU) No 2019/876��341, 369 Regulation on Jurisdiction and Enforcement of Judgments in Civil and Commercial Matters (Brussels I) 2002, Art 22(5)�� 247 Regulation on prudential requirements for credit institutions and investment firms (EU) No 575/2013�� 310, 341, 369 Art 4(1)�� 147 Regulation on Short Selling and Certain Aspects of Credit Default Swaps��377–80 Art 12�� 379 Art 27�� 379 Art 28�� 379 Regulation on the Law Applicable to Contractual Obligations (Rome I) 2008�� 247 Art 6�� 324 Savings Tax Directive�� 252, 254, 422 Second Banking Directive��87, 93, 166, 226, 238, 246–47, 255, 261, 300–2, 304, 310, 316, 323–26, 328–29, 347 Preamble�� 166

Table of Legislation and Related Documents xxix Art 1�� 147 Art 9�� 315 Second Money Laundering Directive�� 352 Securities Financing Transactions Regulation��385–86 Securities Law Directive (SLD)�� 356, 376–77 Securitisation Regulation��395, 397 Settlement Finality Directive�� 319, 352, 356 Seventh Company Directive�� 319 Short Selling Regulation��142, 364, 366, 394, 415, 421 Single European Act��33, 239, 241, 244, 250, 298, 305, 315, 325 Solvency Directive�� 261, 269, 310, 340 SRM Regulation��67, 403, 408 Preamble��410, 412 Art 18(1)(c)�� 144 Art 18(5)�� 412 Art 27(5)��410, 412 SRM Regulation (2)�� 390 SSM Regulation�� 44, 57, 400, 402 Preamble�� 58, 401–3 Art 1�� 410 Art 5��57, 60, 402 Art 5(2)��402, 406 Art 14�� 402 Art 22��58, 408 Takeover Bids Directive��351–52 Transparency Directive��44, 256, 307, 310, 321, 327, 339, 364, 414 Preamble�� 44 Art 2(1)(i)�� 339 Treaty on European Union (TEU)�� 237, 239, 416 Preamble�� 240 Art 3(b)�� 244 Art 5��241, 411 Art 15�� 243 Art 16�� 320 Art 17�� 320 Art 17(1)�� 321 Treaty on the Functioning of the European Union (TFEU)��85, 237, 246, 309, 320, 388, 398, 401, 407, 410, 416 Art 21(2)�� 238 Art 26�� 238 Art 28�� 239 Arts 28ff�� 237, 239, 298 Art 29�� 239 Art 34�� 237–39, 246 Arts 34ff�� 237 Art 36�� 238–39, 298 Art 39�� 248

xxx Table of Legislation and Related Documents Art 45�� 237–38, 249 Art 49�� 238, 248, 298 Art 52�� 298 Art 53�� 299 Art 56�� 237–38, 246, 248, 298, 309, 312 Art 57�� 238, 247–48 Art 58(2)�� 297 Art 62�� 298 Art 63(1)�� 238 Art 63(2)�� 238 Art 114�� 85, 377, 380, 397 Art 114(2)�� 238, 244, 249 Art 115�� 251 Art 127(4)�� 320 Art 127(6)��320, 403 Arts 228ff�� 240 Art 235�� 243 Art 258��244, 321 Art 259�� 244 Art 263�� 244 Art 267�� 244 Art 288�� 245 Art 290�� 394 Art 291�� 394 Art 294�� 244 UCITS (Undertakings for Collective Investments in Transferable Securities) Directives�� 85, 141, 255, 305, 307–9, 321, 326, 343, 357, 364, 397, 414 Preamble�� 308 Art 4�� 308 Art 44�� 308 Art 45�� 308 France Banking Law 1984�� 173 Art 58�� 173 Art 89�� 173 Financial Securities Act 2003�� 69 Germany Banking Act, s 1(1)�� 148 BGB (Bürgerliches Gesetzbuch), s 242�� 171 Kapitalanlagegesellschaftsgesetz 1970�� 208

Table of Legislation and Related Documents xxxi International Basel Accords/Concordat��15–16, 18, 22, 32–33, 43, 47–50, 52, 55, 57, 59, 64–67, 70, 72, 89, 92–97, 99, 101–2, 104, 108–10, 113–17, 120, 126, 129–30, 138–40, 145, 149, 155–56, 163, 165, 167, 257–66, 269–70, 272–74, 276–87, 290, 292–95, 303, 310, 340–41, 347, 358–59, 363, 368–71, 391–92, 413, 417 Bretton Woods Agreements 1944�� 34, 95, 97, 231–32, 236, 238, 251 GATS (General Agreement on Trade in Services)�� 84, 87, 92–93, 135, 216–17, 232–36, 245, 298, 314–15 Art 1��85, 246 Art II(2)�� 233 Art XV�� 388 Art XVII:1�� 388 GATT (General Agreement on Tariffs and Trade)��219–20, 229–37, 251, 298, 314 General Agreement on Trade in Services (GATS)��84, 233 IMF Articles of Agreement, Art VIII(2)(b)�� 220 ISDA Swap and Derivatives Master Agreements�� 357 Marrakesh Agreement�� 233 North American Free Trade Agreement (NAFTA)�� 235 OECD Multilateral Agreement on Investment (MAI)�� 235 Rome Convention on the Law Applicable to Contractual Obligations 1980, Art 4�� 247 Statute of the International Court of Justice, Art 38(1)�� 258 TRIMS��233, 236 TRIPS��233, 236 Netherlands CC (Civil Code) Art 3.110�� 208 Arts 7.420-7.421�� 208 United Kingdom Bank of England Act 1998��33, 43, 57 Pt 1A�� 60 s 9C(2) and (3)�� 62 Banking Act 1987��36, 43, 45 s 3��30, 147 Companies Act 2006, s 678�� 2 Financial Services Act 1986�� 223 Financial Services Act 2012��29, 34, 54 Financial Services and Markets Act 2000�� 34, 43, 52, 81, 131, 147, 179, 385 s 2(2)�� 45 s 3(2)(a)�� 45

xxxii Table of Legislation and Related Documents s 118(1)�� 82 s 137D(1)(2)�� 381 s 138I�� 34 s 138J�� 34 sch 2�� 45 Financial Services Reform Act 2013�� 131 United States Alternative Mortgage Transaction Parity Act 1982�� 109 Bank Holding Companies Act s 4(c)(8)�� 88 s 4(k)�� 88 s 13��130, 385 Bankruptcy Code��133, 228 Code of Federal Regulations 208 app A�� 262 Community Reinvestment Act��109, 146 Dodd-Frank Act 2010�� 24, 49, 66–67, 89, 98, 125, 137–40, 146, 150, 171, 215, 354, 359, 374, 378, 384 s 112��61, 67 s 724�� 140 Financial Services Modernisation Act (Gramm-Leach-Bliley Act)��88, 150 Foreign Bank Supervisory Enhancement Act (FBSEA)��89, 94 Homeownership and Equity Protection Act (HOEPA)�� 109 International Banking Act 1978�� 89 Investment Advisers Act 1940�� 89 Investment Company Act 1940�� 89 JOBS Act�� 193 McFadden Act��88, 246 National Bank Act�� 148 Public Utility Holding Company Act 1935�� 89 Sarbanes-Oxley Act�� 83, 138, 339, 343 s 705�� 128 SEC Regulation S��91, 222, 333 Securities Act 1933 (Glass-Steagall Act)��19, 32, 59, 73, 89, 101, 130, 137, 150, 167, 179, 215 s 2(a)�� 179 s 2(a)(10)�� 90 s 4(2)��90, 92, 199 s 4(a)(2)�� 214 s 5�� 90 s 20�� 150 Securities Exchange Act 1934�� 89–91, 215 s 3(a)�� 179 s 3(a)(1)�� 206 s 3(a)(4)�� 205

Table of Legislation and Related Documents xxxiii s 3(a)(5)�� 205 s 4(2)�� 193 s 5�� 214 s 6�� 214 Tax Equity and Fiscal Responsibility Act��92, 222 Trust Indenture Act 1939�� 89 UCC (Uniform Commercial Code)�� 177 Art 8�� 74 Art 9��152, 159 s 1-302(b)�� 205 s 1-309�� 173 s 8-102(a)(15)�� 218 s 8-102(a)(15)(iii)(A)�� 218

xxxiv

Part I Financial Services, Financial Service Providers, Financial Risk and Financial Regulation 1.1. Financial Services and their Regulation 1.1.1. The Recycling of Money. Commercial Banking and Capital Markets In terms of financial services, products, risks and regulation, it is useful from the outset to distinguish clearly between the money-recycling function of (a) the (commercial) banks and (b) the capital markets. They together provide the main sources of funding (or liquidity in that sense) in society but give rise to different operations and different concerns. The so-called ‘shadow banking system’ (see section 1.1.18 below) and modern technologies often referred to as Fintech (see section 1.1.19 below) may provide others but we will largely concentrate on the two more traditional recycling facilities which remain so far also the most important. Commercial banks typically take deposits from the public, become owners of these deposits, and issue loans in their own name and at their own risk—say, for house mortgages and business activities, or as overdrafts and credit card advances for individuals. Deposits of this nature come from individuals or businesses, or in more technical terms from retail or wholesale, and function as a major funding vehicle for banks (others are interbank borrowings, bond issues, retained earnings, and paid in capital). Banks mediate in the liquidity-providing function by using these deposits to extend loans to the public.1 The consequence for depositors is that, while making

1 In this book it is this mediating function that is emphasised because it is the easier way to explain the operation of banks providing in this view new loans out of their cash reserves, mainly accrued from their deposits made by the public or taken from their own deposits with central or other banks or institutions or from borrowings from them or from issuing bonds in the capital markets. Economically, this view has long been challenged and the emphasis is then rather on money creation by banks, see the Bank of England paper by M McLeay, A Radia and R Thomas, ‘Money Creation in the Modern Economy’ (2014) 1(1) Quarterly Bulletin. It is indeed a fact that banks do not individually mark the funding for their new loans (or any other) and may create ‘phantom’ deposits entering ‘accounts payable’ on the liability or funding side of their balance sheet when entering into new loan agreements. Accounting practices allow it: it appears to result from the nature of the deposit-taking function itself and may mean that in an insolvency, there may be fewer actual creditors than the deposit total would suggest. Another way of looking at this is that the borrower of the money lent by the bank is deemed simultaneously to have made a deposit for the same amount. That is then considered a form of money creation whilst repayment of these loans would then be money destruction as would be the making of payments to suppliers or paying off other debt out of these ‘deposits’, except that the creditors are now likely to hold such claims. It is a facility notably not deemed available to the shadow banking system or capital markets where the intermediaries cannot take deposits and are for client funds subject to a segregation requirement as we shall see.

2 Volume 6: Financial Services, Financial Risk, and Financial Regulation deposits, they lose all ownership rights in ‘their’ money and become mere creditors of (or lenders to) the bank often at very low interest rates or no deposit interest at all. Interest could even be Now that we pay our creditors mainly through transferring claims on commercial banks, which these banks allow us to create on them, another way of saying this is that we can do so backed by our deposits or through overdrafts rather than transferring claims on central banks by physically using banknotes and that that has become a main function of banks. The emphasis is then more on the payment circuit. This type of transfer and the legal form was discussed in Vol 5, s 3.1.5. Payment is here money destruction except that the creditors/payees now hold such claims. We may also use such claims to pay for investments. That would then be money creation also, diminished when we sell them, except that other investors now need this type of funding. Overall it is not likely to make much difference for the money supply unless and until we ask for cash which would be notes from central banks and put them under our mattress. That would then be clear money destruction. It is taken out of circulation. For the rest it is mainly a matter of liquidity: holding claims on banks is more liquid than having investments, there is no position risk either, we incur credit risk but hope that banks are not going broke. From a macro economic point of view, the movement between a consuming and saving or investment mode in the public may have more fundamental implications, however, which are not here further considered except that in this view the role of money and the banking system may become more secondary and only a byproduct or manifestation of more important correlations. Money creation by government (claims on government) as a consequence of its fiscal policies may then play a similar subsidiary role, although it would appear that in a chronically highly leveraged society, leverage to such an extent may become an autonomous macro economic event (besides national product, savings, investments, consumption, export and import, and government expenditure and taxation), with which not only monetary policy but especially macro prudential banking regulation may become much concerned from a stability and risk management point of view, see further ss. 1.1.14/15 below. The autonomous liquidity providing function through banks (and government) on the scale as has become possible and is expected is then considered a separate macro-economic issue, now normally so understood. Leverage is the oil in the machine of a modern economy, but not then something that is merely a resultant or by-product of the underlying economic currents automatically tailored to the kind of economy we have from time to time. It affects the machine itself, especially the consumption factor which appears permanently activated in this manner, perhaps investments also. The question is then how much inflation will it cause and what is acceptable or even necessary to deal with all this debt. The above banking system works largely because it is accepted, practical, and as such considered efficient. The potential transfer at any time into cash, meaning central bank promissory notes, underpins its credibility even though these notes are no longer backed by gold. It follows that someone with a banking licence could start lending even without external deposits or other resources. As long as no cash is demanded (in terms of notes of central banks), all is then a matter of book entries in a system of claims on others. That would be the clearest example of money creation in banks. If there was only one bank in the world and all payments a matter of debiting and crediting within that bank, this could work as long as no one asked for cash. In its most extreme form, this money creating facility may induce a bank to lend money so created to investors who buy its new shares to shore up its own capital base, an activity mostly condoned in banks but usually prohibited in companies, cf s 678 UK Companies Act 2006. This money creation practice in ordinary commercial banks is considerably limited, however, by regulatory capital adequacy and liquidity requirements or leverage ratios. As we shall see, in the approach of this book, see ss 1.1.14/15 below, macro-prudential supervision should be able to limit this facility further through variable capital adequacy, liquidity and leverage ratio requirements per banking activity or even through instructions not to use or limit certain products, eg mortgages without down payments. It follows that this type of money creation is contained and now by itself seldom identified as a source of instability in the banking system. However, especially in the 1930s, this money creation aspect of banking was much highlighted by Irving Fisher and others who considered it inflationary and sought to limit it and these ideas are regularly revisited, see eg J Benes and M Kumhof, ‘The Chicago Plan Revisited’, IMF Working Paper 12/202 August 2012. It should be realised that there is another use of the terminology of money creation and destruction. In this perception, banks may ‘destroy’ money by taking it out of circulation whilst not lending or not investing the money they receive as deposits or out of other funding, especially whilst parking it at central banks. It means that by re-activating these reserves they may then be deemed to ‘create’ money. This is the model that is more readily used by economists interested in monetary policy and monetary equilibria in the context of the money supply and measuring and dealing with inflation or deflation. Although activating or de-activating money in this manner may then still be couched in the language of creating and destroying money, it is distinct and a monetary issue, not directly relevant for the present discussion, which is mainly concerned with the recycling of money and the stability of the financial system and risk management in that context. For the purposes of the following discussion, these are considered details, although they are important in understanding what banks do and how they operate.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 3 negative in a deflationary environment when money increases in purchasing power. The main reason individuals do this is because they want to park their cash somewhere and get access to the payment system for their current income and expenditure. It is no place for keeping their longer-term savings, however, unless they can arrange time deposits at a better interest rate. Mostly the money depositors provide is short term (cash deposits or short-term time deposits) and banks normally lend longer. That is a key part of their business and recycling function.2 In other words, they repackage the short-term deposits they receive. This is also called maturity transformation and has an important economic function. It allows the public to plan and to get for example, 10-to-20-year mortgages for house purchases. The significance for banks is that it allows them to earn an interest rate spread, short-term interest rates usually being lower than long-term interest rates and deposit money often coming for free. This recycling from short to long is the essence of commercial banking and is potentially very lucrative for banks but they carry the credit risk of their borrowers, who might not repay these loans or pay the interest on time. Being funded by short-term money also creates maturity mismatches and as a consequence liquidity risk in banks, which, as we shall see, constitutes a constant and other innate threat to the stability of the banking system. This is one way of recycling money. In the capital market, on the other hand, persons or entities with excess savings meet those who need capital more directly. Instead of depositing excess funds for little reward with commercial banks, investors buy shares or bonds (which are the typical capital market instruments, also called investment securities) issued in that market by issuers who could be governments or their agencies, banks, or commercial companies. This leads to (banking) disintermediation. Investors thus become exposed directly to those who need the money rather than to their banks through their deposits. Also here, they become mere creditors when buying bonds, but these are not deposits, the investors own their investments, and there is likely to be a higher return: the interest rate banks would otherwise have received on their loans to these issuers. Capital market activity of this nature assumes (a) an issuer in (b) the new issues or primary market and (c) some type of investment security as a proprietary instrument. It then usually also assumes (d) a trading facility in these instruments in the so-called secondary market, which provides liquidity, that is (in this context)3 the facility to sell the investment securities and reduce

2 This banking model has not remained unchallenged either and was questioned by Milton Friedman following Irving Fisher, see also the reference in the previous note, who thought that for depositors to invest in this way in unsafe assets was of dubious merit. Narrow banking is motivated by similar concerns, see s 1.4.6 below. But investing in other products might not be much safer whilst the rationale for many depositors is access to the payment system, not investing. Giving depositors a direct interest in banking assets is another approach, and may be approximated in Sharia financing, see also s 1.4.6 below and Vol 5, s 2.1.7 above, but it may also be inefficient and also of dubious investment value. 3 The term ‘liquidity’ is used in at least two different ways: (a) in the present context it is market liquidity, the facility to (easily) sell investments and reduce them to money without affecting the market price adversely, but (b) there is also funding liquidity, which is the just-mentioned liquidity provided by banks and the capital markets to the public through their money-recycling function. See MK Brunnemeier and LH Pederson, ‘Market Liquidity and Funding Liquidity’ (2009) 16 Econ Pol Rev 29. See further also the comment in n 28 below. Within banks, on the other hand, liquidity may refer more broadly to asset and liability management, meaning the maturity mismatch between short term-funding, mainly through deposits, and long-term assets, mainly outstanding loans. Here we see a connection between market and funding liquidity in so far that when market liquidity dries up, banks are likely to be affected in their investment portfolio and liquidity management with the result that they will be limited in their ability to provide more funding or liquidity to society. There is then a close relationship between this funding liquidity and societal leverage, see VV Acharya and S Viswanathan, ‘Leverage, Moral Hazard and Liquidity’ NBER Working Papers Series (2010).

4 Volume 6: Financial Services, Financial Risk, and Financial Regulation them to money when needed at the then prevailing market price. The securities themselves are then issued in transferable or tradable form to facilitate their easy transfer.4 Both the primary and secondary markets are segments of the capital market in operation, and may be concentrated in (i) regular stock exchanges, or in (ii) over-the-counter or ‘OTC’ or informal (or telephone) markets, or now also in (iii) electronic platforms as we shall see in section 1.1.19 below. The activities of issuers and investors in the primary and secondary markets (within the capital market) assume intermediaries of their own. They operate as advisers to issuers, as underwriters, as market-makers, as brokers or as investment advisers, and as service providers in exchanges, clearing, settlement and custody functions as will be discussed in sections 1.5.7, 3.5.8, 3.6.14 and 3.7.6 below. We are here concerned with intermediation of a different kind than that of commercial banks; these are activities in which investment banks or securities houses/investment firms or broker/dealers are likely to become involved (who may still be part of a commercial bank in what is then called universal banking, see section 1.1.16 below). Reference may here also be made to investment services, a term now more commonly used in Europe, where intermediaries like underwriters and brokers are then often called investment firms. In these activities, these intermediaries operate for others (their clients) mainly on a service basis (except in the case of underwriting or market-making as we shall see, when they may take substantial risks) for which they receive a fee, especially as brokers or investment managers or while advising on and organising primary issues for their clients. It follows that the moneys or cash, shares or bonds that they hold for clients do not become their own as do deposits in commercial banks. In fact, they do not normally share in the risk of the recycling of money in this manner (as commercial banks do) whilst organising new issues or buying and selling securities for their clients (except again when underwriting or market-making). It explains the basic difference in the position of commercial banks on the one hand and investment firms, investment banks, or broker/dealers on the other. It follows that even when brokers are dealing in the markets for their clients in their own name, which is normal, the securities they so obtain and the moneys they so handle for their clients do not become their own, although there may still be legal problems in terms of title to the securities shooting through to their clients, and in the segregation especially of fungible securities and client moneys, in particular in civil law countries, all especially relevant in a bankruptcy of the intermediary, as we have seen in Volume 5, but for the moment this may remain a detail except to repeat that legal systems may leave here a lot of legal risk on the table, see further also section 1.5.10 below. However, the principle of segregation should be clear and, unlike in commercial banks, is tantamount in capital market activity, however protected and implemented. A key difference with commercial banking is therefore that investment banks (or securities houses, investment services providers or broker-dealers) do not take client assets as their own and as a matter of principle the notion of segregation operates. It would be a very grave matter indeed if these capital market intermediaries did appropriate these assets, which would legally amount to theft or embezzlement. Instead, investment banking clients will (in principle) hold property rights (rather than contractual or creditors’ rights) in respect of these moneys and securities

4 Traditionally, we are here concerned with negotiable instruments (bearer or order paper, see Vol 4, s 3.1), in modern times replaced by security entitlements, see also the discussion in Vol 5, s 4.1. As we shall see, new issues may not always take the form of marketable or tradable securities and they may remain then wholly illiquid, often in so-called private placements. In that case, the investments, although they may still be represented by negotiable instruments, resemble ordinary loans and are normally held by investors until their redemption or maturity dates and may then be considered part of the loan book rather than of the investment book when held by banks. This may have capital adequacy consequences as we shall see.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 5 against their brokers or custodians even if, as just mentioned, the adequate protection of these proprietary rights may still be a major legal issue in investment services and their regulation. It follows, nevertheless, that at least in principle, the fate of these intermediaries including their bankruptcy should not affect their clients. Again, this is very different in commercial banks, but in respect of deposits only. If these banks operate at the same time as security brokers and custodians, only the money deposited to that effect will be theirs as deposit takers, not the securities they so buy or hold, and they must segregate them.5 As just mentioned, investment banks normally provide services, but, as already noted also, they may sometimes take positions in the securities so issued, especially as underwriters in the primary market or market-makers in securities in the primary and secondary markets. In these cases, they take market risk (something that will also be explained more fully below) in securities of which they are or become owners at their own expense. Again, in these or other activities they will never be able or be allowed to deal with clients’ assets as their own, especially when acting as custodians of the investment securities of their clients. They should in that capacity, for example, never be legally able to use client funds in their underwriting or market-making activity nor ever lend the investment securities they hold for clients to others (without their clients’ consent, see for securities lending Volume 5, section 4.1.3), let alone use them as security for their own debt.

1.1.2. Financial Services and Financial Risks. Financial Stability and Systemic Risk It may be clear from the foregoing that the financial services sector comprises on the one hand commercial banking services and on the other capital market or securities and investment services (it also comprises insurance and pension services which are not considered further here and there is also the shadow banking system and perhaps fintech financing, especially the operation of crypto currencies, to consider, as already mentioned). In most countries, commercial banking has long been regulated and supervised because of the need for its proper functioning for customers, at first particularly to protect depositors in a bank’s deposit-taking function, but now more generally the public at large in the lending or liquidity-providing function of the banking sector, particularly to guard against sudden shocks and interruptions. This is the issue of financial stability often also expressed as the issue of systemic risk. What this means and whether they should be distinguished needs to be considered foremost in terms of the risks banks take, the way they manage them and, in this way, strengthen and weaken themselves, and what other, mostly more external factors there may be which may further affect the stability of the financial system.6

5 It should also be understood that if segregation is achieved by a broker putting its clients’ moneys in a clientaccount which the broker opens with a bank, the clients’ ownership is expressed by them having direct access to this account, especially important in a bankruptcy of the broker. They thus escape the credit risk of the broker, but they still incur the credit risk of the bank where the broker has put their money. 6 It may be better to distinguish financial stability from systemic risk which may be a narrower concept, see also n 8 below. In this book, financial instability may best be considered a state of being, triggered by shocks going through the system and by the way they do. They may be internal; to banking like major disruptions in banks potentially due to mismanagement, or external like the effect of the economic cycle. Systemic risk more properly may then describe the range of shocks that could go through the financial system, precipitate failure, and how this may happen. Financial instability may thus be explained by systemic risk.

6 Volume 6: Financial Services, Financial Risk, and Financial Regulation One major aim of financial regulation7 is in this connection to avoid, contain or minimise some of the considerable risks inherent in banking, foremost the insolvency risk of banks, the issue of insolvency and its different manifestations being discussed further in the next section. Bank insolvency is obviously dangerous for depositors, who may lose all rights to repayment, but in a modern economy it will also affect the lending function and therefore be an impediment to the recycling of money on which society has come to depend. Although bankruptcy does not shorten the maturities of outstanding loans so that present borrowers are safe from that perspective (unless there is a covenant in the loan documentation to the effect that the loan matures upon insolvency or other events of default of the bank, which is unusual), no new credit will be extended and any roll-over clauses or standby credits may become ineffective. Most important in such situations, problems in one bank may affect other banks as they are all closely connected in the interbank credit or wholesale markets and through the payment system. They may be connected in many other ways, for example as each other’s clients in the repo and swap markets or by having guaranteed each other’s risks in the credit derivative markets (through credit default swaps or CDSs, see Volume, section 2.5.3) or by granting credit facilities to one another. The issue of market liquidity also reveals an indirect form of interconnection

Arguing the case for distinguishing between the two is made difficult, however, by the absence of a precise definition of financial stability (or systemic risk, see n 8 below). Definitions range from those identifying it in the negative, as the absence of stability, or quoting special factors e.g. when there are fears that means of payment may be unavailable at any price, see Anna J Schwartz, ‘Real and Pseudo Financial Crises’ in Forest Capie and Geofrrey Wood (eds), Financial Crises and the World Banking System (London, 1986) 11. Financial instability may also occur when there is inefficient allocation of savings to investment opportunities, as identified by Fredrick Mishkin, ‘Anatomy of Financial Crisis’ (1991) NBER Working Paper No. 3934; European Central Bank, ‘Assessing Financial Stability: Conceptual Boundaries and Challenges’ (2005) June Financial Stability Review 117; Otmar Issing, ‘Monetary and Financial Stability: Is There a Trade-Off?’, Paper Delivered to Conference on ‘Monetary Stability, Financial Stability and the Business Cycle’, Basel, 28–29 March 2003) . Instability may also exist when financial market bubbles grow, indeed or the saving–investment balance in the economy is less than optimal, see Olivier De Bandt and Phillip Hartmann, ‘Systemic Risk: A Survey’ (2000) European Central Bank Working Paper No 35; Thomas Padoa-Schioppa, ‘Central Banks and Financial Stability: Exploring a Land in Between’, Paper Delivered at the Second ECB Central Banking Conference ‘The Transformation of the European Financial System’, Frankfurt, October 2002 accessed 16 December 2019; Garry J Schinasi, ‘Responsibility of Central Banks for Stability in Financial Markets’ (2003) IMF Working Paper WP/03/121 ; Andrew G Haldane et al, ‘Financial Stability and Macroeconomic Models’ (2004) 16 Bank of England Financial Stability Review 80. Others have taken the approach of defining stability (as distinguished from systemic risk), variously describing it as as a state in which the ﬁnancial system can withstand unforeseeable events or shocks without major disruption and continue providing its services to the real economy, as the ECB sees it, or a situation in which the financial system can efficiently and smoothly facilitate the allocation of resources, accurately assess and price forward-looking financial risks, and absorbing financial and real economic surprises and shocks, see Gary Schinasi, Safeguarding Financial Stability: Theory and Practice (International Monetary Fund 2006) 82. Despite the multiplicity of definitions in these issues, two key factors may be identified—(i) there is a failure of the institutions of the financial system, and (ii) the failure disrupts the real economy. This last factor is what distinguishes financial instability from instability which is localised and remains within the sector, like failure of individual financial institutions due to mismanagement, but it does not address the question of how much disruption and feedback to the real economy society is willing to live with as these cannot be eliminated completely. 7 See also P Wood, Regulation of International Finance (London, 2007); see further for the regulatory objectives s 1.1.7 below.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 7 amongst banks—common exposures to similar assets. This raises further issues in terms of systemic risk.8 Its sources, and in reality, the more authentic causes of financial stability, include 8 As may appear from n 6 above, the literature often discusses financial instability in terms of systemic risk, see Gabriel Galati and Richhild Moessner, ‘Macroprudential Policy – A Literature Review’ (February 2011) Bank for International Settlements Working Papers No 337, 13, www.bis.org/publ/work337.pdf. As with financial instability, there is no commonly accepted definition of systemic risk. The Vice-Chair of the European Systemic Risk Board (ESRB) observed that ‘systemic risk can mean almost anything (or nothing), depending on whom you ask’, cf SG Cechetti, ‘Measuring Systemic Risk’ in E Gnan and J Ulbricht (eds), The ESBR at 1 (The European Money and Finance Forum, Vienna, Dec 2012) 25. Access to and cost of funding are now sometimes seen as the essence of systemic risk, not the result, cf eg SL Schwarcz, ‘Systemic Risk’ (2008) 97 Georgetown Law Journal 193, which thereby becomes primarily a liquidity issue but it may not cover the full picture as competitive pressures may keep interest rates down and allow the truth to be revealed much later. See further also SL Schwarcz, ‘Controlling Financial Chaos: The Power and Limits of Law’ (2012) 3 Wisconsin Law Review 816; and I Anabtawi and SL Schwarcz, ‘Regulating Systemic Risk: An Analytical Framework’ (2011) 86. The EU defines it as: ‘A risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and real economy’, see Art 2(c) ESBR Regulation (EU) No 1092/2010 of Nov 24 2010, OJL 331/1 (2010), which does not explain much either. This definition appears to mirror the definition of financial stability in that (a) the financial system is disrupted and (b) this affects the real economy. It may show the confusion or why systemic risk and financial instability are often conflated. As mentioned in n 6 above, systemic risk may better be seen as identifying the factors that disrupt the financial system and how they affect and work through it, leading to negative consequences for the economy (the state of instability). These factors and how they disrupt and can be managed are then the essence of systemic risk and the term becomes simply a collective for the many possible triggers of financial instability. As individual banks cannot manage the system, it becomes then more properly a regulatory supervision issue. In a narrower sense, systemic risk is often considered the risk that the toppling of one bank affects others, notably through their connection in the interbank and payment system. This is the issue of interconnectedness or domino effect. Another instance is sometimes thought to be situations where all participants move in the same direction so that no good two-way activity develops, which is more likely to be an internal cause of banking instability. It is of importance especially in market related activities but may also affect banking behaviour more generally eg in making provisions for dubious loans or declaring them non-performing and is then a kind of group think, see n 12 below. If the accent is on the domino effect, it is a matter of judgment how serious any domino effect may be or become at any moment in time; not all bank insolvencies need to be fatal for the system. Moreover, since many borrowers now have access directly to capital markets, it is often assumed that systemic risk of this type in banks is not as important as it used to be in terms of a threat to funding generally, but it may become more costly. Through margin requirements, see Vol 5, s 2.6.4 and the extensive use of set-off facilities, see Vol 5, s 3.2.3, risk in banking proper (especially credit risk) may be reduced. Whether interconnectedness is in itself a source of financial instability may even be contested. It is more likely that it is a contributing factor to greater instability but not itself the cause. In this connection it may be noted that in many industries there is considerable interconnectedness but it is no problem when the industry itself is stable. This suggests indeed that (this type of) systemic risk (when tied to interconnectedness) and financial instability should be well distinguished, the latter having many causes, interconnectedness contributing to it but not being at its origin. This then opens the door indeed for systemic risk to be understood in a broader sense, that goes beyond the vulnerabilities in individual banks, to include other systematic shocks which can directly affect all institutions and markets at the same time. For this broader definition of systemic risk, see Olivier De Bandt and Phillip Hartmann, ‘Systemic Risk: A Survey’ (2000) European Central Bank Working Paper No. 35. Importantly, shocks of this nature are not only amplified by interconnectedness but also by the procyclical nature of the financial system, see s. 1.1.13 below. Interconnectedness and procyclicity may thus be seen as particular transmission channels demonstrating systemic risk. The importance is that macroprudential policy (as we shall see in s 1.1.15) my target these channels in particular, either by limiting the interconnections/failure of a big firm in the network that would trigger contagion or going into a counter-cyclical direction, which has the effect of changing the size of banking. It will be shown that narrowing the policy focus to the transmission channels may be the more manageable way to address financial instability given its varied sources, and the fact that we need to coexist with, rather than eliminate them if we want to maintain the level of credit the world needs and the leverage it allows and has become dependent on. The best we may thus be able to hope for is to create a circuit breaker of sorts in the form of macroprudential policy. As for interconnectedness itself, a further distinction may be made between asset interconnectedness and liability interconnectedness, the one focusing on credit exposure to other financial institutions, the other on short-term

8 Volume 6: Financial Services, Financial Risk, and Financial Regulation liquidity, societal leverage,9 the pro-cyclicity of banks,10 bubbles especially in real estate where most banking crises originate,11 failing capital market support, group think,12 innovation, or complacency.13 Climate and pandemics may cause newer strains; so may crypto currencies and fintech. In respect of innovation, for example, the redistribution of financial risk through securitisation amongst banks and insurance companies rather than investors in the capital markets, proved a major issue in 2008. As for complacency, it may lead to overleverage in good times and this may become a permanent condition and result in a different more unstable credit culture, see the discussion in section 1.3.4 below.

funding that may easily be withdrawn or terminated by other banks. Contagion refers in this connection again to the ripple effect, which may become irrational, fed by a lack of information. Perhaps more importantly, the 2008–09 crisis highlighted the possibility of systemic risk originating not only in one or more banks but elsewhere in the financial system, especially after the bankruptcy of Lehman Brothers (and much earlier, in 1998, the failure of LTCM), which was not a commercial bank but had borrowed large amounts of money from them. It caused (or earlier in the case of LTCM threatened to cause) failed margin calls, immediate close-out, and a serious liquidity crisis, again with the attendant likelihood of an increase in the cost of funding and access thereto by all. In the event, the systemic risk presented by the Lehman bankruptcy proved less pervasive than feared at the moment of crisis. This is often the case. It may still be less important in investment banking activity. In the already mentioned Regulation (EU) No 1092/2010 on the European Macro Prudential Oversight establishing the European Systemic Risk Board (ESRB), see s 3.7.2 below, in Preamble no 9, three criteria are given to help identify the systemic importance of markets and institutions. They are considered to be (a) size (the volume of financial services provided by the individual component of the financial system), substitutionability (the extent to which other components of the system can provide the same services in the event of failure) and interconnectedness (linkage with other components of the system), (b) substitutability (the extent to which other components of the system can provide the same services in the event of failure), and (c) interconnectedness (linkages with other components of the system). This is supplemented by a reference to ‘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 continues to make for a judgmental approach and does not provide a legal criterion. This may be an issue when macro-prudential supervision steps in, further regulates banks, and the question of recourse must be posed, see ss 1.1.13 and 4.1.5 below. 9 On credit and leverage related causes of financial instability see Oscar Jorda, Moritz Schularick and Alan M Taylor, ‘Financial Crises, Credit Booms and External Imbalances: 140 Years of Lessons’ (2011) 59(2) IMF Economic Review 340; Moritz Schularick and Alan M. Taylor, ‘Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, And Financial Crises’ (2012) 102(2) American Economic Review 102; Oscar Jorda, Moritz Schularick and Alan M Taylor, ‘When Credit Bites Back: Leverage, Business Cycles, And Crises’ (2013) 45(2) Journal of Money, Credit and Banking 3; Oscar Jorda, Moritz Schularick and Alan M Taylor, ‘Leveraged Bubbles’ (August 2015) Federal Reserve Bank of San Francisco Working Paper Series Working Paper 2015–10. 10 See s 1.1.13 below. We also see it as a possible amplifier. Banks tend to react to events either by increasing or decreasing credit in good or bad times. Therefore, while excessive credit cycles, in the form of leverage and debt, are a key source of instability, procyclicality sets the destabilising mechanism in motion, 11 Franklin Allen and Elena Carletti, ‘Systemic Risk from Real Estate and Macro-Prudential Regulation’ (2013) 5(1/2) International Journal of Banking, Accounting and Finance 30. 12 See also n 8 above and Xavier Freixas, Bruno M Parigi and Jean Rochet, ‘Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank’ (2000) 32(3) Journal of Money, Credit & Banking 611; Xavier Freixas, Luc Laeven and José-Luis Peydró, Systemic Risk, Crises, and Macroprudential Regulation (Cambridge MA, 2015), Dirk Schoenmaker, Contagion Risk in Banking, LSE Financial Markets Group 1996. 13 See also L Summers, FT Blog, 2 May 2017. The latter two sources of instability were much in the mind of Minsky, who otherwise thought that financial instability was part of the normal economic cycle (and the 2008 crisis seemed to be no other, unemployment not reaching levels beyond the late 1970s after the two oil shocks and nothing like the levels of the 1930s), see HP Minsky, ‘The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory’ (1977) 20 Challenge 20. Innovation was deemed a lesser concern in the Summers FT Blog.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 9 These are external sources of financial instability which may have many causes but affect banks still directly but arise from outside the financial system (rather than internally like the managing of credit, position, operational or liquidity risk), notably the whole economy weakening or entering extreme leverage putting the entire banking system at risk. Here macro-economic features dominate14 and affect the stability of the financial system as a whole, obviously in a macro-economic downturn when even good borrowers weaken, likely exacerbated in the case of overleverage: a bank is never stronger than its clients. There may also be political shocks that destabilise the financial system; they might even lead to misdirected government action and regulation effectively destabilising the system further. Indeed, in section 1.3.5 below it will be argued that government policy itself is likely to be a great if not the greatest destabiliser, cf for example Brexit and its aftermath in the City of London. The pro-cyclicality of banks amplifies these disruptions—it is in the nature of banks to react to events either by increasing or decreasing credit. As far as systemic risk goes, it is commonly thought not to be diversifiable, at least not by individual banks as other risks may be.15 Hence regulation to affect the whole industry, so that shocks do not fatally work through the system and become reinforced, but regulation appears to remain concerned mainly with internal events, especially insolvency of banks, how this happens, and the banking risks that lead up to it, especially (in this approach) credit and market risk, now perhaps also operational risk—traditionally there was less regulatory concern about liquidity risk, as will be discussed in the next section.16 External risks to financial stability may then still be ignored. Another key point may be in this connection that the many different internal and external sources of financial instability are unlikely to occur at the same time and may not lead in the same direction.17 Naturally, banks are foremost in charge of their own fate. Financial regulation is supposed to help and provide a better framework, especially for internal risk management but presumably also to deal with external risks, like the general state of the economy and its cycle, which banks can only anticipate but not change either. Indeed, how banks and regulators react and whether this is effective will be a main issue in the following discussion. The essence is that financial regulation as we know it, which is substantially micro-prudential, focussing on the strengthening of individual institutions within an established rule-based framework has repeatedly shown not to prevent crises and there is no guarantee that it will do better in the future. Much of it remains experimentation, or simply a reaction to past crises which in that form are not likely to recur. Macroprudential supervision is the latest answer and may represent a shift to more forward-looking regulation but it is unclear what that could be and it remains embryonic; its true tools may not yet be fully developed, see sections 1.1.13/14/15

14 On the exogenous causes of financial instability, see Stijn Claessens and M Ayhan Kose, ‘Financial Crises: Explanations, Types, and Implications’ (2013) IMF Working Paper WP/13/28, 10 . 15 See R Prasch and T Warin, ‘Systemic Risk and Financial Regulation: Theoretical Perspective’ (2016) 17 JBR 189. They argue that diversification of risk in deeper markets, even where possible, does not bring greater stability. They relate interconnectedness to complexity and opacity, which in this view contribute to instability and need a specific regulatory response, going beyond the traditional micro-prudential supervision. It is a variation on Minsky’s theory that innovation promotes financial instability, see Minsky, n 13 above. 16 Although it is not immediately clear whether balance sheet or cash flow insolvency is meant, see s 1.1.3 below, the regulatory bias in this regard still appears to be towards the former. 17 The 2008–09 crisis highlighted the possibility of systemic risk originating not only in one or more banks but elsewhere in the financial system, especially after the bankruptcy of Lehman Brothers, see n 8 above and n 31 below.

10 Volume 6: Financial Services, Financial Risk, and Financial Regulation below. It aims at a more flexible framework and may have proven merit in the 2020/21 pandemic crisis, although the immediate response was (rightly and as usual) opening the liquidity tap, which was hardly a macroprudential response in the proper sense,18 neither is the question how this liquidity is going to be tapered and the accumulated large debt repaid. To put it differently, especially in Europe, banks remain fragile even 13 years after the 2008 crisis notwithstanding a considerable revamp of the regulatory system. The reason may be that there is insufficient insight into what is truly going on in society and what causes sudden shocks, especially their timing. If we knew more, they would not occur, or, if they still did, we would better know what to do. It is even conceivable that the main cause of financial fragility in the world as we know it today has not been properly identified and remains to be discovered. It will be argued later that there may be a new paradigm in modern banking which remains poorly understood or inconvenient to consider.19 What is then left is experimentation and the need to save banks in trouble as we cannot be without. In practice, much may depend on where banks are in the economic cycle, which is a matter of judgment, see further the discussion in sections 1.1.13/14/15 below. This then also goes into modern bank resolution facilities, meaning what to do with banks if in crisis, when regulation has failed once more. This became also an area of experimentation after 2008, often still considered a sequel to micro-prudential regulation, see section 4.1 below. It is clear that the aim of government action cannot be to save them all, it would be the ultimate in moral hazard, see section 1.1.12 below; the concern is rather for the whole system but it remains a fine judgment in each situation to determine which banks can or must go and under what conditions or safeguards. A new aspiration is to separate the fate of banks from that of governments, but if it is true that government policy is at least in part at the heart of financial instability, as will be argued later, then this may prove to be a phantasy.

1.1.3. Types of Banking Risk. The Issues of Banking Illiquidity and Insolvency To understand these issues better, and to consider the internal and external factors of instability, it must be realised especially in respect of the former that bank insolvency or the threat of it is a major first issue and needs further exploring. Legally, insolvency or bankruptcy commonly takes two different forms. It may mean that total liabilities exceed total assets. This is balance-sheet insolvency, in England and the US also called legal insolvency, and poses the important and difficult question of asset valuation. It is a type of insolvency risk that derives from other more specific risks such as in commercial banking credit or counterparty risk, which is the degree of risk in the loans a bank has given to its customers who may not repay them, or position or market risk, which is the risk in investments a bank has made and which may go down in value for other than counterparty reasons, for example, in the case of fixed interest rate securities because interest rates go up. This can also be expressed as the difference between the risk inherent in entering contractual relationships and in holding property or investment assets. Thus, buying a bond exposes the

18 See for (scant) details, n 129 below. 19 From the ECB perspective, the problem is simply rooted in the fact that there are too many banks in a relatively small market and in the rise of digitalisation and disintermediation: www.bankingsupervision.europa.eu/ press/speeches/date/2019/html/ssm.sp190704~1f442782ac.en.pdf?2773aa57fc4093122a0effc8247b6a8b.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 11 buyer to the risk of non-payment by the issuer and the value of the bond declines when the risk of non-payment increases. That is credit risk. On the other hand, fixed-interest-rate bonds also decline in value when market interest rates increase for similar maturities. That is market risk. In the case of non-interest-bearing instruments like shares or land, a decline in market values of these assets produces similarly market risk, which is in such cases more direct and perhaps easier to understand. Then there is operational risk to consider as cause of balance sheet insolvency: it is the risk that management is bad and internal processes and systems do not work properly and do not identify correctly and promptly consolidated risk.20 Insolvency may also take the form of inability to pay the debts as they mature. That is called cash flow insolvency or in England and the US also equitable insolvency. In banks, it is common to call the threat of this type of insolvency liquidity risk.21 Cash flow insolvency or illiquidity in this sense is easier to determine than balance sheet insolvency because it does not involve valuations and is generally the more likely form of insolvency to lead to formal bankruptcy proceedings. It could mean, however, that there is no balance-sheet insolvency at all and that as a consequence at the end of the proceedings, there may be a net positive balance in the accounts. It would follow that all is paid but the bankrupt institution will still be liquidated and its activities terminated unless some kind of reorganisation under more modern proceedings takes place. Liquidity risk is innate in all banking activity, which is, as we have seen, characterised by the recycling of short-term money, basically deposits from the public, into longer-term loans for those who need them, such as house buyers in mortgages, and companies in corporate debt. This is maturity transformation. The essence of commercial banking may indeed be seen as the maturity mismatch between assets and liabilities. It means that there are potentially more depositors able to claim their money back than there are borrowers repaying their loans. This may happen daily for no particular reason at all. Some depositors may have large withdrawal or payment needs and may come back with their money the next day. Nevertheless, when there is a rumour that a bank may be less solid than it appears to be because, for example, it has lent to the wrong people who may not return the money, then depositors may start to withdraw their money for fear that they may not be repaid. This may create the conditions for a bank run, especially when large losses in banks are expected. That is the connection between balance-sheet and cash flow insolvency. In other words, the fear of balance-sheet insolvency, which means that not all might be repaid, may create the conditions for a bank run and cash flow insolvency. The maturity mismatch that typifies banking activity means that banks are constantly at risk that short-term funding supporting longer-term lending activities is withdrawn although it is more typical for situations of financial stress. The result is that banks may have no money to continue to fund their lending activities, refund deposits or for depositors to use them as payment, or pay their own bills or employees. This makes banking intrinsically an unstable and dangerous business as banks are dependent for their survival on the continuing indulgence of their depositors who hold mature claims against them and thus have the fate of the bank in their hands at all times. However, they may be sweetened and have in more normal times their own reasons to support the banks: holding large amounts of cash at home is unsafe; deposits may accrue some interest; and holding some money in banks enables depositors to take part in the payment facilities through the banking system, which is for many people the most important aspect of their banking relationship.

20 Michael Power, ‘The Invention of Operational Risk’ (June 2003) ESRC Centre for Analysis of Risk and Regulation Discussion Paper No.16. 21 See for the notion of liquidity also n 3 above.

12 Volume 6: Financial Services, Financial Risk, and Financial Regulation Yet (unless they have made time deposits) depositors may reclaim their money at any time of their choosing, while the bank cannot reclaim this money from its borrowers before maturity. It could be said in this connection that cash flow insolvency is the normal state of affairs in banking and is structural in commercial banks, therefore not dependent on any particular mishap as it may be in other businesses. Hence the intrinsically fragile state of all banking activity and the great importance of liquidity management in banks, whatever the other internal or external threats to the stability of the system. Liquidity is here a liability side issue, but it may also be an asset side problem: in times of stress it may not be possible to liquidate financial investments or use them as collateral, for example, upon margin calls.22 Indeed, it is not lack of capital but illiquidity that is the true or immediate killer of banks.23 This is easily forgotten in good times but it is a major contributor to financial instability probably at the heart of it, and also translates into economic (and social) consequences as a bank getting into liquidity problems is likely immediately to limit its liquidity-providing function to the public. A final observation may be in order. Known sources of the instability of banks were identified in section 1.1.2 above in the management of credit, market, operational and liquidity risk. These are internal to each bank. Bank management can do something about this and it is its main task aided by regulation. Systemic risk may be different and better be distinguished from financial stability—it was already mentioned in the previous section, and concentrates how shocks might work through the system and reinforce themselves, systemic risk is then more about how other risks work, affect and undermine the financial system. As to these other risks and their effect on financial instability, they are the leverage in society, assets liquidity, the economic cycle, pro-cyclicity, bubbles especially in real estate, government intervention through regulation or otherwise and are largely external factors of banking instability. Again, in particular the concept of systemic risk remains contentious and may have different meanings, even whether this risk, at least if seen as following from interconnectedness and its domino effect, is really all that great in commercial banks and the true cause of its instability. It was long assumed to be even smaller in investment banking. Whatever it is and however it contributes to financial instability, it was already said that it is considered not diversifiable, meaning that individual banks cannot do much about it, although they might conceivably reduce their interconnectedness. It is a regulatory issue, where the fear of systemic risk has often been used by regulators to amass more power but the result has not necessarily been impressive in terms of preventing financial crises. The hope is now that (a measure of) macro prudential supervision may do better assuming it can be properly understood and organised, see sections 1.1.14/15 below. Indeed, as for financial stability more generally, which may thus well go beyond systemic risk proper, as we have seen, banks may individually not be able either to do a great deal about any external factors, but its business strategy will have to consider the environment and still develop some response against such events. Clearly, some may do better than others: in the 2008 crisis and its aftermath, JP Morgan did well whilst Citibank collapsed. In terms of regulation, it was the same for both. It will be argued that from a (macro-prudential) regulatory point of view, an important feature in this connection is to determine at what level of economic activity financial stability is to be achieved and what it truly means in terms of the liquidity-providing function of banks and

22 Markus K. Brunnermeier and Lasse H. Pedersen, ‘Market Liquidity and Funding Liquidity’ (2009) 22(3) The Review of Financial Studies 2201. 23 See also J Larosiere, ‘Remaining European and Global Challenges’, Regulatory Reforms and Remaining Challenges Occasion Paper No 81, www.group30.org/images/PDF/ReportPDF/OP81.pdf, 30 (2009).

Volume 6: Financial Services, Financial Risk, and Financial Regulation 13 the size of their operations in each phase of the economic cycle.24 It would appear that financial stability, although very desirable in the abstract, is not in itself an objective criterion or can be a self-standing objective. It may even be asked whether it is truly wanted because it may suggest economic activity at a lower level, which may not be politically or economically acceptable: fewer house loans, consumer or student loans, and credit cards. It may mean less leverage for all.25 Clearly, some balance must be struck and the trade-off becomes public policy. In modern economies, innate instability of banks is often tolerated and politically even enhanced. Again, that is policy, and it must indeed be asked why in such situations depositors or senior bondholders should be in line for making a contribution or bail-in in any subsequent banking resolution or otherwise. It may make things worse. It follows that it is essentially for governments to act and save the banks when banking regulation and supervision has failed once more, see again the discussion in sections 1.1.13/14/15 below.

1.1.4. Liquidity Management and Management of Balance-sheet Risk In all of this, modern liquidity management or management of liquidity risk must prevent cash flow insolvency and bank runs, while modern risk management in terms of counterparty risk, market risk and operational risk is the key factor to limit the threat of balance-sheet insolvency, at least if looked at from the inside of banks.26 This is then also a prime focus of banking regulation, as it has developed which seeks here a legal framework and level playing field for banks, at least in micro-prudential regulation as we shall see. It has already been said that, although distinct, these two forms of insolvency are connected: bank runs or illiquidity of that nature usually start when balance-sheet insolvency is feared, therefore a situation in which not all creditors would be repaid, although the issue may also arise on the asset side, as already mentioned in the previous section: investments may no longer be accepted as collateral in situations of financial stress, much the Lehman problem in 2008.

24 It may be fair to say that stability only exists along a continuum and its definition will depend on who is describing it, see Niklas Luhmann, Risk, A Sociological Theory (Berlin, 1993). The UK appears to offer some method. Financial instability is now measured by constructing a flexible resilience target for each area of the system at different points in time and for each threat. This target is a measure of the capital required to survive an adverse economic scenario. The scenario itself is defined as a situation in which unemployment rises to over nine per cent; the output of the economy falls by nearly five per cent, the global economy enters a recession deeper than the financial crisis and house prices fall by one third. Banks are required to fund at least 13.5 per cent of their riskweighted assets with their own Tier 1 capital, in order to keep lending in this severe economic scenario. In effect the ‘adverse scenario’ is the point between stability and instability at which British society is apparently willing to live. In the case of microprudential regulation, could it be argued that the standards used for stress testing constitute some benchmark for stability for which microprudential regulators are aiming. 25 As Claudio Borio has opined, ‘there is at least some constituency that dislikes inflation, but none that dislikes the inebriating feeling of getting richer’, see ‘Implementing a Macroprudential Framework: Blending Boldness and Realism’ (2011) 6(1) Article 1 Capitalism and Society 1, and Malcom D. Knight, ‘Marrying the Micro- and Macroprudential Dimensions Of Financial Stability: Six Years On’, Address at the 14th International Conference of Banking Supervisors, Mérida, 4-5 October 2006 . 26 See D Murphy, Understanding Risk: The Theory and Practice of Financial Risk Management (London, 2008) and K Alexander, R Dhumale and J Eatwell, Global Governance of Financial Systems: The International Regulation of Systemic Risk (Oxford, 2006). There may also be an operational risk component as we shall see, very much more difficult to assess and hedge.

14 Volume 6: Financial Services, Financial Risk, and Financial Regulation To protect against liquidity risk in terms of the management of this risk,27 some of the money’s banks gather will come from longer-term loans they organise in the capital markets by issuing bonds of varying rank and maturities. They may also issue certificates of deposits which denote maturities of at least some months. That is the issue of liquidity on the funding side. On the asset side, banks may invest in liquid assets,28 normally government bonds or securities, to provide a 27 See the BIS Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision (June 2008). It set out a number of principles which focussed on the importance of establishing a liquidity risk tolerance, maintaining a liquidity cushion, allocating the cost of liquidity per activity, covering contingent liquidity risks (in off-balance-sheet and future cash flow exposures), use of stress tests, access to contingency funding, management of intra-day liquidity, and public disclosure so as to allow the informed judgement of the markets. See further also the EU March 2010 Commission Services Staff Working Document on Possible Further Changes to the Capital Requirements Directive and Mathias Drehmann and Kleopatra Nikolaou, ‘Funding Liquidity Risk: Definition and Measurement’ (12 July 2010) BIS Working Papers No. 316 . In the UK in October 2009, the then financial regulator, the SFA, proposed a far-reaching new regime that would dramatically increase a bank’s need to invest in government securities and limit severely its funding short term. It was thought that as a start, banks’ short-term funding should be reduced by 20 per cent from presentday levels, ultimately rising to 80 per cent (from present-day levels). It would fundamentally change the nature of banking, which has always been to recycle short money and to convert it into long-term loans, the attendant liquidity management being banking’s major skill. As always, the true issue is how far these newer ideas curtail the recycling function of banks and reduce banking activities, including the liquidity-providing function to the public at large, therefore the amount of leverage and the effect on the real economy. Proposals of this nature may mean a substantial contraction of the liquidityproviding function through banks, which may be socially unacceptable. It would also raise the question what banks should do with their excess deposits, which then only could be lent short term, probably mainly to governments, which lending in many countries has also become unsafe. 28 Again, this is market liquidity more directly connected with whether investments can trade, see n 3 above. It is particularly significant in connection with a bank’s liquidity management, as a bank is likely to hold a large portfolio of investment securities to help it manage its liquidity exposure in respect of depositors. The liquidity of such investment securities is commonly demonstrated by the price discount that must be offered if larger volumes are sold. It is also said that a liquid asset in this sense is ‘one which can be converted rapidly into cash with little or no loss of value’, see European Banking Authority (EBA), Discussion Paper on Defining Liquid Assets, 21 February 2013; see further Andrew Crocket, ‘Market Liquidity and Financial Stability’, Banque de France, Financial Stability Review—Special Issue on Liquidity (2008) 14. It follows that the greater the price discount the less liquid the security is considered to be. This can to some extent be measured, more so if there is full transparency on size and price of done deals. See for the danger of an illusion of liquidity in banks, A Nesvetailova, ‘The Crisis of Invented Money: Liquidity Illusion and the Global Credit Meltdown’ (2010) 11(1) Theoretical Inquiries in Law. As liquidity in banks is often equated with and deemed completed by the tradability of its assets, advanced forms of innovation/securitisation become favoured if the underlying loans or investments are not themselves liquid. Through securitisation, they seem to become so, but tradability in this sense still depends on confidence of the market, in good times much helped by proprietary trading of these instruments in banks. This type of liquidity pretends to be a substitute for ready conversion of loan assets into cash. It was traditionally associated with government bonds, which, if issued in its own (paper) currency, can always be redeemed by the country printing money, but the expansion of the notion of liquidity into other assets may suggest here a two-tier notion of liquidity. Indeed, it may assume a more advanced state of market vitality, in which liquidity of this (government bond) quality is ‘privatised’ by market forces, but it may have contributed to the ‘originate and distribute’ model in securitisations by banks before the crisis of 2008: see for the issue of excess Vol 5, s 2.5.4 above, in which the ensuing securitised products proved subject to mispricing and to turning toxic in financial crises. In fact, when the market in these instruments did hot up, there was a tendency for them to seize up at the same time. Continued funding of these products, often by SIVs, which was usually short term, is then likely to become another major problem. As these products may still be held within the financial system (with other banks or insurance companies), they may destabilise the system further, the risk not therefore being sufficiently widely spread among end-investors to reduce systemic risk. The problem of these newer products becoming illiquid while tradability vanishes is not new and had been spotted before, see BIS paper No 2 (2001): Structural Aspects of Market Liquidity from a Financial Stability Perspective, but is soon forgotten in times of euphoria.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 15 liquidity buffer as these assets can be sold off immediately when needed,29 but even this became less certain during the government funding crisis in 2011 in Europe. In any event, most bank funding remains through short-term deposits that go into longer-term loans to client/borrowers. Again, this is the normal activity of banks and their most important economic and social function. It is usual for banks to strive for up to 90 per cent of their loans to be funded by deposits. That is for them the most profitable. Clearly, liquidity becomes a regulatory concern here although often still eclipsed by capital adequacy considerations, which are more an aspect of risk management that primarily addresses balance-sheet insolvency as we have seen. The relative lack of regulatory concern for liquidity risk may well have contributed to the 2008–09 financial crisis, although it should be appreciated that the maturity mismatch between assets and liabilities is the essence of all banking, which regulation cannot remove without destroying this business and the recycling of money facility it represents.30 Banks must be given substantial leeway to manage this risk themselves; it is their business and a matter of competition between them. As for capital requirements, this is not to suggest that they are unimportant in terms of liquidity risk management. Holding adequate capital against risk assets may steady the nerves of depositors and other creditors in terms of balance-sheet insolvency and then also guard against a bank run or cash flow insolvency—the connection was already mentioned in the previous section—but it is true that in the past 20 years, first through the Basel I and subsequently Basel II Accords as international capital adequacy standards (see further the discussion in section 2.5 below), the main emphasis was on standards for capital adequacy (which, in the event, proved too low in crises) in terms of balance-sheet insolvency,31 not on cash flow insolvency or liquidity, lack of which was already identified above as the more immediate killer of banks. As we shall see in section 2.5.12 below, the Basel III guidelines now not only seek to reassess the balance-sheet risks and increase capital from that perspective, but is also concerned with liquidity risk. It must then define what is liquid, not at all an easy task, especially in terms of assets in times of distress. Again, in doing so, these measures are likely to affect the liquidity-providing function of banks, reduce their recycling activity and then potentially also economic growth. There is a balance that must be struck. It is unlikely that in our type of society, which thrives on leverage, we can go back to old-fashioned ‘safe’ banking;32 see also the discussion in section 1.3.8 below. This being said, 29 Banks may enter into liquidity swaps with insurance companies or pension or other funds that hold large portfolios of highly liquid assets, and exchange them for a number of years against their more illiquid assets such as mortgages. By 2011 this had incurred unfavourable comment from regulators in the UK who became concerned about the liquidity position of these insurance companies and funds. 30 Other mismatches between assets and liabilities that need also be managed (in an active asset/liability management) are currency mismatches and interest rate mismatches (between fixed and floating). 31 Interestingly, the weakness of banks during the 2008/09 crisis was not due, at least not initially, to excessively low capital levels within the existing framework of Basel I and II but it is arguable that they became so only after a number of black swans (see n 219 below) had arrived in the US in the form of the plights of Fannie Mae and Freddie Mac and then AIG, which in the event were all nationalised (but soon denationalised with a substantial profit for the US government). Even the lack of a bailout of Lehman Brothers, the bankruptcy of which caused mayhem, was, when the accounts were ultimately settled, in reality not the drama that had been anticipated. This is only to show that wrong perceptions aggravate financial crises, the cause and especially the timing of which may remain largely obscure and are usually only retroactively established as matters of opinion, see s 1.1.2 above and also s 1.3.4 below. It was already said that if it were otherwise these events would be foreseeable and would not occur, or if they occurred regardless, there would be some clear cure. 32 In ‘old-fashioned’ banking, one was likely to find that banks would lend to customers one-third of their money or deposits (if longer, often secured by mortgages), lend another one-third to other banks (shorter), and put the last one-third in (liquid) government bonds. To complete the picture: they would hold capital up to one-third of their risk assets, however defined. This was considered ‘safe’ banking but was also likely to be unprofitable.

16 Volume 6: Financial Services, Financial Risk, and Financial Regulation Basel III has not so far been able to re-establish the solidity of banks in Europe, which is ultimately probably the greater threat to the stability of its financial system.

1.1.5. Risk Management, Hedging and the Commoditisation of Risk Through proper liquidity management on the asset and liability side of the balance sheet as mentioned in the previous section, it ought to be possible for banks, internally at least, to better manage liquidity risk and guard better against illiquidity and cash flow insolvency. Proper risk management in terms of balance-sheet insolvency on the other hand means in modern times extensive hedging or similar activity for credit and market risk and to determine the proper level of capital in respect of the remaining exposures. To this effect, credit risk may be limited or spread through collateralisation, diversity in loan portfolios, avoiding large exposures to one counterparty or through obtaining forms of guarantees, including the use of credit default swaps or CDSs as we have seen in Volume 5, section 2.5.3.33 Market risk is commonly hedged through the use of derivatives: options, futures and swaps (see Volume 5, section 2.6.1).34 Securitisation now also fulfils an important function in the management of both risks and is a powerful risk-management tool in either case, as it may remove these risks entirely from the balance sheet (see Volume 5, section 2.5.1). The issuance of collateral debt obligations (CDOs) by special purpose vehicles (SPVs) as part of a securitisation and the protection against credit risk through credit derivatives, especially CDSs, is now commonly used and has become another essential part of modern risk management in banks. This type of risk management is necessary but costly and not a perfect art as we have seen in Volume 5. Besides liquidity and balance sheet risk, operational risk was also mentioned, meaning concern with systems and proper management. It is a more contentious concept because

However, any less may become ‘unsafe’. Even at the time of the US banking crisis of 1907, it was thought that banks still held about 20 per cent capital against their risk assets, which proved not to be enough. Modern banking is, as we shall see, far removed from this more classical ‘safe’ model. Under Basel I, eight per cent capital became the norm, half of which could be held in so-called Tier II capital. This allowed for and accommodated a high degree of gearing, see further s 2.5.4 below. To give an example: if we allow in this manner a gearing of 12.5 times qualifying capital, institutions needed only lose eight per cent of their asset values to be bankrupt, meaning insolvent in a balance-sheet sense. Through all kind of exceptions to the eight per cent capital requirement, a gearing of 20 or more was not uncommon in banks, which meant that a loss of only five per cent of its assets would bankrupt the bank in terms of balance-sheet insolvency. It is clear that high gearing is here to stay even after Basel III. It will be argued later that a new paradigm appears to be operating in banking, see s 1.3.5 below. 33 Credit derivatives were much criticised in 2007–08 and were requested to be regulated but present a most effective tool to hedge credit risk and are as such of fundamental importance. It is a market that (like the repos and interest rate swap markets) did not seize up in 2008 even though an important protection provider (AIG) had to be saved in the US. One aspect was that this protection had become too easily available (and therefore too cheap) whilst concern for the risk in the underlying portfolio diminished. In fact, this criticism concerned all securitisations. See for the excess in financial engineering, Vol 5, s 2.5.4. 34 Interest rate swap markets were valued in 2008 at around US$ (equivalent) 400 trillion, about eight times world GDP. By 2014, the total was around US$ (equivalent) 600 trillion outstanding. They remained largely OTC products provided by banks and were major sources of profit for them. A greater degree of standardisation through CCPs (see Vol 5, s 2.6.5 and n 243 below) might also regularise this market and this is being implemented even though again the cause of the financial crisis was not here either; it was more part of a general mopping up round that may or may not have been beneficial. In the EU, a Regulation on the European Market Infrastructure (EMIR), was introduced in this connection as of 2011 and became effective at the end of 2012; see also Vol 5, s 2.5.10 and s 3.7.6 below.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 17 it is barely quantifiable and capable of improvement through the addition of more capital, see Section 2.5 below. There may also be legal problems (and therefore legal risk), often not considered or sufficiently understood (and sometimes deemed part of operational risk, although commonly still not rising to the level of regulatory concern), more in particular clear in respect of the status internationally of collateral (such as floating charges), repos, receivable financing and securitisation tranches, as we have seen in Volume 5. Modern assignment, segregation and set-off statutes or facilities complete the system, but it was argued before and also demonstrated in Volume 5 that there may remain substantial legal exposure also in these areas, applicable laws being seldom sufficiently up to date even if it were clear which law it is in international transactions. In fact, it was argued before that one major problem is that the written law often does not help but is a hindrance to better risk management for no obvious reasons. Perhaps more importantly, these facilities often remain too localised under national laws to serve their proper international function, for example, in asset-backed funding based on assets or cash flows and production and sales facilities or chains dispersed or arising in different countries.35 Transnational floating charges still do not exist and they are impossible to organise on the basis of an amalgam of national laws. In terms of risk management, the spreading of risk through securitisation, which allows for the removal of banking assets and/or their risks from a bank’s balance sheet to investors, is here more directly of importance. It also provides the crucial connection between banking and capital markets, necessary as banks can no longer take all lending requirements of the public on their own books. This is financial engineering, which can become excessive as the 2008 financial crisis showed and may lead to all kind of risk layering that may not be fully understood or, while being sold on, be incorrectly priced, and in any event too readily retained or bought with an insufficient concern for risk, even by professionals such as banks,36 either as originators, financial engineers, traders, or investors.37 Moreover, these longer-term, potentially illiquid assets were

35 Much of Vol 4 and of Vol 5 was devoted to this subject. The conclusion was that minimising legal risk requires a greater degree of transnationalisation of the law and the full recognition in particular of transnational industry custom and practices, especially in the areas of set-off and netting and in asset-backed funding using assets in different countries, to be recognised in domestic bankruptcy regimes. Fundamentally we need to put ourselves legally in these international flows rather than trying to chop them up into domestic parts in the hope that the total of the legal regimes that become so applicable to these flows still adds up. It is unlikely. As was argued in the referenced parts and sections of this book, inefficiency, uncertainty and extra cost result for no obvious reasons except mere legal nationalism for its own sake. 36 See for excess and abuse more particularly Vol 5, s 2.5.4. The EU in an amendment to the relevant EU Directives in September 2009 (see Art 1(30) and Art 122(a) Directive 2009/111/EC of the European Parliament and of the Council (CRD 2) [2009] OJ L302/97, and also s 3.7.3 below) demanded from the end of 2010 that originators retain five per cent in their securitised products so as to prevent them losing all interest in the underlying loans or credits they granted but (through securitisation) removed immediately from their balance sheet (including the connected credit risk). Guidelines were published in 2010 which assumed consolidated supervision at the level of the home regulator of the authorised institution. It is a complex issue as the retention must be met by one of four risk retention mechanisms: (a) the vertical slice retention, (b) the originator interest retention, (c) the on-balance-sheet retention, or (d) the first loss retention. In the US, this originally G-20 idea was further diluted to alleviate ‘additional constraints on mortgage credit availability’. An original industry proposal had wanted to exempt mortgages with a 20 per cent minimum deposit and monthly repayments of no more than 35 per cent of the borrower’s income. Ultimately, the loan-to-income ratio was lifted to 43 per cent and the minimum deposit was dropped entirely, see The Economist, 25 October 2014, 68. See further for the role of and comment on the status of Fannie Mae and Freddie Mac in the US, n 205 below. 37 Before the 2008–09 financial crisis, prevailing euphoria in the financial markets created many products of more dubious value, such as: (a) contingent value rights or CVRs, in which buyers do not pay for an asset but

18 Volume 6: Financial Services, Financial Risk, and Financial Regulation often financed short term, thus contributing to and aggravating liquidity risk, while their proper valuation (for capital adequacy purposes in terms of credit and market risk) proved difficult and uncertain when markets seized up. All the same, it is mostly understood that the commoditisation and tradability of risk that has been achieved notably through securitisation and credit default swaps is of great importance and may allow better access to funding by the public on a much larger scale. In the face of growing criticism, in 2009 the International Monetary Fund (IMF) was ultimately forced to underline and support the crucial role of especially the securitisation facility. However, it was already said that if not sufficiently diversified in placement, securitisation has the effect of merely spreading the risk to others in the financial industry, therefore other banks and insurance companies, who may be seriously weakened thereby. In 2008, this required the (temporary) nationalisation of the largest insurance company in the world (AIG) which concerned mainly the back-up of credit derivatives.38 The 2008 events further showed that lack of transparency where the risk subsequently resided could itself destabilise the financial system and reduce confidence. Especially for swaps, approximation to tradability of these contracts through CCP’s aims at being an important risk management reinforcement in the future, see Volume 5, section 2.6.5 and may be seen as a further expansion of the commoditisation of risk. Indeed, more up to date regulation seeks to address these concerns and to promote a legal framework that is meant to stabilise finance along better lines although it does not go as far as to promote legal transnationalisation. However, even this type of regulation may not prevent major shocks and may even exacerbate the situation by limiting the diversification facility. As has already been noted, investment banking activity is traditionally different in that investment banks do not take deposits and issue loans but are intermediaries as advisers, underwriters and market-makers in the recycling of money through the capital markets where investors meet issuers of financial securities more directly. Segregation of client assets follows. As a consequence, they do not carry the same type of systemic and client risks and are therefore traditionally more lightly regulated. But the 2008–09 crisis also showed that they may be so intrinsically part of the system that their demise may still carry great risk for commercial banking, if only because they borrow large amounts from commercial banks and are themselves highly geared, often for their (proprietary) trading activity.39 Through prime brokerage, they also habitually lend to often

instead give sellers an option to future returns (often leading to large payments, although often made subject to many conditions), which may easily stifle a business when they become due; (b) cash-settled options, which allow corporate raiders to top up the purchase price by later cash payments, which could cripple them; (c) accumulators, which hedge cross-currency exposure while limiting the profits that can be made but not the losses, suggesting improper risk distribution; (d) debt accordions, allowing issuers to issue senior debt to new investors potentially forcing existing ones to trade up at large discounts; (e) payment in kind or PIK toggles, which allowed debt issuers to issue more bonds as substitutes for coupons, especially likely in financial crises when bonds may become worth a great deal less and coupons payments valuable; and (f) minibonds, which are not bonds proper but merely contractual rights, often in small nominal amounts to appeal to retail, to a slice of ordinary bonds held in portfolio by the organisers who so reduce their own risk, mostly at some higher yield. 38 One problem is that these protection providers may not hold enough capital against these products when they themselves are downgraded and margin calls are being made on them by the protection buyers—see for these calls, Vol 5, s 2.6.4. Another issue in this connection was that these products appeared mostly not to be properly defined and made subject to regular capital adequacy standards, either as guarantees or in particular as insurance policies (which they are not truly). See for the Basel III capital adequacy amendments in this connection, s 2.5.12 below. 39 Proprietary trading is the trading of banks for their own account in any product where a trading profit may result. Banks may be stimulated into doing this as they are likely to see the trading flows. It may result in a form of insider dealing that reduces their risk but is not commonly found offensive as it does not concern corporate information.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 19 highly leveraged hedge funds, which may thus also become part of the financial system and affect its stability.40 This is now often referred to as the ‘shadow’ banking system, which is large, in the US in 2010 estimated to be a business of about US$13 trillion, almost as much as the national GDP, by 2019 it was thought to have reached US$ 15 trillion. By the end of 2013 it was estimated by the Financial Stability Board at around US$ equivalent of 75 trillion worldwide, an increase of five trillion over the previous year. In 2016 it had reached US$99 trillion in the broadest definition. To what extent it should become regulated and how has itself become a matter of debate—see section 1.1.17 below.

1.1.6. The Role of Central Banks as Lenders of Last Resort. Government Support Systems As far as liquidity is concerned, it has already been said that it may be quite normal for banks to find themselves short of funds at the end of the day when more depositors withdraw money than make deposits. It may be different the next day. To ease short-term liquidity problems of this nature, banks will then normally borrow short term from other banks in the opposite position. They do this in the interbank markets. As some banks may be short of funds and others may be long in this manner, it is only natural that they should do so and that is what the interbank market does for them. In such situations alternatively, central banks may come to the rescue as banks of last resort and lend banks the short-term money they need in these circumstances.41

This trading should be distinguished in principle from the trading in areas where banks make markets for their clients as commonly in foreign exchange, swaps and repos, shares and bonds and now also in CDOs and CDS. This trading is normally short term, geared to managing open positions and requires a different trading talent; see also the discussion below in s 1.3.10 at n 236 on curtailing these various activities, see further also nn 213 and 220 below on the Volcker rule. It will be argued later that the line between proprietary trading and managing trading books is often difficult to draw, see also s 3.7.11 below. 40 See for prime brokerage, Vol 5, s 2.7.5. When, in 2008, US investment banks could no longer fund themselves short term in the market conditions of those days, this also affected the hedge funds, which investment banks often funded through their prime brokerage arm. In these circumstances, investment banks had to obtain funding from the bank of last resort (the Fed), which, although legally not obliged to do so, was forced to provide it for systemic reasons. It made these investment banks subject to greater supervision, which then induced the largest of them, Goldman Sachs and Morgan Stanley, to apply for ordinary banking status to gain access to deposit-taking, especially from their corporate clients as a cheaper way of funding. It was the end for the time being of independent investment banking (except for smaller institutions) in the US. The separation of commercial banking and investment banking had been demanded earlier, under the banking reforms in the US in the 1930s (Glass-Steagall Act), only lifted in 1999, see s 1.1.9 below. An added problem proved to be that, to the extent some or all of these functions were conducted within banks or bank holding companies, no special bankruptcy regime existed for connected financial institutions, even in a country like the US, which has special bankruptcy rules for banks. Ad hoc intervention thus became necessary but was dependent on sufficient political support, which could not always be immediately activated or, as in the case of Lehman’s, was not immediately forthcoming. 41 In times of financial difficulty, the liquidity in the interbank market is likely to dry up as banks do not dare to lend to each other. This was poignantly demonstrated in the banking crisis in 2008, it being uncommon for security or collateral to be asked as protection in this market. The lender of last resort is then the only port of call, but this lender is likely to want security, ie the banks’ investments taken as collateral, usually as repos, see Vol 5, s 4.2.1 above. See Allan H Meltzer, ‘Financial Failures and Financial Policies’ in GC Kaufman and RC Kormendi (eds), Deregulation of Financial Services: Public Policy in Flux (Ballinger 1986).

20 Volume 6: Financial Services, Financial Risk, and Financial Regulation It should be clearly understood that this lender-of-last-resort function is not a question of regulation proper but is an extra facility in banking that is necessary to protect the system. In other words, all banking systems would appear to need some lender of last resort as a special facility to iron out short-term liquidity needs in banks. This facility acquires great importance, size and momentum, however, when meant also to alleviate financial stress and may then well be used to avoid or mitigate systemic risk and achieve financial stability more directly. Nevertheless, this is often considered an improper use of this facility42 and the prospect of banks being saved in The function of lender of last resort is complicated in the eurozone, where the ECB is in charge but in emergencies there is supplementation by the Emergency Liquidity Assistance Facility, which is an acknowledged deviation from the normal role of lenders of last resort. It may be provided by national central banks at their risk if banks have no more eligible collateral available for repos with the ECB (although the latter does relax its rules at times). This support remains subject to ECB approval (by two-thirds of its Council renewable every two weeks, where in emergencies local collateral definitions may also be further relaxed). Since November 2014, the ECB directly oversees the major eurozone banks, see s.4.1 below, and it may be wondered whether this support should still be given by local central banks at their risk. It became an issue in 2015 when Greece wanted to restart the discussion on its debt, which immediately excluded its banks from repos financing via the ECB. 42 Some central banks, such as traditionally the German Bundesbank, do or did not accept the role of lender of last resort in these circumstances as a matter of principle. The disinclination for the central bank to become involved in this manner did not prevent the German government from organising bank bailouts when needed but it did so in another manner. In fact, in Germany there was created a Liquidity Consortium Bank, which could do so, and in which the Bundesbank takes part. Since 1974 it has been able to grant short-term assistance to banks with temporary problems (it is sometimes described as the lender of next-to-last resort) and might as such also become a model for the eurozone, which so far has no such facility. This strict view of the function of lender of last resort may also have been the original position of the ECB, but it still had to provide liquidity to the whole system in 2008–09 when the interbank market dried up because banking trouble was expected but could not be pinpointed in any one particular bank. The ECB was forced to continue this role when many banks in southern Europe and Ireland remained weak and could not find alternative funding, while their own governments were hardly in a position to recapitalise them either, a facility in any event superseded by the resolution regime agreed for the eurozone after 2014, see s 4.1 below. This forced the ECB to accept virtually any type of investment of these banks (including their own government’s low-rated debt and toxic assets) as collateral in the repo. One trillion euros were printed at the time for this (short-term) program. In fact, the ECB became seriously extended in the process and through these banks in the periphery countries of the EU was also funding their governments who depended on banks for the sale of government securities. Later in 2012, under the European Stability Mechanism or ESM, see also n 768 below, in the guise of enforcing its monetary or interest rate policy, the ECB offered to enter the market in these bonds of up to three years directly throughout the eurozone, albeit only at the request of individual countries and subject to conditions. This was on top of the Securities Market Program of €223 billion provided to ailing governments through national central banks as members of the system and meant to provide depth especially in government securities markets. Confusion between monetary and fiscal policy ensued and gave rise to litigation before the ECJ, see n 785 below, which supported, however, the scheme as being within the monetary authority of the ECB. The ECB in fact risked becoming a bank of last resort for government debt thus involving itself indirectly in fiscal policy. Its German and Dutch directors objected and the measures were not intended to be more than temporary. In 2014, ahead of the ECB becoming the bank supervisor in the eurozone, it offered a further program for bank support by relieving banks of toxic assets through a securitisation program of two years supported by the ECB buying the better tranches, the junk to be bought by the European Investment Bank (EIB), at least that was the idea. The ECB set aside another one trillion euros for this program, adopting indirectly the stature of bad bank. The argument in favour was that it staved off looming deflation, which was not, however, apparent overall and, where identifiable as in southern Europe, was probably necessary for these countries to regain competitiveness. The real issue was that the ECB tried to stimulate growth by monetary means, balancing fiscal restraints without restructuring conditions. Further steps in this direction were taken in early 2015, when the ECB started a full quantitative easing (QE) program over German and Dutch objections. Under it, the ECB started to buy up government and some other bonds to provide more liquidity to the markets and reduce longer term interest rates and deflationary tendencies. The philosophy was that regardless of printing money, there was no increase in the money supply as other liquid financial instruments (bonds etc) were withdrawn from the market at the same time. Hence no excessive inflation danger, it was assumed, but this increased liquidity created all the same bubbles, notably in stock markets and real estate, although this was denied by the ECB.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 21 this manner may create even more irresponsibility or moral hazard in them as we shall see below in section 1.1.11. In any event, if the problems in banks run deeper, (central) banks of last resort may not have the means or could be bankrupted themselves or be forced simply to print more money if they have that power, which, except for the European Central Bank (ECB), they no longer have within the eurozone. Governments may then have to step in to save the banking system. This will be the case especially if there is a danger of balance-sheet insolvency, therefore of big losses in banks, which usually sets off liquidity crises as we have seen. In fact, in EU terms, this could still result in improper and therefore distorting government aid. Conditions will therefore normally be imposed. As already mentioned, in the eurozone, this is now very much connected with the resolution regime or the Single Resolution Mechanism (SRM) as we shall see in section 4.1.4 below, but everywhere the question of the safety net especially for large international banks in distress is becoming a key issue: see further section 1.3.11 below. State intervention of this nature denotes in truth the inadequacy or failure of financial regulation to offer sufficient protection or stability. The 2008 financial crisis and the governmental and central bank support for banking it engendered demonstrated once again the weakness of banking regulation in terms of guarding the health of the financial system as a whole. The subsequent idea that in the government debt crisis which followed in southern Europe, the ECB indirectly should act as lender of last resort even to euro countries themselves43 denotes an extreme use of the facility of lender of last resort, which may then come down simply to printing money to finance indebted states, including their banks, and goes far beyond liquidity support proper. Although in grave financial crises, there may be reasons to do so (open the liquidity tap and forget all discipline), little suggested that that stage of despair was reached in the southern European government debt crises after 2010, long-term interest rates for Italy and Spain hardly moving beyond six per cent. Even in the 1990s, these countries had seen much higher interest rates and similar unemployment levels. Yet in the minds of many, printing money is a cure for most economic ailments. Its ultimate effect is inflation, at first demonstrated in asset bubbles, and if that is not happening immediately, for example, because open markets favour cheaper products and labour costs, this type of funding will at least postpone the necessary structural adjustments but cannot avoid the day of reckoning for ever. Such an approach usually denotes a long era of decline. See for a discussion of the 2008 crisis and its aftermath more in particular section 1.3 below.

1.1.7. The Role of Regulation and the Major Regulatory Concerns: Financial Stability, Depositors and Investor Protection (Conduct of Business), and Market Integrity In the previous section, central bank and government support were presented as non-regulatory issues, at least if one considers financial regulation to be rule-based. Rather, this regulation is meant to prevent the need for central bank or governmental support beyond the mere activity

The greater problem may be that the ECB is getting involved in too many potentially conflicting functions: (a) monetary policy, (b) protection of the euro, (c) bank of last resort, (d) micro-prudential supervision of banks, (e) macro-prudential supervision of the financial system, and (f) banking resolution, besides (g) its involvement indirectly in fiscal policy and economic stimulation. 43 See also the comment in n 42 above.

22 Volume 6: Financial Services, Financial Risk, and Financial Regulation of lender of last resort to smooth out banking’s daily liquidity requirements. In its modern form, regulation became primarily focussed on (a) financial stability, although other important features of financial regulation remain (b) the conduct of business, meaning the protection of depositors, investors and even borrowers in respect of unsuitable financial products and (c) market integrity as we shall see. These are the three pillars or prongs of a modern financial (micro-prudential) regulatory system, that is rule-based and enforceable through regulatory action under court supervision (judicial review) aiming at the protection of the system and the behaviour of banks or more directly through civil court proceedings and damage actions aiming at the protection of clients. It has already been said that the concern for financial stability in terms of solvency and proper liquidity has now come to dominate regulatory thinking. That is solvency affecting the whole system and financial regulation then figures as important support. This raises the issue not only of micro-prudential supervision, but more recently also that of macro-prudential supervision, which distinction will be discussed more extensively in sections 1.1.13/14/15 below. The essence of micro-financial supervision is in this connection that it represents indeed a pre-existing legal frame work of risk management and capital adequacy and potentially also of liquidity management and leverage ratios that aims at stabilising the system through legally enforceable rules and a level playing field for all. It is based on the idea that through internal action in a coordinated manner the financial system as a whole can be sufficiently stabilised never mind external shocks. Again, this micro-financial supervision and the formulation and operation of its rules has been much of the governmental concern in the last generation in the context of the promotion of financial stability. The narrower issue of the immediate effect of insolvency on depositors or investors, should it still happen, is in this approach more specifically alleviated by the organisation of (a) deposit guarantee schemes for bank depositors and (b) investor protection schemes for investors in securities.44 Macro-prudential supervision on the other hand is, as was already shown, the result of scepticism of this micro-prudential approach from a financial stability point of view and puts the micro-prudential regulatory approach in this aspect in the balance, especially its capital adequacy and liquidity regime, also the one in Basel III as we shall see in sections 1.1.13/14/15 below. Legal predictability considerations are then abandoned in favour of pure policy initiatives to prevent or resolve financial crises. It suggests (a) a form of regulatory flexibility as to the capital and liquidity requirements and leverage ratios depending on the situation and product, (b) supervision or at least guidance of micro-financial regulation, and (c) crisis management or resolution supervision if all goes wrong. It will be argued later in sections 1.1.13/14/15 below, that this puts considerable pressure on financial regulation as a legal framework and on the idea of a level playing field for all. It also affects the judiciability of regulatory action so taken which tends towards pure policy. Indeed, although traditionally, commercial banking regulation was more concerned with what banks did with depositors’ money after it had become their own, and subsequently focused in particular on balance sheet insolvency and more recently also on cash flow insolvency and

44 It should be noted that these protection schemes do not by themselves reduce the insolvency risk or eliminate the systemic risk connected in particular with major commercial banking crises, but it allows the regulator to take broader policy considerations into account when deciding on the suitability of action where it is still given some discretion in a rule-based system (eg to close a bank) in the knowledge that at least the smaller depositors or investors are protected. This is important as systemic considerations have often come to prevail over the immediate protection of depositors, although in the end in the 2008 financial crisis, when the system had to be saved, all came together, leading in several countries to a complete government guarantee of all deposits and in others to a considerable increase in the amounts deposit schemes would reimburse.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 23 liquidity issues, as we have seen, this concern is now eclipsed by deeper concerns for financial stability and systemic risk, more extensively discussed in the previous sections, hence also the experimentation with a macro-prudential approach. However that may be or evolve, for the moment the more traditional concerns and tools of micro-prudential supervision need to be more directly explored, especially for commercial banks, therefore primarily the rules of regulatory capital and liquidity. It also concerns the role and impact of risk management and particular of risk spreading and hedging facilities internally, including the set-off and netting of exposure. In the securities industry or capital markets, the prime micro-prudential concern, on the other hand, was not stability but more the proper segregation of clients’ assets. Beyond this, regulatory concern in the securities industry was and still is very much about the advice that is being given and prices obtained for clients,45 therefore conduct of business rather than stability issues. In respect of clearing and settlement systems, there is further the risk that trades are not, or wrongly, executed, or that there is insufficient cash or that there are insufficient back-up securities in modern book-entry entitlement systems, see Volume 5, section 4.1.1. It is important in this connection to recall the different functions of commercial and investment banks, their different roles in the recycling of money, and the variations in the traditional regulatory concerns and tools depending on the structure, function and risks of their various activities and products. In section 1.1.5 above, it was already said that these risks and concerns may extend to the types of financial products on offer, such as, for instance, complicated derivatives structures, and in the way they are sold to unsuspecting investors, therefore to the intermediaries’ conduct of business. We may here also be concerned with the legal risk in financial products, and therefore with the question whether these products are sufficiently embedded and protected by modern legal systems and function properly.46 It may be noted that within conduct of business concerns, products have gained in attention, although it is not always possible to distinguish here sharply between service and product, see also the discussion in section 1.1.8 below and for the question of suitability, and more in particular section 1.5.9 below connecting them both. Even so, there is an increasing reference to financial products, in which the structuring and distribution of them is distinguished. This is expressed in the new product governance obligations set out in MiFID II as we shall see and in the EU product intervention powers set out in MiFIR even ex post, see section 3.7.10 below. These conduct of business and product issues, although traditionally more connected with investment banking activity, may also increasingly arise in commercial banking in respect of more specialised banking products and services (where they were traditionally less acute as banking products used to be fairly simple), for example when mortgage products become complicated or the deposit interest structure and banking charges become un-transparent or too one-sided. The offering of consumer loans and the distribution and charging of credit cards may here be other areas of legitimate concern. It raises conduct-of-business and product issues also for commercial banks, even if, as was said before, the emphasis in commercial banking regulation is now rather on stability. It may also be considered in this connection that, although the crisis of 2008 was often attributed primarily

45 Traditionally, systemic risk was thought to be less important in this area of investment services, but as already pointed out in n 6 above, the 2007–09 financial crisis and especially the demise of Lehman Brothers highlighted the systemic risk originating in the investment service industry as well, enhanced by its increasing dependence on short-term funding from ordinary banks and its large exposure to hedge funds through prime brokerage activity. 46 See also R McCormick, Legal Risk in the Financial Market (Oxford, 2006).

24 Volume 6: Financial Services, Financial Risk, and Financial Regulation to the irresponsibility of banks in terms of their liquidity and risk management, the fact that there was no public sympathy when banks had to be saved at considerable cost was due in large part to conduct-of-business shortcomings and client irritation when it came to their personal protection over time, never mind the almost unlimited access to liquidity and leverage banks had provided to them. Perhaps conduct of business and product supervision are areas where microprudential regulation is better able to achieve something, at least a great deal more, and more visibly, than it does at the moment. Hence under Dodd-Frank in the US the special attention to consumer protection in banking as we shall see. Here the issue is that because of more protection of this nature, these services will become more expensive or even largely unavailable to the general public. Undoubtedly banking clients, especially the smaller ones, are at risk of a mentality in banks that means to grab as much as possible. This became a more important issue after the crisis faded and the attitude of banks was more independently probed. At least in respect of their smaller customers, banks are in a dominant position. This could correctly create regulatory concern, but regulation often fails also in this area. It may be more successful in the securities or investment business. In banking, far too much may still be left to the unilateral decision making of banks, if only in terms of interest rates and charges, particular in the areas of credit cards, but it goes much further. The banking contract itself (see section 1.4.9 below) is very one-sided and commonly allows a bank to fill in and change many conditions unilaterally. Competition between banks is mostly quoted as protection for the banking public, but it is often insufficiently understood that changing banks is not easy and that all banks tend to behave alike. It is therefore not surprising that in the latest US legislation (Dodd-Frank) there was created a regulator especially for consumer clients. As for these conduct of business concerns, in the investment area proper, as early as the 1930s in the US regulation of conduct of business became important (the issuing of investment securities, securities underwriting, brokerage and advice—activities now often concentrated in so-called investment banks) with particular emphasis on (a) investors’ protection, (b) transparency in public offerings and trading, and (c) ultimately fair dealing. Again, this concerned especially the operations and investment risks in the capital markets. This early US regulatory example in the area of investors’ protection has now been followed elsewhere, and the securities industry has as a consequence become substantially regulated also, indeed originally especially from this investor-protection or conduct of business perspective, although still with very different levels of sophistication from one country to another and from one investment function to another (for example, it is very different for underwriters and brokers). There is here even less of a consensus transnationally about the risks that need regulatory attention and on the objectives of such regulation.47 These concerns have acquired added poignancy in connection with the increasing need to create a sound climate for investments to cover the financial needs of an everageing population. Investments must be carried and be made safe, or safer, for very long periods. In this vein, regulation of this type is now becoming important also for the pension industry, which is closely connected with the life insurance industry. As already mentioned, besides financial stability and conduct of business, a third overriding regulatory concern in this area is market integrity, which goes back to the issue of the protection of the public at large and of confidence in the markets, at first particularly in issuing and trading investment securities. It is connected with fair dealing, but goes beyond it and is also different

47 Even in the US, the broker was not subject to the same fiduciary duties in this regard as is the investment manager, a difference meant to be cured by the Dodd-Frank Act.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 25 from the issue of stability. It concerns the prevention of market abuse, anti-competitive behaviour, insider dealing, money laundering and other forms of corruption (see further the discussion in Section 1.1.18 below), and tax evasion and is as such not a supervision issue proper but rather one of civil and criminal penalties or sanctions, including the disgorging of any benefits obtained. There is an obvious public concern with markets being clean and operating properly, which is also in the interest of these markets themselves, their legitimacy, and the confidence in them but modern securities regulation will also be concerned with market integrity from other perspectives and may as a consequence continue to cover certain specific market aspects, especially pre- and post-trade price transparency and proper settlement of transactions and this is increasingly likely to be reflected in regulation. However, in other respects, markets must be free, especially in price formation, and not be interfered with by regulators so that false markets result. This also affects the issue of short selling, as to which see further section 3.7.9 below.

1.1.8. The Basic Structure of Modern Financial Regulation. The Type of Recourse In the previous section it has already been said that micro-prudential financial regulation proper implies some prescribing and supervisory function or authority while aiming in a rule-based system at (a) greater financial stability, (b) better protection of depositors, investors and sometimes also bank borrowers as a matter of conduct of business, and (c) a better functioning of the financial markets (including the payment and settlement systems) especially avoiding abuse and promoting integrity. It has also been said in this connection also that at least in commercial banking, the search for greater stability and minimising systemic risk has taken over from other concerns while depositors and investment protection schemes guard against the more immediate effects of insolvency on clients. It left other aspects of regulation, especially conduct of business issues, often undervalued. Conflicting policy objectives and concerns in micro-prudential supervision of this nature will be discussed further in section 1.1.10 below. Financial regulation, at its best, should be seen as reinforcing internal procedures and practices which banks and other financial intermediaries already have in place to adequately manage their risks and conduct. That is their prime responsibility, but they may weaken in the pursuit of other objectives, mainly volume and profits, especially in good times. Here regulation becomes a warning and a bottom line, more than necessary in practice but still notoriously ineffective in preventing financial crises, some of the reasons for which will be further explored later in section 1.3 below. One is the outside risks which banks themselves can hardly control or diversify, see section 1.1.2 above. To repeat, the present type of (micro-prudential) financial regulation is rule, or at least legal principle, based, which means that, although regulators will apply the rules to individual banks (which is what micro-supervision means), they will not enter into the business of a particular bank or other financial intermediary itself beyond enforcing these rules, in essence the same for all. It has already been said that they are not equipped to do so or educated to that effect, and it could make them liable for the consequences, which regulators would want to avoid at all costs. Yet financial crises commonly lead to calls for more ad hoc intervention and a so-called judgement-based approach to (micro-prudential) supervision may support it as we shall see: it has also led to increasing emphasis on a macro-prudential approach, as noted, see further sections 1.1.13/14 below. For micro-prudential regulators it is a mistake to interfere in a discretionary manner, unless perhaps in emergencies when this power goes well beyond their ordinary

26 Volume 6: Financial Services, Financial Risk, and Financial Regulation regulatory role while one may still ask whether it might make things even worse. There is no guarantee of any better insight of such regulators in what needs to be done in extremis. Rather, the more normal objective is to provide a legal framework within which financial business must be conducted and can be supervised. This then requires clear rules to be enforced rather than a daily (ad hoc) involvement of regulators. At least in micro-prudential financial supervision, the key is therefore a legal regime of checks and balances, not of discretionary intervention, although, again, if there are specific and serious reasons, that is not to be ruled out entirely but it should remain exceptional even if there may be some room under the regulatory rules to do so. This being said, regulators still tailor the rules to individual institutions to the extent these rules allow and require it. Again, that is micro-prudential supervision as distinguished from macro-prudential supervision, which is not regulation in this more traditional sense (see again sections 1.1.14/15 below) and is geared, it is submitted, more in particular to an anti-cyclical policy attitude towards capital and liquidity requirements, therefore to the intensity of banking activity and its size in every phase of the economic cycle, which puts this function, it will be argued later, at the level of monetary and fiscal policy, although well separated from them (especially monetary policy even if macro-prudential supervision and monetary policy may both operate at the level of central banks). A micro-prudential regulatory framework of this nature, although rule-based even though allowing for some variations in its application to individual banks, will still be diverse and varied, also because of the different financial functions exercised by financial intermediaries, be they banks in commercial banking activity or investment banks in the capital markets. But there may also be differences in the weight and nature of the activities, and even different perceptions and evaluation of risk per country, and different objectives or traditions and ways of doing business. This is likely to result from the size of the industry or financial market in a given country and from differences in the level of regulatory sophistication. In connection with the details of financial regulation of this nature, there is, however, a general pattern or model and it is useful to (a) focus first on the type of service rendered, such as commercial banking, securities or insurance services, which may be broken down further into specialised functions such as deposit and payment services for commercial banks, and underwriting, trading or brokerage, clearing and settlement or investment advice in investment banking. Subsequently it is useful to (b) distinguish between the service provider and the service itself. In respect of both, the regulatory issues can be broken down further. In the case of the service provider (per industry or function), there is commonly concern with (a) authorisation and (b) prudential supervision. Thus, commercial banks as institutions and investment banks per function are likely to need some form of authorisation or some governmental licence. The authorisation itself will depend on (i) reputation of managers and shareholders (the fit and proper test),48 (ii) capital, (iii) adequate infrastructure and systems, and (iv) the 48 Senior management is often made directly subject to the fit and proper test even though it applies foremost to their institutions, and they are then brought into the supervision personally through a system of examinations and supervision of minimum qualifications. What is fit and proper remains, however, a difficult issue in practice and has two features: ability and moral standing. As to these requirements, which tend to be quite basic in the way they are expressed, the first is usually left to management and shareholders, the latter may attract more regulatory attention. They may also be seen as matters of corporate governance, although, again, regulators may be careful not to get involved in the running of financial institutions more than absolutely necessary. In the EU, a Commission Green Paper of 2 June 2010 on corporate governance in financial institutions and remuneration policies identified a series of failures in corporate governance in credit institutions and investment firms that should be addressed. Among the solutions identified, the Commission referred to the need to strengthen significantly requirements relating to persons who effectively direct the business of the credit

Volume 6: Financial Services, Financial Risk, and Financial Regulation 27 business plan or profile of the financial service provider. It will be followed by (micro) prudential supervision, which is based on the ongoing requirement that the basic authorisation requirements remain in place and are fulfilled, for commercial banks especially in the aspect of adequate capital (and potentially also liquidity) and its management to prevent insolvency. There will now also be leverage ratios. Ultimately there is also concern with enforcement and the consequences of failure, notably leading to banking insolvencies and need for a resolution regime. Important as they are, these are aspects of regulation that concern the aftermath and will not here be the main focus of the discussion, although, as we shall see, it becomes an important issue in banking resolution regimes and macro-prudential supervision of that nature. See for the EU section 4.1 below. It has already been said that in commercial banking regulation remains largely confined to the supervision of the service provider, therefore to the two regulatory aspects of authorisation and prudential supervision. It is the issue of financial stability. For commercial banks, the activities of deposit-taking, providing loans and organising payments are usually conduct of business issues, mostly still considered secondary in terms of services rendered and products used. In the securities industries, on the other hand, there was traditionally less emphasis on the service provider as such but more on the regulation and supervision of the services or conduct of business concerning their activities, issues of authorisation and prudential supervision being often more secondary, therefore in fact the reverse of the situation in commercial banks. It has already been noted that concern about the services may become increasingly relevant for the more sophisticated banking services as well, for example in the areas of derivatives and insured mortgage credit when offered to the public. There is further to go but it means that also for banks, conduct of business and product supervision may increasingly become a regulatory issue for them. In this connection, it was also mentioned that the way they unilaterally charge customers for their services may become relevant also, especially in respect of the smaller banking clients. Credit cards may be a special area of concern and other consumer loan incentives. On the other hand, it may also be repeated that licence conditions and stability issues are now also becoming more relevant for investment banks which have become more systematically integrated in the financial system. As regards these financial services, from a regulatory perspective, a further distinction was already made between (a) the conduct of business proper and (b) the type of products offered (per function). This focuses on what is sold and how, and the safeguards in these respects for investors (or, in the case of banks, borrowers), traditionally especially important in respect of the smaller or retail investor and the way they are serviced or protected by their service provider, who may have some innate duties of care here. When it comes to types of products, it is also an issue of legal risk: do these products work and are they sufficiently transparent. In sections 1.5.9 and 3.7.10 it will be demonstrated that the service and products covered are increasingly separated in this connection, although especially when it comes to the issue of suitability of any advice rendered, they cannot always be clearly distinguished.

institution. They should be of sufficiently good repute and have appropriate experience and also be assessed as to their suitability to perform their professional activities. The Green Paper also underlined the need to improve shareholders’ involvement in approving remuneration policies. The European Parliament and the Council noted the Commission’s intention, as a follow-up, to make legislative proposals, where appropriate, on those issues. Some action came in the Capital Requirements Directive (CDR3), Directive 2010/76/EC of the European Parliament and of the Council of 24 November 2010 [2010] OJ L329/3, but it did not truly clarify the criteria, see also s 3.7.3 below. Especially the UK Regulator took more resolute action in its Senior Management Regime (SRM), s 1.1.14 below.

28 Volume 6: Financial Services, Financial Risk, and Financial Regulation In the area of issuing new securities (or primary market), there are likely to be further regulatory requirements. These concern the issuer or fundraiser more directly, not the intermediaries, such as its registration with the Securities Exchange Commission (SEC) in the US (if the issue is targeted at US investors), which commonly leads to a prospectus requirement. Issuers are thus regulated and the need for them to produce at least a prospectus is now also an increasingly common requirement in Europe—see for the EU regime section 3.5.10 below. Here we are concerned with corporate transparency and identification of corporate risks.49 This transparency may be required all the more if the issue is at the same time listed and traded on an official stock exchange, therefore targeted at the public at large.50 To repeat, in the new issue or primary market, financial regulation will foremost affect the issuer, therefore the party that needs money and raises it publicly. So is the type of securities offered and their advertisement, now commonly subject to prudential regulation, here as part of the issuing process. The conduct of the financial service providers or intermediaries, largely underwriters and placement agents, activities mostly concentrated in investment banks, is also important, but their regulation is quite different and takes the model of bank regulation, as we have seen, but, again, the emphasis may be different: less on financial stability and more on conduct of business. So may be the involvement of financial service providers as advisers to the issuer in respect of the available funding alternatives and in arranging the documentation, including the prospectus. Again, this is the world of intermediaries, especially of investment banks, here in their corporate finance departments, which also involves lawyers, although this purely advisory work may not be regulated or require authorisation in the manner already discussed as long as it does not involve offering investment advice to the public (the same may go for merger and acquisition activity and advice). Rather, it may attract other forms of supervision and will not normally extend to the lawyers (although they may be liable for negligence). The latter tend to be supervised by their own professional bodies, such as the Bar of which they are members. In terms of legal protection and recourse for or against financial intermediaries, the regulatory concerns with proper authorisation and prudential supervision of commercial banks and securities intermediaries or investment banks, and with the supervision of the issuing activity itself, have in many countries resulted in new structures of administrative law and in the creation of new supervisory authorities that grant licences for or authorise the various financial functions and supervise the implementation of their conditions. Failure to comply may then lead to a loss or suspension of these licences or authorisations, subject to some forms of judicial review in the administrative courts. It means that private parties will not have standing to sue their banks

49 Besides these special regulatory requirements in respect of issuers, there may also be company law issues for an issuer if it is a corporate entity (and not a government or governmental agency), for example the necessary corporate approvals or the nature of the securities that can be offered. In company law, one sees here an important shift in interest from typical organisational or company law matters to capital markets and regulatory concerns, most importantly also in connection with the financial information given and the accounting principles underlying this information. There may also be tax and stamp duty aspects of new issues and, in international offerings, there may be restrictions on issuers as to the markets in which they may issue or currency restrictions and money transfer problems. 50 In respect of the trading activity, a new area of law has in the meantime resulted from the emergence of new types of securities (shares or bonds) in terms of book-entry system entitlements. They are replacing the older negotiable instruments, the way investment securities are held and transferred, and bona fide purchasers of them are protected. This has been dealt with more particularly in Vol 4, Part III, summarised in Vol 5, s 4.1 above. It is not a regulatory issue proper, rather a question of private law protection or legal risk that is nevertheless also of relevance to regulators where it affects investors’ rights and remedies. This therefore concerns the nature of the investment product and the investors’ protection from that point of view.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 29 or intermediaries under these rules, although some so-called horizontal effect is not always excluded, but it must still be considered rare. The only thing aggrieved parties can do is to write and complain to regulators, who may or may not act.51 For banks, this supervisory function was in the first instance mostly exercised by central banks and often still is. For the securities industry, it had in the US already led in the 1930s to the creation of a specialised regulator, the SEC. The Financial Services Authority (FSA) in the UK was a much more recent creation (1997) and was until 2012 the sole (consolidated) regulator for all financial services in the UK. It thus also covered commercial banking supervision, which was earlier taken away from the Bank of England, but this division of labour is reversible and is often determined by political considerations. In fact, in 2012, in the area of financial stability, banking regulation reverted in the UK to (a subsidiary of) the Bank of England in a specialised separate function. This is the Prudential Regulation Authority (PRA), which decides on authorisation and prudential supervision of all financial activity. What was left of the FSA became the Financial Conduct Authority (FCA). It concerns itself primarily with conduct-of-business issues.52 As just mentioned, client protection foremost concerns the services provided (rather than the service providers), and covers conduct of business and types of products. In terms of legal protection and recourse, this is likely to lead to concern with the reinforcement of private (rather than administrative) law, especially in the area of agency (and duties of care, loyalty and confidentiality), segregation of assets, and constructive trust.53 Here aggrieved parties can sue for damages or for the cancellation of improper transactions. These issues and protections will be discussed at greater length below in section 1.5.9 and concern in particular ‘know your customer’, ‘suitability of the investment’, and ‘best price or best execution’ issues. The difference with authorisation and prudential rules is thus that even when these protections are further elaborated and expanded in regulatory rule books, the remedies are likely to be in private law in terms of breach of contract, breach of fiduciary or statutory duties especially in situations of dependency, or tort liability, although special statutory (ombudsman) schemes may also be put in place instead to facilitate proceedings brought on these (reinforced) grounds, especially by small investors against their brokers. It has already been said that regulatory concern may then also cover the (proper) legal characterisation of modern financial products, such as security entitlements and custodial arrangements, clearing and settlement, collateralisations, securitisations, derivatives (including swaps), and repurchase agreements, set-off, and netting, here again primarily as matters of clarification, reinforcement or amplification of private law. These problems (and therefore the legal risks inherent in these financial products) were discussed in Volume 5. Again, if improperly sold, the recourse would be in private law, resulting in damages or the undoing of the transaction at the intermediaries’ expense. For corporate issuers, modern issuer activity may result in amendments to corporate and commercial law in terms of disclosures, accounting principles, and types of securities on offer.

51 See n 54 below. 52 See for the latest recast of the supervisory system in the UK, the Financial Services Act 2012, operative as of 1 April 2013. While more modern proposals increasingly seek to separate stability issues from client or investor protection as already noted and may lead to a regulatory split, like in the UK, many other countries still have specialised regulators for the various functions, although there continues some trend in the direction of regulatory consolidation in a single regulator (but most notably not in the US and no longer in the UK). Whether this is a good development may be reconsidered further in the wake of the 2008–09 crisis. 53 Iris H-Y Chiu, ‘The Nature of a Financial Investment Intermediary’s Duty to his Client’ (2008) 28 Legal Studies 254.

30 Volume 6: Financial Services, Financial Risk, and Financial Regulation In clearing and settlement, there may be particular concern with safety and proper functioning of these facilities, leading to regulatory supervision from that perspective (although less so in Europe), but also to the further development of private law, such as the evolution of the guarantees of clearing members and of the legal acceptability of close-out netting agreements. Such private law developments may make more direct regulation of these activities superfluous. Again, in all these instances, the balance between private or administrative law intervention is of considerable interest, the key always being that administrative law remedies do not automatically give rise to civil remedies.54 Of immediate importance is here to realise that administrative law remedies do not give private investors’ protection, see however also the discussion in section 3.7.19 below. To reiterate, there is normally no horizontal effect in that sense and civil liability of regulators is also exceptional. Thus, licences or authorisations and their repeal is a matter between an intermediary and its supervisor as an issue of administrative law. Neither bank clients nor investors can insist on it, nor does such a repeal give them any direct claims against the regulator or relevant intermediary/perpetrator. As noted, the emphasis of modern financial regulation in the area of commercial banking remains particularly on authorisation and prudential supervision and is less conduct of business and product oriented. Again, financial stability and systemic risk have become the main concerns; administrative law rather than private law issues arise here. In the capital markets, the regulatory focus is instead on issuers in respect of transparency and securities offered and on intermediaries or service providers in respect of their services. That is private law, although even here there may also be authorisation and prudential supervision, at least for the underwriting, trading, brokerage and advisory activity, and sometimes also for support functions such as clearing, settlement and custody, but the emphasis is still more likely to be on conduct of business and products, therefore on private law protection rather than on administrative law remedies, even in respect of retail investors.

1.1.9. Deregulation and Re-regulation of Modern Financial Activity. The Institutional and Functional Approach to Financial Regulation. Monetary, Liquidity and Foreign Exchange Policies Distinguished It is important to repeat that not all financial services are directly related to deposit-taking or the selling of banking products and investments to the public. In commercial banking there is, importantly, also the payment function. In investment services, there are underwriting, market-making

54 Indeed, 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 legal restrictions on civil 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 now 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), largely superseded by the Credit Institution Directives of 2000 and 2006 and its successors, 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.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 31 or order matching, brokerage, investment management, information supply, clearing, settlement and custody functions. These are market functions traditionally grouped around the formal or official markets or stock exchanges but now often split out and spread over different entities which have no official status and may compete. This is clear where unofficial or OTC markets started to operate and compete with the more traditional stock exchanges (see for these markets and their operation section 1.1.18 below). They are often markets created by investment banks for their own clients or each other. Electronic trading platforms have facilitated this development (see also section 1.5.6 below). It is also clear in the information supply and clearing and settlement functions, where private organisations increasingly compete with the official exchanges for this business, notably central counterparties (CCPs): see Volume 5, section 2.6.5. As already mentioned, some of these market functions may also be taken over by different departments of investment banks. It follows that modern financial regulatory objectives and requirements in terms of authorisation, supervision, conduct of business, and product control, may be different in respect of each type of financial service or service provider. Regulation by function rather than by institution like a bank or exchange, has thus become more normal and may be done through different regulators. This is the approach in the US, where there are many regulators, although it may also be done by a single (consolidated) regulator, as did the FSA in the UK until 2012, but in that case within a single set-up still differently according to function. It is also possible to split regulation and have one regulator in respect of the authorisation and prudential supervision (of commercial banking, investment banking and insurance) and another in respect of conduct of business and product supervision, therefore one for stability issuer and another for client protection. This may be a regulatory improvement and is probably the latest trend, as borne out in the UK where we now have the PRA and the FCA, see the previous section.55 So, in the structure of financial regulation, we have gone from an institutional to a functional approach and now to a sharper distinction between stability and client protection. These trends are not necessarily complete, but it is apparent that there was in modern financial regulation a fundamental shift away from the regulation of institutions, like again the traditional commercial banks and stock exchanges as such, to the regulation of intermediaries according to their different functions, particularly relevant in investment banking. As a consequence, one service provider may be subject to different regulatory regimes. Again, this is clearer for investment banks, but it may also increasingly affect commercial banks. The emergence of bank holding companies where different activities are relegated to different subsidiaries reinforces this functional approach also, therefore even in commercial banking, but if this is still less obvious for commercial banks, it has largely to do with the overriding aim to avoid commercial bank insolvencies, insolvency being an institutional phenomenon which engenders systemic risk and issues of financial instability, traditionally less of an issue for investment banking, as we have seen, although perhaps becoming more so now because of their size and their increasing interconnectedness with commercial banks from which they borrow large amounts. On the other hand, as we have also seen already, even within commercial banking proper, there is now greater concern about conduct of business, therefore about protection especially in respect of borrowers and the financial products on offer, less for depositors. Although other regulators may thus come on board, especially in so-called universal banks which also conduct

55 See Ellis Ferran, ‘The Break-up of the Financial Services Authority’ (2011) 31 Oxford Journal of Legal Studies 455 and Adair Turner, ‘The Turner Review: A Regulatory Response to the Global Banking Crisis’ (FSA 2009).

32 Volume 6: Financial Services, Financial Risk, and Financial Regulation investment business—see section 1.1.17 below—the institutional approach is not fully abandoned and the supervision for commercial banks remains largely subservient to the aim of preventing insolvency, relevant especially in the determination of sufficient capital for the entire entity, the ultimate aim being to reinforce financial stability. For this reason also, there still remains more of an emphasis on authorisation and prudential supervision in commercial banks, indeed with a predominant concern for capital adequacy and increasingly also liquidity for the whole institution (or even group). It is in any event likely that there will be only one lead regulator for capital adequacy (and liquidity) in respect of all activities. That is normally the banking supervisor. Again, at least in commercial banking, it highlights institutional concerns at the expense of conduct of business and product supervision, which lead to a more functional supervisory approach. It follows that the functional approach itself is more evident in the securities business when operating on a stand-alone basis. Regulation along functional lines is sometimes also referred to as objective-based regulation and may thus differ for underwriting and trading, for brokerage, clearing, settlement and custody functions, and for investment advice and fund management. The shift in regulatory approach in the capital markets from institution to function in the above sense was, for the securities business, already achieved in the US under the 1933 Securities and 1934 Securities Exchange Acts, which, in the Glass-Steagall Act (as part of the Securities Exchange Act) legally separated the banking and underwriting businesses. They could no longer be combined in one institution. This separation endured until 1999 but became uncommon, especially after the financial crisis in 2008, when the main investment banks in the US applied for a banking licence. Separation directed against proprietary trading is among the newer regulatory proposals since 2010 in this regard: see the discussion in sections 1.3.10 and 3.7.11 below (the Volcker rule). In a country like the UK, after the so-called ‘Big Bang’ in 1986, the functional approach also became clearer and part of the breaking up of the club atmosphere and monopolising tendencies in the stock exchange in London, official markets having traditionally been institutionally self-regulated. A sequel to this was in the UK that market, settlement and custodian facilities could henceforth be freely created, as had already happened in the offshore Euromarkets (see for these markets section 2.1.2 below) even to the extent operating from London. These services are (unlike in the US) no longer subject to regulation per se, although transparency (and price reporting) was imposed by law on all market participants operating from the UK, while there is a system of official recognition possible, which gives such recognised markets (which must be well distinguished from official markets), or settlement and custody entities that want to operate within them, some advantages in their reporting duties and then often also more credibility. It also protects them against any charges of engaging (inadvertently) in regulated activities without a proper licence. The charge is often heard, especially after the financial crisis of 2008–09, that there has been aggressive financial deregulation during the last generation, see also section 1.3.2 below. Beyond the lifting of Glass-Steagall in the US in 1999, this is hardly the case for financial intermediaries and services, as may be seen from the mushrooming of compliance departments, long before 2008. If there was a regulatory shift from institutions to functions and therefore a form of deregulation of the former, it was accompanied by re-regulation, now often along functional lines. It was more that in good times enforcement of regulation became lax and liquidity management was neglected by regulators altogether. At the formal level it is also true that capital requirements had been ever further reduced, which was certainly confirmed by Basel II. So, one could say that there was a government inspired deregulation of the capital requirements further demonstrated by the self-assessment possibilities of Basel II. More particularly, newer financial products were not normally considered for regulation, which applied, for example, to securitisations, hedge

Volume 6: Financial Services, Financial Risk, and Financial Regulation 33 funds, and credit derivatives, although they were gradually brought within the reach of the capital adequacy rules, especially under Basel II. This being said, it is also clear that an ex-ante approach is here hardly possible and it is only logical that regulation is always behind: it is often hard to see at first where the problems with these newer products are and they are likely to be only truly tested in financial crises when regulation comes (by definition) too late. So, we may have a lack of regulation by default, but this is not deregulation. Licensing of all innovation would be the answer but is not realistic where the risks change all the time. This should not be confused with another fundamental element of de- and re-regulation in finance. We are then concerned with the deregulation of the flows of financial services and products, therefore of markets (except to protect their integrity), and the re-regulation of participants therein. In this approach, flows or markets are free in concept and not to be manipulated or distorted by regulation or otherwise, especially in their price formation aspects. This deregulation of the flows has acquired an international dimension and concerns the free flow of financial services and products internationally. Again, there should not be interference with the price formation function in respect of these services and products. Participants are different and may be regulated locally and per type of activity. In the capital markets, they may be issuers and intermediaries as we have seen or even investors, who may thus all be regulated in some form or another (the latter, for example, in the case of pension funds to redirect their investments). The deregulation of the flows of financial services and financial products in this manner should in turn be distinguished from the regulation and subsequent deregulation of the capital flows, although the increasing liberalisation of these flows internationally has given an enormous impetus to the financial services industry worldwide, while greatly encouraging the cross-border delivery of financial services and products. In the EU, as we shall see in section 2.4.1 below, the liberalisation of the capital flows after 1988 was indeed the catalyst for the further liberalisation and therefore deregulation of cross-border financial service flows and products as such, even though in principle already freed under the original Treaty of Rome of 1958, which created the original EEC. Again, it left the question of the regulation of issuers and intermediaries as market participants. In practice, the free flow of these services and products was delayed in the EU because of the regulatory complication and the lack of clarity, especially in terms of host regulator competencies to regulate incoming service providers from other EU countries. Only in the so-called Third Generation of EU Directives in this field, issued in the context of the Single European Act 1992, was a division of labour achieved between home and host regulator of financial services in this respect (with the emphasis on the former, as we shall see), which made the flow of these services to, and the right of establishment of the service provider in other EU countries practicable, while at the same time achieving harmonisation of the regulatory aims and regimes: see sections 1.2.1, 2.3.4 and 3.1.1 below. Unlike in the liberalisation of financial services and products providers, which was meant no longer to inhibit the financial flows or markets except to safeguard financial stability, promote proper conduct in intermediaries, and protect the integrity of the marketplace, in the liberalisation of capital flows themselves we do not primarily think of depositors or investors and their regulatory protection or of borrowers or issuers and the financial services provided to them by financial intermediaries. There are here domestic and international aspects. Domestically, we think of monetary and liquidity policies (in terms of the economy at large and not individual banks), including issues of money supply, exchange rates, and (short-term) interest rates, inflation control, and the allocation of credit to various economic sectors, the first two (monetary and liquidity policy) being traditionally conducted by central banks and of particular concern for commercial banks. In England, these matters come under the Bank of England

34 Volume 6: Financial Services, Financial Risk, and Financial Regulation Act 1998 (while the deposit-taking function of commercial banks is now regulated under the Financial Services and Markets Act 2000 as amended). Internationally, in terms of capital flows, we think foremost of the free movement of investments and payments, including the export and import of the related currency and its convertibility. Deregulation concerns here domestically the freeing of exchange rates and of interest rates (at least the longer ones), henceforth to be set by market forces, and internationally the freedom and ability to borrow or raise and invest capital wherever one wants and in whatever currency. Another aspect is here the freedom to make and accept payments in any currency one wants. The deregulation of capital flows at the international level and their possible re-regulation to prevent financial upheaval or to deal with the international investment and taxation consequences—matters which the 1944 Bretton Woods Agreements essentially left to national governments—raise very different issues from the regulation of the financial services industry, its structure and organisation. Unlike the regulation of financial services, this can hardly be left to (domestic) home/host regulation alone. They are dealt with internationally, partly within the IMF, and in Europe also at the EU level. In other words, this is not merely a matter of the division of labour or recognition thereof between (regulators from) Member States. It will not be considered here in greater depth. As just mentioned, in the EU after 1988, capital flows were fully liberated (see section 2.4.1 below) while the re-regulation possibilities in respect of them are now limited. This left a number of investment and taxation issues, which will be discussed in greater detail in section 2.4.2 below. It should also be noted that it is not uncommon to discuss regulation/deregulation in terms of cost/benefit analysis (CBA) and it has often become an integral part of the regulatory process, although not seldom ending in lip service with uncertain criteria, even if scientific objectivity is often pleaded. It may be challenged and not be as neutral as it may claim, its credibility being often shaky.56 If, as suggested in section 1.1.8 above and below in sections 1.1.10 and 1.4.7, the essence of modern banking regulation in a narrower sense is now financial stability, it may become increasingly directed towards macro-prudential supervision. This may mean curtailing banks at the top of the cycle for them to build capital at that time. This suggests another facility besides micro-managing banks through regulation in the manner so far discussed. This is indeed policy, a facility closer related to monetary policy than financial regulation as we know it and is, as will be argued later—see sections 1.1.14/15—below, another typical central bank function, which like monetary policy may or may not be conducted independent from government.57

56 Cf D Farber, ‘Regulatory Review in Antiregulatory Times’ (2019) 94 Chicago-Kent LR 101. See also John C Coates IV, ‘Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications’ (2015) 4(124) Yale Law Journal. In the UK for instance, quantified CBA of proposed rules is mandatory for all financial regulatory agencies unless they cannot reasonably estimate the costs and benefits or it would not be practical to do so. Reasons for failure to conduct the CBA must be provided. Such rulemakings and CBA are subject to judicial review, although judicial review has not generally been used to challenge rules for inadequate CBA. See Financial Services Act, 2012, amending inter alia sections 138I (Financial Conduct Authority) and 138J (Prudential Regulation Authority) of the Financial Services and Markets Act 2000. 57 Financial and business cycles tend to co-move, with the most severe fluctuations in the business cycle often associated with the boom and bust cycle of the financial system, see for instance Claudio Borio, ‘The Financial Cycle and Macroeconomics: What Have We Learnt?’ (December 2012) BIS Working Papers No.395 ; Òscar Jordà, Moritz Schularick and Alan M Taylor, ‘Macrofinancial History and the New Business Cycle Facts’ in Martin Eichenbaum and Jonathan A Parker (eds), NBER Macroeconomics Annual 2016 Vol 31 (NBER 2017) 213; Douglas Arner, Financial Stability, Economic Growth, and the Role of Law (Cambridge, 2007) 36.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 35 The true issue is here the determination of the banks’ size in each stage of the economic cycle. Operating besides monetary policy, such a macro-economic banking policy must then also be distinguished from fiscal policies, which concern budgets and taxation and are the preserve of government. Indeed, these three policy vehicles are the preserves of governments or their central banks, although this banking policy in particular may have to be internationalised through international agencies determining the top of the cycle as a signal for stricter capital requirements, if only to maintain a level playing field between the larger banks in their global operations. It may have to be backed by a stability fund to be created in good times cross-border so as to provide an international safety net for larger banks: see further the discussion in section 1.3.8 below. It is submitted that this is likely to stabilise the banking industry much more than present microprudential supervision can do.

1.1.10. The Different Aims of Modern Financial Regulation Altogether the conclusion so far is that (apart from issuers and, sometimes, investors), the emphasis of modern regulation of the financial services industry at the micro- prudential supervision level is on the service providers, therefore (a) on the intermediaries in the banking and securities business, their function, their proper authorisation and supervision, where financial stability is increasingly the issue, (b) on the way they provide their services and on the products they offer, where the protection of depositors and investors is the issue in terms of the conduct of business, and (c) on the proper functioning of financial markets, hence the interest in pre and post-trading price disclosures and transparency in that regard, but not or no longer in the flows or markets and price formation processes themselves, except for the important issues of market abuse, insider dealing, anti-competitive behaviour, money laundering, and corruption. It follows that, depending on these services or functions and the way they are provided, the main aims or concerns of modern financial regulation may be quite diverse, although likely to be concurrent, but they may also conflict as we shall see in the next section. Even if generally the objectives crystallise in the three categories mentioned—stability of the financial system, conduct of business, and the integrity of the markets—to be effective, the regulatory aims should be oriented towards some more clearly defined risk per function. Yet clarity of purpose remains a major problem in financial regulation, and regulatory objectives often remain clouded in vague ideas and sentiment or cloaked in unspecific, even though highly desirable policy aims, such as indeed the stability of the financial system, protection of depositors and investors, and the avoidance of market abuse. The question is how? Can these aims be achieved effectively and efficiently, and at what cost? What is the model or method? This is foremost a question of properly defining the sub-objectives in terms of regulation, which is often lacking, so that the discussion tends to become confused. Financial stability, for example, may be achieved at too low a level of banking activity which may become destructive for the economy as a whole. More precisely and by way of summary of

It follows that macroprudential policy acquires a macroeconomic dimension, because it does not just focus on limiting individual firm risk – but on how the collective system is heating up and how this will affect the broader economy. See also Dirk Schoenmaker and Peter Wierts, ‘Macroprudential Policy: The Need for a Coherent Policy Framework’ (July 2011) Duisenburg School of Finance Policy Paper No. 13 and Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro, ‘Rethinking Macroeconomic Policy’ (12 February 2012) IMF SPN/10/03 www.imf.org/en/Publications/IMF-Staff-Position-Notes/Issues/2016/12/31/RethinkingMacroeconomic-Policy-23513.

36 Volume 6: Financial Services, Financial Risk, and Financial Regulation what has mostly already been said, the main objectives are the following (although, again, their intensity is likely to vary according to function and type of institution or product or even from country to country): (a) The minimalisation of contagion or systemic risk in that sense, meaning foremost the prevention of the collapse of one financial firm affecting others. This is a main feature of financial stability, as we have seen, although interconnectedness may by no means be the only cause of instability, see section 1.1.2 above.58 The concern is then primarily insolvency risk, which risk has important contagion aspects. As we have seen, it is especially considered in commercial banking, where, through the interbank market, trading accounts, and financial settlement, swaps and repo exposure, CDS guarantees, and payment systems, all banks are closely connected and the failure of one may seriously affect others. It could thus endanger the entire liquidity-providing function of banks and also the payment system, especially the off-line clearing systems (see Volume 5, section 3.1.6). Systemic risk of this nature was found to be traditionally less relevant in respect of investment services providers unless they become very large (as the major US investment banks were found to be in the crisis of 2008, while being at the same time important borrowers from commercial banks). Concerns of this type may now conceivably also extend to other large financial entities or non-banks in the so-called shadow banking system (see section 1.1.18 below) but the more proper question is, as we shall see, which ones and in what way. To address these concerns, now increasingly morphed into concerns for financial stability more generally, an authorisation and prudential supervision regime is commonly provided59 and the remedy here is administrative action in terms of loss of licence and/or fines. Bank bankruptcies occur, however, unabated, including even in more recent times even a bank run, while it has also become clear that through regulation, especially of the capital adequacy requirements and limitation on large exposures, systemic risk is hardly reduced and financial stability not guaranteed. In consequence, so far, modern (microprudential) regulation has been proven to be largely irrelevant to redress systemic risk or to increase financial stability. Proper insulation of problems and greater discipline in banks may require more radical action, perhaps even leading to some form of narrow banking, as will be discussed more extensively in section 1.3.6 below.60 It could, however, dramatically shrink the banking business, which is likely to have serious consequences in terms of growth and employment. It may therefore in truth no longer be a realistic option. It was already said and will be expanded later that much stricter regulation of banks at the top of the economic cycle as a matter of macro-prudential supervision, may be more effective and efficient, see section 1.1.15 below. It goes well beyond the established regulatory model, which mainly

58 See for a discussion of systemic risk nn 6 and 8 above and the tendency to overrate this risk by regulators. It gives them more power, but the question is how they are exercising it, see for macro- and micro-prudential supervision, ss 1.1.13/14/15 below. 59 As has already been observed in the previous section, for commercial banks this leads to a more institutional approach. In a more functional approach, conduct of business and product concern, on the other hand, are mainly associated with securities activities, therefore with the operations of investment banks and securities houses or independent brokers in the capital markets. 60 It is also of interest that limiting systemic risk as a regulatory objective became implied in older regulatory systems that never meant to combat it. That was so, eg, in the UK, where under the Banking Act 1987 the objective of banking regulation remained depositors’ protection. Systemic risk was not mentioned and only appeared subsequently in the Bank of England’s three-monthly reports.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 37 focusses on what banks can or must each do internally, and is in fact policy much as monetary and fiscal policy is: see also the discussion at the end of the previous section. (b) The protection of clients or customers, such as bank depositors and securities investors, against: (i) bankruptcy of the service provider; (ii) bad selling or advisory practices and uncompetitive prices often caused by a conflict of interests between service provider and client; or (iii) risky products.61

The impact of insolvency of the institution on its depositors and customers is now commonly covered by deposit and investors’ protection schemes; see also section 1.1.12 below.62 On the other hand, the modern concerns about financial products and the way they are treated or sold, are not or no longer primarily limited to investment securities as transferable instruments, such as negotiable shares and bonds. They may also relate to derivatives and deposits or other structured banking products. Even in commercial banking activities, credit card business or specialised mortgages may increasingly become a proper modern regulatory concern. It is appropriate in this connection to distinguish between the needs of the professional clients and others that have less experience. In general, only the latter need special protections. The result is often an increased possibility for private action by them against brokers and other intermediaries through private law remedies, as we have seen, especially damages or the avoidance of the transaction, often as the result of reinforced fiduciary duties, but it may also extend to the reinforcement of segregation of client assets in a broker’s bankruptcy. (c) The creation of a proper legal framework for financial products and services generally. This is legal risk and its minimisation. Regulatory concern in this aspect may and should increasingly extend to the legal characterisation and structure of newer financial products and services, especially obvious in the case of derivatives (and the ways in which they are cleared and settled) and other modern types of investments such as book-entry entitlements and custodial services and their operation transnationally. It may also concern modern set-off and netting facilities, and the functioning of exchange and payment systems, including CCPs. In banking proper, it may cover insurance-related loan or mortgage products. These raise mostly issues of private law and its reinforcement which were the subject of Volume 5. It is an important (but often ignored) area of modern regulatory concern, which may also go to the transferability or proper unwinding of investments, as in the case of the more sophisticated derivatives. As we have seen, civil law in particular is largely consumer law focused and tends to be formalistic in its system approach which is not geared to professional dealings and to a dynamic legal environment that can more readily deal with financial innovation. Again, regulation would not be along the traditional lines of authorisation and prudential supervision,

61 In the area of investors’ protection, the regulator is often enabled to react through setting further rules (for the future) under delegated rule-making powers (in a private law manner) and may in this way also be able better to tailor these rules to the different functions of intermediaries and different products and selling techniques as they develop. The remedy is not here normally the termination of authorisation as an administrative measure but rather (reinforced) private law remedies leading to claims for damages. 62 See for these schemes also n 44 above. Note that the compulsory segregation of client assets in non-bank intermediaries, may provide additional protection, notably of investors’ money.

38 Volume 6: Financial Services, Financial Risk, and Financial Regulation but may acquire the form of more specific facilitation and intervention in private law, which is then likely to become mandatory in these areas. (d) The creation of a simplified enforcement mechanism is another important, closely related, client-protection aspect of financial regulation that may introduce a quick and cheap complaint procedure especially for the smaller customers or investors, either through ombudsmen or compulsory arbitration schemes in their recourse against financial intermediaries. This may also be extended to commercial bank customers, taking into account, however, the differences between various types of customers: borrowers have protection needs different from those of depositors and the latter have a different legal status vis-à-vis their bank. (e) The protection of the payment system. This concerns the continued unhindered operation of the payment system regardless of insolvency of banking participants and the proper and efficient operation of the clearing system between banks, see the discussion in Volume 5, section 3.1. (f) The integrity and smooth operation of markets. This is of importance foremost in the investment services industry. In terms of public policy, it could be seen as the investment services’ equivalent of systemic risk. This is not a question of regulating markets as such, whose flows and price formation process should not or no longer be hindered, but regulation is here first of a facilitating nature.63 It is likely to concern adequate information on issuers (through prospectuses and regular information supply) and adequate price transparency, therefore proper pre- and post-trading price information supply in these markets, as well as proper clearing and settlement and custody facilities. But regulation in the broader sense here also means the combatting of market abuse or manipulation, including insider dealing (although the latter may be more an issue of corporate integrity and credibility, see also section 1.1.21 below). In terms of market abuse and manipulation, there can hardly be a regulatory oversight system but civil and criminal sanctions will be the normal remedies. Regulatory concern in this connection may be limited to these aspects while other market operations and activity may be self-regulated OTC or telephone trading or may remain largely unregulated like mostly information supply, clearing and custody. The Eurobond markets showed early that full-scale regulation of major financial services and activities is not unavoidable, especially in professional dealings by experienced participants.64 Even in traditionally more heavily regulated domestic markets, a form of deregulation soon followed for information supply, clearing, settlement, and custody activities. Indeed, competition may create the better environment for protection here in the sense that the

63 Of course, formal markets, such as stock exchanges, will be subject to clear operating rules. Even informal or OTC markets will have to enforce some order as do the Euromarkets through the International Capital Market Association (ICMA), and therefore through self-regulation. These rules are internal and mean to promote the functioning of the market and do not mean to protect the investors in those markets. 64 See for these markets and their operation s 2.1.2 below, with Euroclear and Clearstream (formerly Cedel) as clearers and custodians. In these markets, until the EU Prospectus Directive of 2004, a prospectus was not compulsory (which appears not to have led to great problems in a market that has become one largely for professionals) and is not even now necessary in many cases: see ss 3.5.10 and 3.7.14 below. Except again for concern for proper price information and market abuse, key market functions, as well as the issuing activity itself, may thus remain entirely unregulated in a modern system. In fact the Euromarkets are the prime example of clean, self-regulated markets and became the largest capital market in the world. It demonstrates that there is no absolute need for regulation to make markets operate properly.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 39 better capitalised and better managed institutions are likely to attract the most business in these areas. This may also hold true for modern derivatives markets with their own counterparty and clearing functions (see for the EU regulatory efforts in this connection under EMIR sections 3.6.14 and 3.7.6 below and for built-in protections along the lines of CCPs in particular Volume 5, section 2.6.5). As the Euromarkets also showed, competition may even deal with issuers in the sense that in the absence of prospectus requirements, the market will decide the fate of issues that lack sufficient issuer transparency.65 (g) The prevention of monopolies among intermediaries in financial services. This is a subject closely related to market integrity. The risk of monopolisation has always been considerable in financial markets, especially in the securities business, but now also affects banking where, not least because of regulation, new entry is very difficult and there is to be further consolidation. At least the club atmosphere in stock exchanges, which were often given statutory monopoly status, is now mostly found objectionable and informal markets as competitors are often encouraged. Again, related services such as price and other information supply, clearing and settlement and custody may now mostly be offered in competition. Importantly, modern competition agencies may also force settlement and clearing systems of established exchanges to open to off-exchange dealings by non-members. The hold of (universal) banks over their smaller customers and the payment system, including the credit card business, may then be a particular matter of competitive concern. On the other hand, another issue in commercial banking is precisely the access of smaller companies to affordable banking services. It is the opposite problem, which touches on the public service function of commercial banks, see section 1.4.10 below. That may also relate to the ability of relatively small account holders to hold on to their accounts and in this way to their access to the payment system. These concerns suggest better access and competition rules, not financial regulation in the traditional sense (of authorisation and prudential supervision, conduct of business or product control).66

65 Particularly in professional markets, as the Euromarkets have become, issuer transparency is often much less of a concern as the type of issuer that issues in these markets tends to be well known and is watched by credit agencies and analysts while their findings are immediately divulged and discounted in the price for their securities. Interesting in this connection is Jesse Fried, however: ‘Should Corporate Disclosure be Deregulated? Lessons from the US’, Law and Economics Workshop Paper 4 (UC Berkeley, 2007), who argues against the market function in this area on the basis of the American experience. See also John C Coffee Jnr, ‘Market Failure and the Economic Case for a Mandatory Disclosure System’ (1984) 70 Virginia Law Review 717, who argues that voluntary disclosures are likely to be insufficient, and Merritt B Fox, ‘Rethinking Disclosure Liability in the Modern Era’ (1997) 75 Washington University Law Quarterly 903. In the meantime, much Eurobond primary and secondary activity is regulated to the extent it is organised from a particular country, in the EU under the Prospectus Directive and Regulation with large private placement exceptions, see ss 3.5.10 and 3.7.14 below. 66 It is tempting to think that regulation is ultimately inspired by efficiency considerations, and that therefore a number of the above-detailed objectives can be grouped together under that heading. This is misleading if only because the demands of efficiency may not be clear or may be different, eg in terms of internal risk factors (such as counterparty or market risk) or be external ones such as the system’s stability, but there are also distribution considerations that may enter the equation or notions of economic health and social consequences that transcend efficiency considerations. In terms of stability, one concern is likely to be the externality or lack of incentives for firms to limit their internal risk, thus their unwillingness to internalise the cost of stability, which would translate into higher capital, therefore less gearing, and stricter liquidity requirements. This is a legitimate regulatory concern, the cost of which could be calculated and shown to be either higher or lower than the benefit in terms of stability.

40 Volume 6: Financial Services, Financial Risk, and Financial Regulation (h) The concern with asymmetric markets.67 This is a particular academic concern with the functioning of the markets and with market transparency. The idea is that goods that cannot be properly inspected and valued sell at an average price which may be so low that it induces the sellers of the better goods to withdraw from the market altogether, which becomes low quality as a result. Thus, an un-transparent market may become ever more inferior in the quality of goods (or services) offered. It also means that, if the better quality of certain goods can be demonstrated, their market price rises. Transposed to securities trading, it suggests that in the offering of investment securities, enforced disclosure requirements might lead to a better-quality market and higher prices. It supports centralisation of markets and their regulation to provide transparency, which in turn creates liquidity. In commercial banking, asymmetry in this sense also arises in and may result from customers (including other banks) not knowing how strong a particular bank’s position is in terms of liquidity, maturity of its assets and liabilities, counterparty, position or operational risk, and its asset and liability management. This could in this view lower the quality of the entire banking system, while leading to an unease or even unwillingness to fund banks. The same could happen in the insurance and investment brokerage industries. Regulation enforcing proper disclosure or suggesting adequate financial supervision would then be the answer and (at least in theory) be likely to upgrade the whole system and be another justification for and objective of regulation going to the market integrity pillar of regulation. This could, however, also derive from the guidance given by rating agencies, which (whatever the criticisms of these agencies) might be more effective, reliable and incisive. Banks on the other hand have always been successful in arguing that confidentiality requirements prevent them from much disclosure, but this has to be weighed against public policy, which may require much more transparency for proper evaluation by analysts and academics alike.68 The asymmetric markets theory also implies that in the investment industry, through proper disclosure (forced by regulation), brokers with better or superior knowledge of the markets could be identified. Whether or not this is a realistic regulatory expectation is a different matter entirely. Regulatory emphasis on proper disclosures and on transparency nevertheless finds extra justification here, but asymmetry considerations were not the original motivation for them and have not so far inspired specific new regulatory measures either.69

67 This resulted particularly from the researches of Professor George Akerlof at UC Berkeley. See his seminal paper, ‘The Market for Lemons’ (1970) 84 Quarterly Journal of Economics 488–500. A similar situation was identified in respect of a bank’s creditors by J Stiglitz and A Weis, ‘Credit Rationing in Markets with Imperfect Information’ (1981) 71 American Economic Review 393–410, as a bank cannot know whether its borrowers are serious entrepreneurs or gamblers. The idea is that in the case of increases in interest rates to cover the risk, the category of serious entrepreneurs borrowing money becomes smaller so that (in view of the increased risk) a bank’s profit may even decrease. Asking for security (rather than regulatory disclosure) may overcome this problem and seek out the better credits. In this view, applicants for credit may order themselves into different classes according to their willingness to give security. To the extent these borrowers are rated, other sources of information will also be available. 68 See n 199 below. 69 As for financial markets themselves, there seems to be little proof that, left to their own devices, they incline towards lower-quality trading. They have their own decentralised ways of information gathering at least amongst professionals and it is not at all certain whether regulatory insistence on transparency (unlike in banks) can add a great deal in this connection. Asymmetric information concerns would in any event not appear to justify or provide a proper argument for the centralisation and regulation of the market function as such (in official exchanges), which is sometimes suggested as an additional remedy.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 41 The problem of asymmetrical information is much raised in respect of retail investors who obviously have less information than the professionals. But they have a professional broker to help them and are price wise protected by the markets made between professionals.70 (i) The creation of a level playing field, especially between commercial banks. The idea is that the more prudent bank should not in the short term be punished for its financial prudence and affected in its competition with other banks. In particular, imposition of similar capital adequacy and infrastructure standards on all is in this connection considered an important regulatory leveller, even if a somewhat odd objective of financial regulation as it does not then seek to protect customers or the system as a whole, but rather financial institutions against each other. In that sense, it is regulation to protect fair competition.71 (j) Concern for the reputation and soundness of the financial services industry and financial sectors and markets in the centre(s) from which they operate. This goes beyond systemic concerns and market integrity and is more properly the issue of confidence. Yet the regulator needs to strike a balance between regulation that supports the reputation of its financial community and centre thereby attracting business, and regulation that is so unfocused or severe as to drive business away. The details may be less important than the general drift and the perceived credibility of the regulator becomes here a major issue and was badly shaken in 2008. On the other hand, the survival of national financial centres cannot be the end-objective. If other centres can provide the better facilities (in terms of efficiency, reliability and cost), they must prevail. Especially in Europe where irrationally each country still aspires to have its own stock exchange (like its own airline), this remains often a delicate issue. After Brexit it will be of interest to see how the cards may be reshuffled.

1.1.11. Conflicting Regulatory Objectives. Lack of Clarity in Statutory Regulatory Aims Although the true end-objective of financial regulation may now well be the promotion of financial stability, it was already submitted that it is unlikely to be achieved through financial regulation of the present micro-prudential type to which regular financial crises testify. Indeed, in the UK, the Parliamentary Ombudsman showed as early as June 2003 the fallibility of regulators

70 Probably much more important is that retail investors only deal in the market occasionally, guided in such cases by the prices set by the professional dealers who discount their own superior information. That is the true retail protection and explains why financial markets evolved with strong retail support even in the absence of much regulation of intermediaries and notwithstanding substantial insider dealing and serious conflicts of interests between brokers and their clients, of which churning and front-running are the most obvious examples. 71 Fair as the level-playing-field requirements might be, in the financial sector they may impose extra costs on non-banking business even if operating on a stand-alone basis, eg the broker-dealer business. Although the capital required for such security business is likely to be small unless large market positions are taken, it makes a difference for universal banks, which combine commercial banking, non-bank securities business, and even insurance activity, and need capital for all of them. To level the playing field, this may lead to similar requirements for nonbank securities intermediaries which engage in investment activities independently even though, as mentioned before, concern for insolvency and therefore capital adequacy may be less strong in relation to them, first because these intermediaries should segregate client assets and moneys and second because their insolvency is less likely to entail systemic risk, even though in the 2008 financial crisis this became less clear, see also the discussion in s 1.1.2 above. Nevertheless, the imposition of an authorisation requirement with the related capital requirement on this separate business may well have been hastened by level-playing-field considerations for universal banks.

42 Volume 6: Financial Services, Financial Risk, and Financial Regulation (the FSA of those days) in this regard and the limited preventive effect this type of regulation can have, at least in terms of financial stability. As will be submitted throughout (see more particularly sections 1.1.14/15 below), the issue of stability cannot be satisfactorily covered by the present micro-prudential financial supervision and requires a macro-prudential component with a very different (anti-cyclical) policy approach that is cannot be fully rule-based or judicial. After the issue of financial stability, the next objective as we have seen may be the protection of the deposit and investment climate especially for an ageing population that will be increasingly dependent on their savings and investments. It may truly be the key concern in all of this and the longer term objective. It shows that conduct of business is ultimately a much greater concern than it is usually perceived to be, stability concerns having taken over. But it is then an expanded concept where the safety of savings in terms of deposits and government bonds may come first, although it also touches on inflation, the hardness of the currency, and a fair return on investments not unduly hindered by a manipulation of interest rates in monetary policies. Importantly, even stability is a major issue in this context and confidence an important factor, which also touches on market integrity. It may indeed be enhanced by regulators who might still be perceived as helping, at least in these areas, whatever their failings. It was already said that especially in the narrower issue of client protection against financial intermediaries (conduct of business), regulators could be more effective even if the depositor or investor must in the end retain the ultimate responsibility for the choices made in terms of bank, intermediary, and product. Caveat emptor remains a key issue, although now subject to deposit and investor protection schemes, see section 1.1.11 below and a great deal of conduct of business protection. There are here also justified concerns about the reliability of payment systems, which may also more properly and effectively depend on regulatory acumen and expertise: see Volume 5, section 3.1.8. At the more theoretical level, regulation has often been defined as governmental intervention through mandatory law in the pursuit of the public interest, more particularly in the pursuit of some social or economic goal. Here it is or has become foremost financial stability, as we have seen, and confidence.72 In its pursuit, administrative agencies (or regulators) will take the decisions in terms of authorisation and prudential supervision. To protect the affected intermediary or issuer against an improper refusal or withdrawal of authorisation, it was shown that there is likely to exist an appeal possibility to the courts (in administrative review proceedings). In respect of the rule books that these agencies may impose, there may also be a formal review process to determine whether they acted intra vires. On the other hand, (reinforced) rules of private law, especially in terms of fiduciary duties, notably to guard against abuse by intermediaries, was shown normally to lead to damages or rescinded transactions to be obtainable through the ordinary civil courts or in special complaint procedures (of private law-like arbitration or ombudsman schemes). The latter may still allow the customer or investor an appeal to the ordinary courts (which facility may not be given to the intermediary). Market integrity issuers, on the other hand, especially in terms of avoiding manipulation, insider dealing, money laundering, corruption and monopolisation, will be countered by criminal and civil sanctions. It was already

72 In all this, it should be remembered that there are different ways to achieve public policy objectives. Discarding nationalisation, it could be done: (a) through new governmental agencies, which normally supervise under administrative law; (b) through self-regulating industry organisations (SROs), which often operate on the basis of contract law vis-à-vis their members over whom as a consequence they acquire some power by contract or through membership; (c) through a strengthening of private law in a mandatory fashion, especially to protect depositors and investors vis-à-vis their banks or brokers; or more likely (d) through a combination of all three.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 43 mentioned that this is not regulation in the more traditional sense but nevertheless an important public policy concern, see section 1.1.8 above. These objectives and the way they are pursued in financial regulation may prove, however, to be quite contradictory and there may be no clarity in the priorities, quite apart from the problems with the details and the implementation. Providing liquidity to the public, as against stability of the financial system, was mentioned in this connection earlier. There are other potential conflicts: the proper protection of depositors could require an early closure of a bank, which for the functioning of the payment system or for other systemic reasons might not be opportune. Some of this was shown in the BCCI case in London in the 1990s.73 In a regulatory shift in commercial banking away from depositors’ concerns (which are now often thought to be better covered by deposit insurance) to stability and systemic risk or concerns for the payment system, supervisors may be perfectly entitled to let the latter concerns prevail as English case law has shown,74 even if banking law may put the main emphasis on the former as was still the case in the UK Banking Act 1987, now superseded by the Financial Services and Markets Act 2000 (FSMA as amended several times), which also deals with deposit-taking, while the other functions (such as liquidity, monetary policy. and the function as bank of last resort) of the Bank of England are now covered by the Bank of England Act 1998 as amended. Because of these various complications, the approach to financial regulation has in more recent times become more pragmatic, at least until the 2008 financial crisis. It is largely accepted that no one single theory of financial regulation is able to adequately underpin and explain the needs and evolution of modern financial regulatory systems. To repeat, perhaps the true function and impact of regulation, whatever its real effect, is simply to create greater confidence, not mainly stability,75 but much of this was seen to fail in 2008–09. Poor liquidity management, the lack of sufficient regulatory capital, and the vagaries of an internationally effective safety net may be seen as the more direct causes of this crisis, the deeper problem probably being in our credit culture; see also the discussion in section 1.3.6 below. It suggests that the bite and sophistication of the regulator is itself the major point and that the rules may even become secondary. The downside of this emphasis on the bite and sophistication of the traditional regulator is that rule books may become ever larger but also more unfocused/uncoordinated and guided by the ideas of those who happen to write them and their personal perspectives and changing views, subject to public pressures. Given the very different objectives and levels of regulation and possible contradictions in purpose, and the differences in sophistication of regulators, this is hardly surprising, yet unsatisfactory. Even among those who favour the present trends in financial regulation, there is a recognition that this unavoidably leads to uncertainty and a lack of balance in its core. It has already been said repeatedly that, as for financial stability, the effectiveness of managing banks through micro-prudential regulation must be mistrusted. After Basel III, this kind of regulation 73 See also TC Baxter and JJ de Saram, ‘BCCI: The Lessons for Banking Supervision’ in RC Effors (ed), (1997) 4 Current Legal Issues Affecting Central Banks 371. 74 See n 54 above. 75 See also C Goodhart et al, Financial Regulation: Why, How and Where Now? (London, 1998), C Ford and J Kay, ‘Why Regulate Financial Markets’ in F Oditah (ed), The Future for the Global Securities Market (Oxford, 1996), EP Davis, Debt, Financial Fragility, and Systemic Risk (Oxford, 1995), J Norton, Devising International Bank Supervisory Standards (London, 1995), S Valdez, Introduction to Global Financial Markets, 2nd edn (Basingstoke, 1997). See also, C Goodhart and D Schoenmaker, ‘Should the Functions of Monetary Policy and Banking Supervision Be Separated?’ (1995) 47 Oxford Economic Papers 539, D Llewellyn, The Economic Rationale for Financial Regulation, FSA Occasional Paper no 1 (April 1999), M Taylor, Twin Peaks: A Regulatory Structure for the New Century (London, 1995).

44 Volume 6: Financial Services, Financial Risk, and Financial Regulation now seems to be focused on making banks smaller and again more domestic, but it will be argued throughout that it is hardly an answer to the liquidity needs that are prevailing in a globalising environment from which the little growth that is still expected may have to come. In all financial regulation, it would seem only normal for the legislator to ask itself at least what the precise concerns are, which financial service functions it wants to regulate, what risks it wants to or can protect against, therefore what the true objectives of such regulation are in each instance, and how they can most effectively be achieved. What is needed therefore is a more extensive risk analysis of the modern financial services activities and the need for them in order to develop a clearer view of (a) what risks must be handled by the industry internally, (b) how its risk management can be enhanced through regulation, and (c) in what manner. This is mostly not forthcoming except in a haphazard way, and modern legislation shows this in a lack of clear direction. In this book, one important reason is perceived to be that a full discussion of the future worldwide liquidity requirements and of the realistic capital needs of a banking system operating in that environment is avoided, see the discussion in sections 1.3.6 and 1.3.7 below. Haphazard micro-management through regulation is then preferred. If this leads to smaller and national banks, the negative effect on growth is commonly ignored, at least for the time being. In the EU in the meantime, the original banking and investment services Directives, which will be discussed later in section 3.5 below, did not give any unequivocal answer to the objectives of financial regulation either. Nor do their successors, respectively the Credit Institutions Directives 2000, 2006 and the 2013 SSM Regulation or the Markets in Financial Instruments Directive (MiFID) 2004 and its 2014 successor (MiFID II) or the 2003 Prospectus, now followed by a Regulation, and 2004 Transparency Directives. That is more understandable, as these instruments are primarily concerned with the division of regulatory powers between home and host states, although the original Investment Services Directive (ISD) in Recitals 2 and 42 of the Preamble stated investor protection and the stability of the financial system as the aims of the authorisation requirement. Especially in Article 11 it was also concerned with markets and their smooth operation and integrity. Recital 1 of the Transparency Directive wants to improve the allocation of capital and reduce costs. The 2004 updating of the ISD in MiFID referred more extensively to market integrity, in this book considered the third prong of financial regulation besides financial stability and customer protection—see section 1.1.6 above. The Market Abuse Directive in Recital 2 concerned itself more in particular with the smooth functioning of securities markets and public confidence in them. This would also appear to touch on investor protection and conduct of business,76 but the texts are less than complete and clear. This is about issuing and trading of investment securities, the behaviour of issuers, intermediaries and investors, not to forget advisors, financial analysts, rating agencies, investment managers and funds, and about efficiency but also integrity and safety of the system, which goes into competition, transparency, adequate clearing, and fair treatment or the other fiduciary duties that service providers owe investors. It also concerns proper and efficient execution and enforcement of the rules in terms of internal or external monitoring (notably of auditors, rating agencies, and financial analysts), or administrative supervision. Traditionally there are great differences in the details between the various Member States’ approaches whilst lack of clarity at EU level is often used to cover the cracks and avoid more principled and potentially divisive discussions.

76 They are or should be communicating vessels, see K Hopt, Der Kapitalanlegerschutz im Recht der Banken (Munich, 1975) 52.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 45 In the UK, the Banking Act 1987 referred especially to the protection of depositors and hence devoted much attention to the deposit protection scheme. Perhaps surprisingly, it did not refer to systemic risk concerns in the context of banking supervision at all, although the Bank of England in its regular reports started to do so, suggesting an informal shift in regulatory emphasis.77 The earlier Financial Services Act 1986 did not make any general statement about its objectives either, except to say that it meant (amongst other things) to regulate the carrying on of investment business and to make provisions with respect to the listing of securities, insider dealing and fair trading. What it did and what the true aims were remained unspecific, even if it was clear that it was for the most part investor protection against intermediaries in terms of conflicts of interests, bankruptcy and market manipulation. The UK FSMA 2000, which also covers the commercial banking activity (in which connection ‘deposits’ are defined and treated as investments), was more specific and refers in section 2(2) to: (a) maintaining market confidence which is further defined as confidence in the financial system; (b) promoting public awareness which is further defined as promoting public understanding of the financial system particularly in assessing benefits and risks of investments through appropriate information supply and advice; (c) protecting consumers to secure an appropriate degree of consumer protection taking into account different degrees of risk, different degrees of experience, the need for advice and accurate information but also their responsibility for their own decisions; and (d) reducing financial crime by reducing the likelihood that authorised intermediaries become involved in it or are used by criminals. Interestingly, financial stability was not expressly mentioned. In any event. it is not made clear what the status of these principles is and whether they are meant to be overriding and therefore have a force of their own. That would not be in the nature of the traditional English approach to legislation, which avoids purposive interpretation of this sort—see Volume 1, section 1.3.3. The list might be no more than a summary of concerns of the legislator without further relevance for the application of the statute. According to its title, the Act also covers markets (section 3(2)(a)), not in the sense of regulating them but rather to promote confidence in them. They may apply for recognition (section 286), which makes them more official and exempts them from the general prohibition to engage in any regulated activity. This activity is defined in section 22 and schedule 2 mainly as dealing in investments, managing investments and giving investment advice. Making or organising markets itself is not a regulated activity per se and does not therefore need to be authorised in the UK. As for these markets, in the UK the supervisory interest is primarily on the distribution of price information, transparency of corporate information, and proper settlement.

77 Even without a statutory change, the refocusing of the banking supervision objectives in this direction became clear from the annual reports of the Bank of England on banking supervision before this activity was handed over to the FSA as from 1997. If managing systemic risk becomes a valid regulatory objective, it may easily be at the expense of depositors’ protection as we have seen in BCCI. It is in any event clear that this protection objective is less overriding than it once was. It seems that in a modern banking regulatory system, they are primarily left to whatever protection depositor guarantee schemes may give them and whatever protection capital adequacy requirements may yield them in a macro sense. See for the concept of systemic risk n 6 above.

46 Volume 6: Financial Services, Financial Risk, and Financial Regulation In the meantime, the International Organization of Securities Commissions (IOSCO, see section 2.5.1 below), in its 1998 Principles and Objectives of Securities Regulation states as principal objectives: (a) the protection of investors; (b) ensuring that markets are fair and transparent; and (c) the reduction of systemic risk. As already noted above, this last objective would be a less obvious regulatory objective in the securities intermediaries’ business, which is the proper concern of IOSCO. It became an issue only after the Lehman crisis in 2008.

1.1.12. Financial Regulation and the Issue of Moral Hazard. The Operation and Effects of Deposit and Investor Guarantee Schemes. The Issue of Regulatory Capture As we have seen, in commercial banking, regulation became universal early, but the true objectives were never fully clear and shifted over time. It has been mentioned before that first there was the concern with depositors, although it became clear that in practice banking survival could not be achieved by merely requiring authorisation and the supervision of a minimum capital under an established regulatory framework. In times of crises, ad hoc interventions could often not be avoided and there was little proof that modern financial regulation led to fewer such emergencies. The fear of insolvency was more likely to provide banks with extra liquidity through central banks operating as banks of last resort in the hope that the relevant financial institutions would ride out the storm in this manner. If they themselves were banking regulators, it could even be a way for them to avoid admitting past regulatory shortcomings or failures. Indeed, the existence of this type of informal safety net for banks or even the mere existence of depositor guarantee schemes could lead to adverse effects in terms of the behaviour of bank management.78 It could make it less responsible as it comes to rely on public bail-outs of the bank or at least of its depositors, either through deposit guarantee schemes or otherwise. This is the issue of moral hazard, much highlighted by the Chicago school of economics.79 It indicates

78 J Friedman and W Kraus, Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation (Philadelphia, 2011) question whether this is a conscious process in bank management. It may easily be fired, so it cannot be sure to benefit. 79 See for example K Dowd, ‘Moral Hazard and the Financial Crisis’ (2009) Cato Journal 142, 160. The term derives from the insurance industry where insurance, eg of one’s house against fire, was thought to increase the fire risk. People become less careful. It truly means that benefits are privatised and risks are socialised, see also A Buckley, Financial Crisis, Causes, Context and Consequences (Hoboken, 2011) and R Meyerson, ‘A Model of Moral Hazard Credit Cycles’, U Chicago Working Paper, 25 (2010). It separates control from risk, which is laid somewhere else and in particular assumes for banks that insolvency will be prevented by outside action or is irrelevant because of some future discharge from debt. It is one idea behind the need for capital adequacy but there is still the danger of these requirements becoming nominal under pressure of the banking lobby. It is also said that moral hazard may arise from asymmetric information: issuers have it and investors not, so they are likely to be abused. Deposit guarantee and bailout schemes may have a similar effect. Securitisation also showed moral hazard aspects where originators were not required to retain some skin in the game, see n 24 above. Remuneration schemes can be similar: bonuses are collected up front, regardless of future risks in the transactions. The same applies in investment management, where up-front gains may be generated to increase fee income leaving a long risk tail, which may well lead to insolvency of the scheme at the end.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 47 a situation in which the rescuer or even the fact of its existence itself creates the need for rescues because it promotes carelessness in management. Regulators are aware of this and like to keep the banks guessing and even let them go under. A last stand in this regard was not saving Lehman Brothers (considered only an investment bank, therefore less connected) in 2008, which backfired badly, although it can be maintained that the deleveraging through market forces that had already been in motion and much accelerated as a consequence would have taken place anyway, but probably not to the same extent so soon. AIG was nationalised on the rebound. Indeed, in future crises, insurance firms and even hedge funds may well have to be offered similar support, again for stability reasons. The unavoidable result is more moral hazard in good times and therefore greater instability in bad. The continuing need for liquidity in the system may itself add to this moral hazard. But even the existence of regulation may create it: all that is still allowed can then be exploited to the full. Excess becomes the regulators’ fault! More modern thinking is indeed conscious of the fact that regulators and supervisors may be captured by the market in these situations, which may force their hands in terms of rescue, making the industry itself less careful. Regulation may thus suggest an implied guarantee to depositors or investors in a regulatory environment in which the notion of caveat emptor is superseded or suspended—see for the role of bank regulators as lenders of last resort in this connection also section 1.1.6 above. At the operational level the lack of care on the part of bankers may manifest itself in more risk taking, supported by the innate profitability of banking business, which easily leads to assuming all kinds of additional exposure for more instant profits, especially in good times when banking is very profitable and there seems no direct need for restraint. Again, it is the pro-cyclical nature of all banking, see further the discussion in section 1.1.13 below. To counter moral hazard, lesser or at least better focussed regulation could be suggested, including a limitation of pay-outs by deposit guarantee schemes. In modern resolution regimes for banks, the emphasis is on depositors and lenders to take a cut before regulators or governments can give financial aid, see section 4.1 below, which may make bankers mildly more prudent. In practice, the regulatory regime and therefore the regulatory protection ethos (and responsibility) has mostly been strengthened over time, not only in respect of commercial banks. We see it in ever larger rule books even if its effectiveness may not have been enhanced. But there were also lapses. Note the traditional regulatory lack of interest in liquidity management, in Europe also in leverage ratios. The lack of enforcement of regulation in good times has also already been mentioned. It does not diminish the need for, and in fact justifies the support of governments and their regulators at least to guarantee deposits in bad times and it may be asked whether modern resolution regimes for banks will change this. One way to protect depositors is to split a bank in trouble in a good and bad bank and transfer all ordinary deposits to the former. It means that only a selected class of depositors suffers, so far often with little due process in the selection process, however, see also section 4.1.5 below. Even bond holders may be saved in this manner in order to avoid universal panic. Both in the US and EU, as we shall see, much regulatory attention became focused on this resolution regime for banks, including the creation of some common safety net, which assumes a measure of mutualisation of their obligations (up to the value of the fund so created)—see also sections 1.3.8, 3.7.16 and 4.1.3 below. However, it remains to be seen whether it will make an appreciable difference in future financial crises. It will be shown later that this system may be very arbitrary and the separation of banks from government a pipedream, especially because banking activity is very much a part of government policy and much used by it to activate the economy. Hence also the virtual elimination of the capital requirement in Basel I and II and the absence of liquidity requirements.

48 Volume 6: Financial Services, Financial Risk, and Financial Regulation Even a leverage ratio was rejected by the EU at the time. That is policy, no matter how easy it is to blame banks afterwards for the consequences.

1.1.13. The Pro-cyclical Nature of Banking and Micro-Prudential Banking Regulation It has long been acknowledged that banking is highly pro-cyclical. It means that in a situation in which the whole banking industry suffers, it becomes restrained in its appetite and ability to continue its money recycling or liquidity-providing function, and this may last for years. Loans may thus be hard to come by at the moment they are most needed. It potentially makes the crisis worse. Regulatory sentiment may at the same time start supporting this sentiment and shift to financial stability, reinforcing the regulators’ powers, but the need for liquidity is then likely to become an opposing force. This became clearer in the EU after 2010 when a strong regulation drive ended in banks increasingly providing insufficient liquidity to the public, thus undermining the growth prospects which were needed and desired but failing, forcing central banks to inject liquidity more directly. The regulatory idea apparently was that growth can be had without risk, or that somehow the banking system can be exempted and be made ‘safe’ without consequences. It was already noted that it raises other issues, notably whether a special bankruptcy or resolution regime must be devised for such situations and could be effective in making banking activity better survive when major insolvencies loom.80 Again, the prime issue in such situations should be the continuing facility of banks to recycle money; nobody is interested in lame banks. This may even require the abandonment of considerations of stability and of capital, liquidity requirements, and leverage ratios for the time being, which is what is perceived in this book as the essence of macro-prudential supervision, see the next section. It is less odd where governments have already been forced to guarantee all bank deposits anyway. At the other end of the spectrum, banks may suffer from extreme hubris in good times when everyone thinks the sky is the limit and loans are extended freely; there is no restraint. This is the other side of pro-cyclicity. It is also common in banks and results in excessive leverage and aggravates the situation, likely to result in monetary booms and asset bubbles which invariably turn into bust, thus endangering the banks when these loans cannot be repaid. It means that banks should be submitted to higher capital requirements in good times to avoid irresponsible

80 As already mentioned in the previous section, a related feature is that the traditional and very necessary governmental support for banks in crisis is becoming problematic for modern states, which are now also largely bankrupt. The 2008 banking crisis thus soon became a government debt crisis. In this atmosphere, decoupling banks from government in times of financial stress became a political priority, much promoted by G-20, but it may be asked how realistic this truly is. Banks are becoming ever more government tools, encouraged (if not forced) to provide the financial support to the public at large that governments are unable to give, not least to consumers. It was very much behind the extreme reductions in capital requirements under Basel I and II, which exacerbated the pro-cyclical nature of banking. This was thought to promote growth but it was always questionable whether this money-driven type of growth could ever be more than a temporary fix, mere monetary fluff, see also s 1.3.8 below. With higher capital adequacy and liquidity requirements for banks, plus the introduction of leverage ratios, and a desire for smaller banking after 2010, governments may have to find other ways to make our type of society work beyond suggesting that central banks keep the liquidity tap open. To find that alternative may not be easy. Promoting access for everyone to the capital markets is a fancy idea but not realistic for smaller borrowers, see also s 3.7.15 below for the EU Common Market Union. It is too costly and would probably also mean a substantial dilution of the prospectus requirements. More likely is that, as in countries like China, the shadow banking system is seriously activated.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 49 behaviour. The same counter-cyclical attitude might then prevail in the area of liquidity supervision. Leverage ratios should be increased, which could be done differently per activity or asset class. Again, it is the view of this book that except for matters of conduct of business and market abuse, we should consider to deregulate in bad times and to re-regulate in good times, see further the next sections. The true risk of banks appears in good times, at the top of the cycle. They should be severely restrained in their moments of hubris and be required to build up their capital, watch liquidity, and limit dividends and bonuses, whilst the largest must create an international safety net. In bad times, on the other hand, banks should be encouraged in their liquidity-providing function and that may mean reducing capital for new business to zero and remove liquidity requirements and also leverage ratios. Thus, where the liquidity-providing function must be a major concern in bad times, the stability of the system should be the main consideration in good times. In fact, whatever lip service is paid to the idea of stability, it was already said that we may not truly want it,81 especially not in good times when there appears to be no problem. Even governments may join the spending spree: see the discussion in section 1.3.6 below. However that may be, financial stability cannot be the main consideration in bad times, nor indeed the rebuilding of capital at the worst moment. In any event, and never mind the existence of some bank resolution regime (see Title II Dodd-Frank Wall Street Reform Act 2010 and for the eurozone sections 3.7.16 and 4.1.3 below) or government help/taxpayers support, all else will prove counter-productive in such periods and further regulation or more capital will only add to financial stress. The true problem, it is submitted, is that our society in order to progress must take considerable and probably ever-increasing risks, also in finance.82 We can manage it to some extent and may be able better to avoid excess both in bad and good times, in bad times indeed through forceful deregulation especially of the capital adequacy and liquidity requirements and leverage ratios and in good times through forceful re-regulation and enforcement in these areas. In fact, there may be no advance without it and no growth either, especially now that populations are becoming smaller and older in many parts of the developed world and the needs much larger in others. Banks are in the forefront of these developments and finance was substantially recast in the 1980s to deal with providing the attendant liquidity to government, business, and consumers alike, on a scale never seen before, whilst operating increasingly at the transnational level. It is this liquidity-providing function83 which is the oil in the machine of the entire modern society but it requires risk management on a similarly increased scale. It may have been thought that we had the means and Basel I and especially Basel II reflected greater sophistication, see section 2.5.10 below, but the latter flopped immediately, and the financial crisis after 2008 made clear that our means properly to manage financial risk on this scale are limited. It remains to be seen whether Basel III will fare much better; it basically increased the capital requirements somewhat, introduced a leverage ratio and, on an experimental basis, liquidity requirements. Although substantially reinforced after 2008, it must be asked whether this model can ever save banks or

81 It may indeed be questioned whether we want stability at all if it means no more consumer and student loans, see also the discussion in s 1.1.2 above and s 1.3.5 below. 82 It will be submitted throughout that stability may be more difficult to achieve in an over-leveraged society which is naturally more sensitive to shocks, notably the sudden drying up of liquidity. In modern times, this may be the truer cause of financial instability or at least greatly contributes to it, see further the discussion in ss 1.1.2 above and 1.3.1ff below. 83 Cf also the discussion on liquidity in s 1.1.3 above.

50 Volume 6: Financial Services, Financial Risk, and Financial Regulation hold out the prospect of doing so, see also the next section.84 The real question is whether the traditional micro-prudential supervision and its models are sufficient.85 So far, it would appear, science has proved to be unable to provide better risk management models or better ways to spot financial shocks and similar upheavals in good times. Moreover, the quality of financial data is often weak and the data themselves incomplete, so the financial landscape is often poorly mapped out or understood (except with the benefit of hindsight). In practice, the answer has not been more sophistication, which is very much needed, but limiting financial activity altogether, indeed in many countries by making banks smaller or limiting their activities through more stringent capital and liquidity requirements at the bottom of the economic cycle. As liquidity or the lack thereof is the true killer of banks (see section 1.1.3 above), not therefore its balance sheet, the emphasis on capital was probably always misguided. Adequacy of this nature in any event depends much on valuations and a lot of it is opinion. It was already said that at the beginning of 2008, many banks had more capital than was required and still proved unsafe. Later on, it appeared that stress tests meant very little because of similar valuation issues. In a crisis, the simplest answer remains for authorities simply to open the liquidity tap, which is what normally happens, and not to require banks to re-build capital nor to want smaller banks as a result. Again, that is conceivably the worst of all worlds in those circumstances and resolves nothing. First, smaller banks increase banking instability as they can diversify less. They are riskier—stress tests show this all the time86—even if, of course, a bigger bank in trouble creates bigger problems. Second, the idea that smaller banks can provide the liquidity for big business on the scale now necessary in the international flows is a fallacy. Virtually all larger borrowing would have to be syndicated, which is more costly and time consuming. There is also an adverse effect of smaller banking on profitability, therefore on the ability for banks promptly to recover. Heavy regulation and supervision have a similarly negative effect and prevent banks to grow out of their problems, assuming there is capable management. Especially in Europe, banks have had considerable difficulty to recover and resume their function after 2010. This contributes to a structurally low growth rate, which is in turn creating ever greater problems in financing the social welfare state (and its governments). It is submitted that banking is a highly dangerous activity, especially at the top of the economic cycle. In good times, there is no end to the euphoria and the public attitude and government indulgence may make things a great deal worse.87 Banking activity needs to be heavily supervised in such situations; perhaps capital adequacy then needs to be put at 30 per cent for new business while profits should be retained, bonuses capped, and financial buffers (and resolution funds) built for the bad times which invariably follow. From a liquidity management point of

84 See also N Sarin and LH Summers, ‘Have Big Banks Gotten Safer’, Brookings Papers (Sept 2016), who warn against complacency; and Martin Wolf, ‘Basel III: The Mouse that Did Not Roar’, The Financial Times, September 14 2010 at . 85 Ed Scott, Capital Adequacy Beyond Basel (Oxford, 2005) and Daniel Tarullo, Banking on Basel (Patersen Institute, 2008) questioning whether the capital adequacy approach is fundamentally misguided. 86 It is well known that the multitude of smaller banks were the major problem in the US during the 1930s financial crisis. 87 There is strong empirical evidence supporting this. N Kiyotali and J Moore, ‘Credit Cycles’ (1997) 105 Journal of Political Economy 211 demonstrate this in the housing markets when in good times collateral values increase supporting further borrowing while in bad times decreases leading to crises. K Brunnermeier and Y Sannikov, ‘A Macro-economic Model with a Financial Sector’ (2014) 104 American Economic Review 379 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.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 51 view, funding should match new lending in terms of maturity. Financial buffers should be built in this manner in good times, not in bad. That is what macro-prudential supervision should be all about. It determines in fact the size of banking in each phase of the economic cycle. The introduction of yet another committee in this connection, as has now happened in many countries in terms of stability boards (see the next section) does not by itself clarify anything and there is considerable confusion about their tasks as we shall see. The failure of the earlier Financial Stability Forum at G-7 level was a case in point—see section 1.2.5 below. At best, the introduction of macroprudential supervision committees creates the impression that something is done but without a clearer view of what is needed and a redistribution of the competencies, it still leaves society exposed to the same, very considerable risks. It should be more than just an adjunct to monetary policy and micro prudential regulation, see further section 1.1.15 below. It was already said at the end of section 1.1.9 above, that macroprudential supervision must operate besides monetary and fiscal policy as a separate and preferably independent function in the management of the economy. Notably, macro-prudential supervision should be able to suspend the capital, leverage ratio and liquidity requirements in times of crisis when it would also be normal for banks to be nationalised and the liquidity tap to be opened widely. A resolution regime asking bond holders and depositors to contribute in such times, now often believed also to be part of the answer (and part of macro-prudential supervision), would only hasten bank runs and undermine stability further. Rather, a substantial safety net should have been built in the good times as a buffer and then be activated and the macro prudential regulator should insist on it. An important key is probably also that the regulatory aim of financial stability is meaningless as long as it is not clear at what level of activity this is going to be reached. It was already argued in section 1.1.2 above that we may not truly want it because it may come at too low a level economic activity. Financial stability is not an objective criterion or an aim that can be objectively achieved or a result which automatically derives from a given micro-prudential approach. It was shown that such a rule-based system is itself likely to be pro-cyclical and may promote instability. Other contributing factors were pointed out also, largely external, notably financial innovation and even prolonged financial stability itself, especially noted by Minsky,88 which may suggest less risk than there is, or when extrapolation is used, like in value at risk (VaR) approaches, an ever smaller market risk in good times when the period from which the experience is taken is (too) short. To repeat, in the society we have and have chosen to live in, a substantial amount of risk must be taken to progress, not least in finance. There is a downside but it should not be exaggerated. The 2008 financial crisis was a sign of a bigger economic crisis which all the same did not go beyond a normal cyclical event in its size and impact. It was nothing compared to what happened in the 1930s when GDP shrank by 25 per cent in many countries and became persistent. Unemployment did not go beyond what had been seen in the early 1980s after the two oil shocks, even if there were higher pockets and youth unemployment became a problem more generally, a product of a lack of structural reform in labour markets. Unpleasant as it was and still may be, a crisis of this nature can be overcome and was in the US sooner than in Europe, probably because of a better understanding of the situation and a less defensive and more imaginative approach to banking and its supervision after the initial Dodd-Frank regulation fervour when dividends and bonuses were also more rigorously curtailed. Banks must be given room to get themselves back on track and no amount of regulation can substitute. What macro-supervision can and must do is to call the moment when the screws must

88 See

nn 6, 8 and 13 above.

52 Volume 6: Financial Services, Financial Risk, and Financial Regulation be tightened, capital buffers built, leverage ratios increased, and liquidity ratios strengthened to activate counter-cyclical forces and create capital, of which Basel III now also speaks but it leaves it at the margin; rather it should be put at the centre, at least of macro prudential supervision. Resolution funds should also be strengthened in these situations. To call that moment is an issue of policy not regulation.89 The various stability committees (rather than central banks) could be put in charge, assuming they can acquire the expertise.90 In times of crisis or distress, they should be able to instruct the micro prudential regulators and set the standards, thus be able to reduce the capital requirements and leverage ratios to zero and also decide on opening the liquidity tap, on resolution including nationalisation, and manage this involvement and unwind it as soon as possible. In the longer term, they might even redirect micro-prudential policies if indeed they can show better risk management tools, but these are different functions. Micro-prudential supervision rather depends on a legal framework or rule-based system, which may vary for the different types of involvement or functions but in essence means the same jacket for all. That is the level playing field; it is not wrong but as we have seen it is directed to the strengthening of all banks in the system by improving the management of internal risks even if this does not demonstrably save them. Again, the issue of calling for counter-cyclical measures is one of pure policy, determined also by external factors, and is concerned with the jurisdiction issue (who can call and when). So is the liquidity providing function. Resolution on the other hand, also more properly the preserve of macro prudential authority, still needs a legal form—a liquidation or reorganisation regime without rules is a bad idea.

1.1.14. Principle-based Regulation and Judgment-based Supervision in the UK. Micro- and Macro-prudential Supervision Unease with the existing micro-supervisory regulatory models is not new. In 2005, emphasis emerged, especially in the UK, on principle-based rather than rule-based regulation with full implementation foreseen by 2010. The first question was to what extent the Financial Services and Markets Act (FSMA 2000) allowed for this new approach. As it left much to the FSA, the UK regulator of those days, and its rule-making authority through its rule books, especially in retail protection and in financial crime and prudential supervision, this was not considered a substantial formal hindrance. It is a natural response to the impossibility of regulators to adapt to new protection needs in a pre-ordained legal framework and an acceptance of a more dynamic market-driven approach where rules should not be a bar to legitimate innovation nor to new protections. It is an admission

89 Policy makers define the fundamentals, parameters and direction of financial stability, this is what distinguishes them from regulators, see Ashley C Brown, ‘Regulators, Policy Makers, and the Making of Policy: Who Does What and When Do They Do It?’ (2003) 3(1) International Journal of Regulation and Governance 1. A policy driven approach moves supervisors from micro-managing banks and trying to prevent past events from recurring, to focusing on ‘big picture’ issues. The idea is tat they become more forward looking and react to issues as they arise. 90 The IMF found mixed results in the use of macro-prudential tools in reducing systemic risk in 49 countries, see C Lim, F Columba et al, ‘Macro-prudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences’, IMF Working Paper WP/11/238 (October 2011), but these measures where incidental and did not amount to a more strategic counter-cyclical policy here advocated. The various stability committees may lack diversity in their membership and risk to be central bank clones, see W Buiter, ‘The Proposed European Systemic Risk Board is Overweight with Central Bankers’ Willem Buiter’s Maverecon (28 October 2009).

Volume 6: Financial Services, Financial Risk, and Financial Regulation 53 that rule-based regulation of this nature cannot fully be conceived ex ante but needs regular and speedy adjustments ex post.91 Still there is a need for a legal framework if there is to be a level playing field and regulatory issues are meant to be justiciable. A similar more principle-driven attitude could subsequently also be detected in the EU: see section 3.4 below. Hence a reduced emphasis on prescriptive rules and the rejection of a regulatory mentality of box ticking. Lesser concern results here with an abstract notion of certainty than with guidance and the search is on for an interpretive community among regulators, industry associations, and especially retail. In the UK, much earlier a predecessor of the FSA (the Securities and Investments Board or SIB) had initiated a similar approach but it was soon forgotten. It is important in this connection to understand that this concern at first turned out primarily to affect the protection of investors and depositors, perhaps also borrowers of banks, therefore substantially dealt with conduct of business and products issues, not with the issue of financial stability, and therefore foremost with private law protection against intermediaries, not even their insolvency as depositors; depositors and investors were largely considered to be sufficiently protected in this regard through depositors’ and investors’ compensation schemes. Contrary to what was meant, it remained true, however, that the move to principle in this manner could inhibit rather than favour private law sanctions in courts of law for lack of clarity as there might not be a sufficiently precise cause of action, especially an issue in common law countries, although much less so in ombudsman schemes.92 On the other hand, a principle-based approach of this nature could be used against intermediaries in enforcement actions before regulatory tribunals and affect their licence and its conditions if clients had allegedly been mistreated from a conduct of business perspective. The result could be that regulators in their eagerness more readily found some breach of principle. It followed that there still had to be some reasonableness test and some reliance on reasonable predictability in outcome. In any event, in the UK, the FSA (and now its successor, the FCA) was to have the burden of proof of any wrongdoing under these principles if they were used by the regulator against intermediaries rather than in private actions by investors or depositors, but even for the latter there was a need for some precision. 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 (segregation) of client assets, and active interacting with regulators. In several succeeding FSA reports, the notion of TCF became the central theme while the whole concept of conduct of business was in the process of being recast. Note that the focus was here on all intermediaries, commercial as well as investment banks. Again, it is clear that financial stability was not the main concern here, important as it remains in other contexts, and this regardless of the reference to adequate financial resources in banks. The emphasis thus shifts in terms of principle more in particular to the protection of depositors, investors and ultimately perhaps also borrowers from commercial banks. The idea is that consumers must be comfortable with the culture of their financial intermediaries, that the products and services on offer are designed to meet their requirements, that advice is suitable, that they get what they have been led to expect, are kept properly informed before, during 91 Cass R Sunstein, ‘Problems with Rules’ (1995) 83 California Law Review 953. 92 Indeed, the principle-based approach had been criticised for lacking certainty, promoting arbitrary regulation, overreaching, and retrospective interpretation of norms, see SL Schwarcz, ‘The “Principles” Paradox’ (2009) 10 European Business Organization Law Review 175.

54 Volume 6: Financial Services, Financial Risk, and Financial Regulation and after a sale or purchase, and do not face unreasonable post-transaction barriers and costs. Intermediaries should continually reconsider their procedures and practices in the light of these issues. Regulators should reflect them in their rule books concerning client protections. There is also the idea that they 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. In this approach, wholesale is basically left to its own devices. At least in the UK, this newer policy, especially relevant for smaller investors, seemed undisturbed by the crisis of 2008 and may particularly be used to challenge intermediaries more intensely on the decisions they are making in respect of their clients, how they ensure continuing compliance with the principles, whether they regularly review the consequences of their decisions, and whether they adequately consider the potential for risk crystallisation and new risks when moving their business forward. This may go beyond the mere protection of depositors and investors and principle-based regulation may then even enter the world of financial stability.93 If it is true that conduct of business concerns suffered from excessive regulatory attention for stability, this principle-based approach was at least one way to redress some of the balance. After the financial crisis, another idea took hold in the UK when banking supervision was re-transferred to the Bank of England (in a separate subsidiary: the PRA to be distinguished from the FCA, which became the successor to the FSA and concerns itself with conduct of business in particular as already mentioned). The idea of judgment-based supervision was then presented as a key new feature,94 although it was never made fully clear what it was. Again, it is a micro supervision issue, at first introduced to counter further a box-ticking mentality in the regulator. It then appeared to stand for a degree of regulatory discretion that focuses on the activities of the micro prudential supervisor in terms of a challenge to business models, risk identification, and proper action to be taken by banks, now more in particular to promote financial stability. It appeared to denote an intensifying preoccupation with financial stability as the main regulatory objective and concern. As just mentioned, it was, however, still considered micro-prudential supervision, therefore directed to individual financial institutions within a common legal framework for all and remained basically concerned with the causes of instability in terms of the internal banking operations and risks. It thus concerned itself mainly with the fit and proper nature of management and its systems as part of enforcing the licence conditions, mostly an operational risk issue, and continued to assume that supervision of individual banks within these ground rules would ensure the stability of the whole, even though the assumption that maintaining stable individual firms would lead to a stable financial system had already turned out to be a fallacy.95 93 Cristie Ford, ‘Principles-Based Securities Regulation in Wake of the Global Financial Crisis’ (2010) 55(2) McGill L.aw Journal 257. 94 It is one of the innovations brought about by the Financial Services Act 2012, which introduced a new supervisory structure in the UK, operative as of 1 April 2013. Promoting confidence and transparency in financial services was a main aim. The new structure is also given a strong mandate in promoting competition. This is all very laudable, but it may be politics devoid of a compass, see also RM Lastra, ‘Defining Forward Looking, Judgement-based Supervision’ (2013) 14 Journal of Banking Regulation 221 and JH Dalhuisen, ‘The Management of Systemic Risk from a Legal Perspective’ in M Andenas and G Deipenbrock (eds), Regulating and Supervising European Financial Markets (Cham, 2016) 365, SSRN under Search Jan Dalhuisen. 95 To complete the picture, in the UK, there developed another innovation promoting the idea of a special Senior Management Regime (SMR) meant to promote greater discipline in senior managers who are now required to sign a statement about their tasks and duties and how they intend to fulfil them giving rise in appropriate cases to personal liability. It is another new idea that has not acquired much following so far but is another important English innovation.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 55 Again, it must as such be clearly distinguished from macro-prudential supervision in terms of instability and systemic risk96 which is then concerned with broader policy and links with the larger economy, especially external threats to the financial system.97 The more common definition is now ‘the use of primarily prudential tools to limit system-wide financial risk, and so prevent the disruption to key financial services and the economy’.98 As already repeatedly noted, it leaves, however, the methods and tools to be decided99 and the greater concern for the moment seems to be with the institutional framework rather than with its operation and coverage.100 In this connection, political independence is normally emphasised, but raises important issues of accountability and transparency.101 Commingling with the other functions of central banks is mostly still condoned or even promoted but would seem to be undesirable.102 To repeat, micro-prudential supervision may mainly be seen as a rule based tool to maximise economic efficiency in the banking industry and promote better risk management in order to prevent failures, which may ultimately trigger systemic risk. It is only in that sense concerned with financial stability. It operates at the level of individual institutions and is focussed on their internal management within a given structure. Newer regulatory proposals and objectives discussed in section 1.3.8 below remain also largely in this mould. Again, the emphasis is on credit and market risk, operational risk, although increasingly also on liquidity risk (since Basel III). Newer micro-prudential concerns may thus be summarised as foremost concentrating on systems and information failure in this context, including the models used to monitor and manage these risks, therefore more in particular operational risk issues, although they might also cover principal– agent failure, earnings retention, share buy-backs, and bonus problems. Yet, since these tools and models used are unlikely to be comprehensive and up to date, and may be much affected by outside risk factors, there continue to be serious problems with

96 It is sometimes believed that macro-prudential supervision, which deals primarily with financial stability and systemic risk, is there not only to guard against banking failure but rather to protect the system as ‘system’, see S Schwarcz, ‘Systemic Risk and The Financial Crisis: Protecting the Financial System as a “System”’ (2014) 97 Georgetown LJ 193. It thus suggests that it must also concern itself with instability issues that do not derive from banking activity, see in this connection also A Crocket, ‘International Standard Setting in Financial Supervision’, Lecture General Manager BIS (Cass Business School London, 5 February 2003) mentioning as reasons for increased vulnerability the increased liquidity resulting from liberalisation and innovation and the tightening of financial linkages across institutions, markets and countries. 97 FSB-IMF-BIS, ‘Macroprudential Policy Tools and Frameworks: Progress Report to G20’ (27 October 2011) at accessed 4 December 2019. 98 J Caruana (General Manager BIS 2009–17), Monetary Policy in a World with Macroprudential Policy (Kerala 2011). 99 The true mandate and tools remain a major issue, see also Joanna Gray, ‘Lawyers and Systemic Risk in Finance: Could (and Should) the Legal Profession Contribute to Macroprudential Regulation’ (2016) 19(1) Legal Ethics 122. 100 See Tracy Maguze, The Power and the Glory: An Evaluation of the Legitimacy of Independent Macroprudential Authorities PhD dissertation, Universidade Catolica Portuguesa, 2021. 101 See EW Nier, ‘Financial Stability Frameworks and the Role of Central Banks: Lessons from the Crisis’, IMF Working Paper 09/70 (2009); D Lombardia and M Moschella, ‘The Symbolic Politics of Delegation: Macroprudential Policy and Independent Regulatory Authority’ (2017) 22(1) New Political Economy 92; P Tucker, Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State (Princeton, 2018); D Archer, ‘A Coming Crisis of Legitimacy’ (2016) 3 Sveriges Riksbank Economic Review 86; A Baker, ‘The Bankers’ Paradox: The Political Economy of Macroprudential Regulation’, SRC Discussion Paper No 37 (April 2015). 102 See for the (undesirable) commingling of these functions at the level of the ECB in the eurozone and the dangers for regulation as a predictable legal framework, n 30 above, n 114 below, and s 4.1.5 below. Three models have emerged: a central bank mandate, a mandate for a committee within it, or for an interagency body, see R Edge and N Liang, ‘New Financial Stability Governance Structures and Central Banks’, Hutchins Central Working Paper no 32 (10 August 2017). A separate body is preferred in this book to avoid conflicts and favours a facility separate from monetary policy and micro-prudential banking oversight.

56 Volume 6: Financial Services, Financial Risk, and Financial Regulation micro-prudential regulation and its legal framework. Even with a judgment approach, it is unlikely to eliminate internal risk, especially market risk and could even promote it, misjudge system failure, and thus create more systemic risk at the same time. There may be other unresolved issues: unreliability of (ever more) information may promote bank runs. Mark to market may defeat rationality in depressed markets. They may themselves be subjected to worn models that make things worse.103 In the previous section it was already shown that macro-prudential supervision is different.104 It may have mainly three prongs: (a) in appropriate situations to put safeguards in place and manage them like leverage ratios, capital adequacy and liquidity requirements, request ringfencing regimes, or require CoCo bonds, and establish stabilisation funds,105 (b) when necessary to guide and instruct micro-prudential supervision accordingly, and finally (c) to try to stabilise the system when micro-prudential supervision has failed once more, macro-prudential supervision has not helped either and a crisis is started.106 This can be done by providing liquidity (indiscriminately), nationalising affected banks, and/or starting resolution, calling in CoCo bonds, or any stabilisation fund assuming its investments can be quickly liquidated.107 It will be argued that the three functions are quite different. The first is the true core and pure policy: see also the discussion in the previous section and, it was submitted, should have a strong anticyclical bias. This book is sceptical of all micro-management through financial regulation beyond the area of conduct of business, product supervision, and market integrity. It may be agreed that it cannot be based on discretion leading to a direct involvement of the regulators in the running of financial institutions. Regulators are not equipped for it and, except perhaps in emergencies, regulators of this nature should not do so: it is not their task. They are not bankers; it would lead to a financial system being operated by complete amateurs. It is therefore a bad idea and may well be the worst of all worlds. Ideas of legality, proportionality108 and non-discrimination would also alter in such an environment, especially tricky if there is subsequently also a macro-prudential overlay that is legally more indeterminate. Hobbyism and vindictive attitudes in regulators, desires to impose large fines and create an income of this nature may get space. As far as these regulators are concerned, as a minimum they and their organisations should be held accountable for the consequences of such interference in terms of civil liability. 103 See also B Eichengreen, ‘Euro Area Risk (Mis)management’ in E Balleisen et al (eds), Recalibrating Risk: Crises, Perceptions and Regulatory Change (2014). 104 The concept is not new, see P Clement, ‘The Term “Macro-prudential”: Origin and Evolution’ (BIS Quarterly Review 2010). In origin it was much connected with the rapid rise of lending to developing countries, the impact of innovation on the capital markets, and unconventional lending techniques in non-traditional markets. 105 See JN Gordon and C Muller, ‘Confronting Financial Crisis: Dodd-Frank’s Dangers and the Case for a Systemic Emergency Insurance Fund’ (2011) 28 Yale Journal on Regulation 151, 156. See further Lim Cheng Hoon et al, ‘Macroprudential Policy: What Instruments and How to Use them? Lessons from Country Experiences’ IMF Working Paper No 11/238 (2011). Here the emphasis is on countercyclical capital and reserve requirements, caps on lending, sectoral loan limitation, and generally on the asset side of bank balance sheets, its composition and market risks. Others are more directly concerned with the boom and bust cycle in the financial system, see O Jorda, M Schularick and AM Taylor, ‘Macrofinancial History and the New Business Cycle Facts’ (2016) 31 NBER Macroeconomics Annual. 106 Goodhart and Perotti argue, however, that ex post crisis interventions fail to address the root causes of the systemic crisis and can even exacerbate risk-taking and moral hazard, which lead to financial crisis. See Charles A.E. Goodhart and Enrico Perotti, ‘Preventive Macroprudential Policy’ (2013) 1(1) Journal of Financial Management, Markets and Institutions 115. 107 See also Bezhad Gohari and Karen E Woody, ‘The New Global Financial Legal Order: Can Macroprudential Regulation Prevent Another Global Financial Disaster?’ (2014–15) 40 J Corp L 403. 108 See for the notion of proportionality further the discussion in s 4.1.6 below.

Volume 6: Financial Services, Financial Risk, and Financial Regulation 57 Macro-prudential supervision will not directly get involved in bank management either. It is policy oriented and does not depend on and may lack a clear legal framework, especially when it concerns itself with counter-cyclical capital adequacy and liquidity requirements or leverage ratios, and is in this book seen as an essential policy tool, outside the regulatory framework proper—much as monetary and fiscal policies also are,109 as already mentioned and distinguished at the end of section 1.1.9 above and in the previous section. Properly understood, it is primarily concerned with the size of banking and its activities in each phase of the economic cycle in view of all internal and especially external forces of instability it may identify from time to time. Currently, however, it appears to inhabit some world in between discretion and rules, between micro-prudential regulation and monetary policy. In practice, policy makers, whoever they may be, now often adopt an approach of ‘guided discretion’, which uses a combination of statutes, like the Bank of England Act 1998, Dodd-Frank, and CRR/CRD IV in the EU, and formal extra-statutory devices, such as memoranda of understanding, exchanges of letters, and general statements of policy, which may provide explicit guidance to policy makers on which tools they may use and the benchmark reference rates and principles. These policy makers may then exercise a substantial amount of discretion because this guidance may still not capture all the risks to the financial system that must be factored into policy calibration. Further guided discretion is likely to result from the novelty of macroprudential policy, but little is known so far about the long-term effects of a mixture of multiple policy tools being balanced against the need to maintain flexibility and some more forward-looking approach to financial stability. It may indeed make sense and even be necessary sharper to distinguish macro- and microfinancial prudential supervision—if only from the point of view of legal protection of and recourse to financial intermediaries. It may be noted that within the eurozone as part of its banking union (see section 4.1 below), the ECB according to Article 5 of the 2013 Regulation setting up the

109 The President of the ECB on 17 November 2014 made an Introductory Statement in a Hearing before the Committee on Economic and Monetary Affairs of the European Parliament, discussing also macro-prudential instruments. This was done with reference to Basel III as incorporated in the EU Capital Requirements Directive (CRD 4) and related Regulation (CRR), see s 3.7.4 below, not with reference to the SSM Regulation, see s 4.1.2 below. Reference was also made to a June 2014 ESRB recommendation that uses a credit-to-GDP ratio to signal increased lending activity while seeking a common framework for all Member States in which connection it spotted around 30 national macro-prudential measures. They were broken down into two, addressing either (a) excessive credit growth and leverage or (b) systemic risk arising from the operation of large and complex banking groups, usually considered too large to fail. The counter-cyclical capital buffers belong to the first category but could still be considered less suited or insufficient to address credit developments in specific sectors, such as real estate, where limits on loan-to-value, loan-to-income and debt service-to-income may be preferred either alone or in addition. The ‘too large to fail’ problem, on the other hand, was thought to be better addressed by imposing extra capital as a permanent requirement. At virtually the same time, the President of the Cleveland Fed, Loretta Mester, ‘The Nexus of Macroprudential Supervision, Monetary Policy, and Financial Stability’ (5 December 2014), www.clevelandfed.org, laid heavier emphasis on macro-prudential instruments and identified structural and cyclical macro-prudential tools. The former are meant to build the resilience of the financial system throughout the business cycle. They were believed to include Basel III capital and liquidity requirements, central clearing of derivatives, and living will resolution plans. The cyclical tools are meant to mitigate the systemic risk that could build up over the cycle. That concerns the imposition of counter-cyclical capital buffers and stress tests scenarios. This tool is sometimes thought to be directed to the prevention of or otherwise the cleaning up of bubbles but the better view is probably that it should affect the liquidity-providing function of banks more generally at the top of the economic cycle. This comes close to monetary policy, which should still be used as an additional instrument, but since it has only one tool—shortterm interest rates—it may be less effective and too broad. It would also not serve as a means to make banks stronger in the face of future crises.

58 Volume 6: Financial Services, Financial Risk, and Financial Regulation Single Supervisory Mechanism (SSM) (see section 4.1.2 below) exerts both functions and notably decides on when and how banks may be made subject to extra counter-cyclical capital buffers. Again, it is a different function, and should as such be clearly set apart as it may raise important issues of level playing field between banks, more properly the concern of micro-prudential supervision as we have seen, specifically relevant if these newer measures are addressed to specific activities or products. It does so also between countries if these buffers are still nationally set by the ECB as still seems to be the structure under the relevant Regulation. Under Article 5, the ECB may do much more in the name of financial stability (even if this remains in principle also the area of national competencies), and might then even incorporate it into its micro-prudential supervision role, when these policies are applied to individual firms. This is joined by further ECB powers under the Single Resolution Mechanism agreed in 2014, especially in terms of initiative—see section 4.1.3 below.110 Again, it may well be asked whether that accumulation makes sense and may leave the ECB heavily conflicted.111

110 As we have seen, it raises legal issues and questions of adequate protection for intermediaries in the case of principle- or judgment-based micro-supervision, but also in macro-financial supervision. As to recourse, Art 22 of the 2013 SSM Regulation requires due process, especially a hearing for aggrieved persons (Art 22) taking into account also the EU Charter of Fundamental Rights (Preamble 63) but not in the case of emergency or for macroprudential measures. The ECB’s acts more generally are subject to review by the ECJ but without prejudice to the ‘margin of discretion left to the ECB to decide on the opportunity to take these decisions’ (Recitals 60 and 64 of the Preamble). However, the ECB must make good any damage caused by it under ‘the general principles common to the laws of Member States’ (Preamble 62). Preamble 30 at the end further refers to the ‘principles of equality and non-discrimination’ (legality and proportionality are not mentioned) but it is preceded by a long policy declaration emphasising first the safety and soundness of credit institutions, the stability of the financial system, and the unity and integrity of the internal market. The protection of depositors comes later and there may be considerable conflicts of interest, see also the discussion in s 1.1.11 above. All in all, the legal framework and recourse possibilities for financial intermediaries appear weak. In the present anti-banking environment, they clearly had little priority. 111 The EU situation is not unique and the IMF has found that in a majority of countries the independent central bank has been granted the sole mandate for macroprudential policy, see International Monetary Fund, ‘Macroprudential Policy: An Organising Framework’ (March 2011) IMF Policy Papers