Economic review of the financial regulation agenda

The European Commission has today published a first comprehensive review of the financial regulation agenda as a whole. This economic review sets out how financial reform measures – most of which are now adopted – will deliver a safer and more responsible financial system by enhancing financial stability, deepening the single market for financial services and improving its efficiency whilst improving market integrity and confidence. Evidence suggests that the total expected benefits of the financial regulation agenda will outweigh the expected costs, both on a rule-by-rule basis and when considering the reforms as a whole. Many rules create considerable positive synergies, e.g. between the capital requirements package in banking and the reform of derivatives markets. The financial system is already changing and improving. This change will continue as the reforms take effect.

1. What is the EU financial regulation agenda?

The financial crisis showed that a fundamental overhaul of the regulatory and supervisory framework was necessary. Between 2008 and 2012, a total of €1.5 trillion of state aid (i.e. more than 12% of EU GDP) was used to prevent the collapse of the financial system. The crisis triggered a deep recession and led to large losses in output. The EU unemployment rate increased from a pre-crisis low of 7.2% in 2007 to 10.8% in 2013. Compared with the end of 2007, an additional 9.3 million people are now unemployed in the EU. Trust in the financial system has been seriously shaken and many EU households have experienced significant losses in income and wealth.

In response to the financial crisis, the EU pursued an ambitious regulatory reform agenda that has been coordinated with international partners in the G20. As the crisis evolved and specific risks emerged which threatened financial stability in the euro area and the EU as a whole, deeper integration to put the banking sector on a more solid footing and restore confidence in the euro was necessary. This led to the development of the Banking Union.

The aim of all financial legislation has been to restore financial stability on a global scale and build a financial system that serves the economy and can play its part in putting the EU back on a path of sustainable growth. To meet that overall objective, the Commission has tabled more than 40 proposals in under five years (most of which have been adopted, and many of which are already in force). The reform measures deliver on this overall objective by:

• enhancing financial stability and the resilience of the financial system to reduce the likelihood and impact of future financial crises in the EU
• restoring and deepening the EU single market in financial services
• securing market integrity and confidence in the EU financial system by protecting consumers and investors, countering market abuse and enhancing disclosure and transparency
• improving the efficiency of the EU financial system and ensuring that transaction costs are minimised and financial services are priced correctly to reflect underlying risks.

Chart: Overview of the reform objectives

2. What is the economic review of the financial regulation agenda?

The economic review study examines the overall coherence of the reform agenda and the expected or actual economic impact, including the interactions and synergies between different reforms.

Each Commission reform proposal, when it was adopted, was accompanied by a thorough impact assessment that evaluated in detail the associated costs and benefits. The economic review does not replace or supersede the individual impact assessments. Rather, the study builds on the existing assessments and reviews whether the different reform measures have delivered (or can be expected to deliver) their objectives and intended benefits. It also examines the potential costs and adverse unintended consequences of the rules, as well as the interactions and complementarity between the rules.

3. Why is the economic review published now?

As this Commission approaches the end of its mandate, it is appropriate to take stock and review the financial regulation agenda as a whole. Agreement has been reached on the majority of the Commission’s reform proposals, many of which have already entered into force (e.g. the CRD IV package, European Markets Infrastructure Regulation, Single Supervisory Mechanism, Short-selling Regulation). While it is too early to assess the overall final impact of the reform agenda, the economic review presents an important first step, of a mostly qualitative rather than quantitative nature, in a longer process of systematic review and evaluation of the reforms.

4. What are the main conclusions of the economic review?

The EU financial regulaton agenda effectively addresses the regulatory shortcomings and market failures that contributed to the crisis. The reforms will deliver greater stability and reduce the likelihood and negative impact of financial crises being repeated in the future. In addition to enhancing financial stability, the reform measures will help meet the other key public policy objectives of market integrity (including consumer protection), efficiency and financial integration.

The total benefits of the financial regulation agenda are expected to significantly outweigh the costs. Individual impact assessments showed net benefits, and many of the rules create considerable positive synergies when combined. The reforms are expected to improve the functioning of the financial system and make it more stable, responsible and efficient, to the benefit of the EU economy.

The reforms impose costs, but many of these are private costs to financial intermediaries that arise in the transition to a more stable financial system and are offset by societal benefits. The reform agenda has been mindful of the need to minimise costs, allowing longer phasing-in and observation periods and adjusting rules where significant costs are anticipated.

While the reforms address the problems revealed by the recent crisis, the risk of future crises cannot be regulated away. The Commission will remain vigilant and proactive, monitoring financial innovations and identifying new risks and vulnerabilities as they emerge.

5. Why does the economic review not contain a quantitative estimate of the total net benefit of the reforms as a whole?

The full impact of the financial reform agenda can in principle only be assessed in the years to come, as most rules have only been recently adopted, there are phasing-in periods and some rules still need to be complemented with delegated and implementing acts.

Even then it will be difficult to isolate regulatory impacts from other factors, such as the direct consequences of the crisis (e.g. increased risk aversion, uncertain market conditions, monetary policy interventions and low interest rates) and wider macroeconomic, technological and demographic changes. Pre-crisis market conditions cannot serve as the relevant benchmark, as it is precisely the boom-bust experience which much of the financial reform agenda aims to avoid being repeated.

In addition, there are severe data limitations that impede the quantitative assessment of many reform measures. For many market variables, there is either no publicly available data or the available data does not go sufficiently far back to enable meaningful analysis. Also, many impacts cannot easily be quantified in available models. It would therefore not be possible to come up with a reliable and comprehensive quantitative estimate of the total costs and benefits of regulation.

Therefore, the approach taken in this study is largely qualitative in nature, using quantitative evidence where available, relevant and appropriate. This study should be understood as a first step in a longer process of systematic review and evaluation of the reforms.

6. What are the main expected benefits of the reforms?

The reforms will deliver greater stability and reduce the likelihood and negative impact of financial crises being repeated in the future. For example, based on simulations by the Commission, reforms in the banking sector are estimated to deliver macroeconomic benefits of around 0.6-1.1% of EU GDP per year (or about €75-140 billion per year, based on 2013 EU GDP), not counting the other reforms that enhance the stability of the financial sector.

The reforms enable supervisors to oversee markets that had been beyond their reach and provide transparency for all market participants. They establish ambitious new standards to limit excessive risk-taking and make financial institutions more resilient. When there is risk-taking, the burden is shifted away from taxpayers to those who stand to gain financially from the risky activities. The reforms make financial markets work more effectively in the interests of consumers, small and medium-sized enterprises and the economy as a whole.

The reform measures also deepen the single market in financial services, notably through the action of the European Supervisory Authorities (ESAs) as part of the European System of Financial Supervision (ESFS) that has been in force since 2011. Furthermore, the Banking Union constitutes a milestone for European integration and is not only essential for the euro area but for the EU as a whole.

Overall, the reforms therefore help in delivering the overriding objective of building a financial system that serves the economy and facilitates sustainable economic growth.

7. What are the main expected costs, including unintended consequences?

Financial reform imposes costs on financial intermediaries (and their shareholders and employees) as it introduces compliance costs and requires adjustments in the way business is conducted. A part of these costs are temporary adjustment costs during transition to a more stable and responsible financial system. The recurring costs that financial intermediaries will incur on a regular basis to meet the stricter regulatory requirements after the transition period are the costs that matter more in the long term. These costs are expected to be more than offset by the benefits of enhanced stability and integrity of the financial system.

For economic welfare, the aggregate societal costs and benefits are relevant, i.e. the impact on all stakeholders in the economy, including users of financial services (e.g. depositors, borrowers and other consumers of financial services), taxpayers and the wider economy.

The reform process has been mindful of the potential costs of regulation and in particular the interaction of the new rules with the current difficult conditions in financial markets and the wider economy, for example by introducing longer phasing-in periods of the rules and adjusting the rules to minimise anticipated costs.

Quantitative estimates of the macroeconomic costs of banking sector reforms indicate a long-term negative output effect of about 0.3% of EU GDP per year. By comparison, the benefits of the same reforms that relate to reductions in the incidence and costs of future crisis are estimated to be in the order of 0.6-1.1% of EU GDP per year. While subject to significant modelling uncertainty, the findings of net reform benefits are consistent with quantitative results from other studies by public authorities.

There are areas of concern where the reforms may have unintended consequences if left unaddressed. These include, for example, a concentration of risks at the level of central counterparties (CCPs) and the risk of increases in the cost of financial intermediation. These risk areas are either the subject of ongoing work and addressed through careful implementation or are not considered, at this stage, to require immediate policy action. They will nonetheless be subject to continual monitoring. Ongoing monitoring and review of all reforms is required to ensure that they deliver their intended benefits while avoiding the undesired effects.

8. What does the economic review say about the impact of the reforms on the flow of finance to the economy?

The financial crisis and the costs it imposed on the economy show that a fundamental reform of the financial system was necessary. The reforms have been guided by the clear overall objective of building a financial system that serves the economy better and facilitates economic growth and jobs in Europe. The financial system can only fulfil its key function of intermediating finance in the economy if, as a prerequisite, there is financial stability and if consumers and investors have trust and confidence in the financial sector. Most of the reforms in the financial regulation agenda aim to do just that.

Furthermore, efforts have systematically been made on a rule-by-rule basis to strike a balance between ensuring financial stability and allowing a sufficient and sustainable flow of finance to the economy. The evidence presented in the economic review shows that the main impediments to the flow of finance in Europe have had little to do with regulation and that higher capital and liquidity requirements for banks and other rules are unlikely to have a significant impact on bank lending rates. The reform process has been mindful of the potential costs of regulation, by granting longer phasing-in and observation periods and, where required, adjusting the rules.

The reform measures devote particular attention to small and medium-sized enterprises (SMEs), given their particular difficulties in securing external finance and their important role in EU employment and growth. The EU financial framework has been adapted considerably over the last three years, on the basis of an action plan adopted in December 2011. The measures include:

• reducing the administrative burden and reporting requirements for SMEs (Prospectus Directive, Transparency Directive, Accounting Directive, Market Abuse Regulation/Criminal Sanctions for Market Abuse Directive)
• creating a dedicated trading platform to make SME capital markets more liquid and visible (Markets in Financial Instruments – MiFID II)
• addressing the issue of risk weights in the bank capital framework to make SME-lending relatively more attractive (Capital Requirements Directive – CRD IV package), and
• introducing new EU frameworks for investment in venture capital and in social entrepreneurship funds. The proposal on European long-term investment funds further aims to ensure the long-term financing of SMEs and key infrastructure investment. Additional measures to facilitate the long-term financing of the EU economy are currently being developed, as set out in the March 2014 Communication on long-term financing of the European economy.

9. What does the economic review show about the interaction of the various reforms?

The large number of regulatory reforms at EU level, and their broad scope, is a reflection of the battery of underlying problems that needed to be addressed. No single reform would have been capable of achieving the four objectives of greater stability, integrity, efficiency and integration to improve the functioning of the financial system overall and facilitate sustainable economic growth.

The combination of different reform measures helps the four objectives to be achieved more effectively and at lower cost – see table in the annex for an overview. For example, if higher capital requirements were used as the only regulatory tool to enhance stability in the banking sector, the capital levels required might need to be set so high that it would be difficult for banks to raise sufficient capital, given the size and leverage of their balance sheets. The consequent costs from disruptions to the efficient flow of financial services to the economy could then outweigh the stability benefits. Complementing the new capital requirements with further measures (in particular the new framework on bank resolution and recovery and the proposed bank structural reform helps to meet the stability objective while limiting disruptive effects.

There are cross-sectoral synergies between some reforms. For example, there are synergies between the CRD IV package in banking and the European Markets Infrastructure Regulation reform on derivatives markets. The former imposes higher capital and collateral requirements on banks concluding derivative contracts that are not centrally cleared under EMIR. This will encourage a critical mass of contracts to be cleared through central counterparties (CCPs) and thereby effectively enable central clearing to mitigate counterparty risk (as intended by EMIR), contributing to financial stability overall. As a second example, the Credit Rating Agencies regulations are strengthened by measures in all EU sectoral legislation to reduce the mechanistic reliance on credit ratings. Finally, requirements for risk retention, due diligence and monitoring of securitisation positions were first introduced in the new bank capital framework and then extended in a consistent manner to other sectoral legislation. This cross-sectoral approach reduces the opportunities for circumventing the requirements by shifting exposures to less regulated sectors.

Apart from such synergies, the review also examines other kinds of interactions between different reforms, for example between the CRD IV package, the Bank Recovery and Resolution Directive and Solvency II.

10. Does the economic review propose any policy actions?

No. The economic review is a Commission Staff Working Document that reviews the reforms to EU financial services legislation adopted or proposed in the period between 2009 and the first quarter of 2014. While it does not specify new policy actions, the economic review highlights areas of on-going work (see below). It also emphasises the need for on-going monitoring and evaluation of the reforms to ensure that they deliver their intended benefits while avoiding the undesired effects.

11. Is the EU financial regulation agenda completed?

Much has been achieved in a short period of time, but the reform process is not yet fully accomplished. Some important reforms still need to be adopted by the co-legislators, in particular on bank structural reform, shadow banking, and financial benchmarks). Furthermore, work is still under preparation at international and European level in particular on a resolution framework for non-banks.

With the majority of reforms agreed, it is now important to ensure effective implementation and consistent application of the new regulatory framework. Ongoing monitoring and review is necessary to evaluate implementation and the overall impact and effectiveness of the reforms. The economic review provides a first step in this process.

The Commission will also continue its efforts in promoting an internationally coordinated approach in the area of financial regulation. Ensuring regulatory and supervisory convergence between all major financial centres around the world remains a significant challenge.

In addition to full implementation of the reforms, regulatory attention is now focusing on tackling long-term financing and developing a more diversified financial system with more direct capital market financing and greater involvement of institutional investors and alternative financial markets. As set out in the March 2014 Communication on long-term financing, addressing these issues is a priority to reinforce the competitiveness of Europe’s economy and industry.

Further information

Annex: Complementarities in achieving the objectives