Recent Developments in European Financial Services and Banking Law

Jie LIN

1. MiFID and the Single Market for Investment Services

1.1 MiFID Integration

MiFID, a key element of the European Financial Services Action Plan (‘FSAP’), has entered into force in the end of 2007. One of the main purposes of the directive is to harmonise investor protection at a high level.

MiFID introduces for the first time what is effectively a European conduct of business rulebook. The conduct of business provisions provide for different levels of protection according to the system of client classification. This distinguishes three categories: retail clients, professional clients and eligible counterparties. Conduct of business obligations do not apply to eligible counterparties. The conduct of business obligations under MiFID cover disclosure, ensuring suitability of advice and discretionary investment management services, and appropriateness of certain execution-only services, record-keeping and reporting to the client. Another important provisions relating to investor protection is best execution. Firms subject to the new requirements need to implement arrangements to comply with the new best execution framework, produce and implement a best execution policy consistent with the new framework, provide appropriate information on the policy and obtain client consent to the policy, and continuously monitor policy compliance and update and notify clients of policy amendments.

One year has passed. It is time to check MiFID implementation. On November 4, 2008, Commission of the European Communities made MiFID Transposition Quality Check, summary of responses to DG Internal Market and Services questionnaire. Most respondents share the view that in general MiFID+L2D (including investor protection rules) well transposed and few transposition failures reported. But sometimes different application of MiFID rules in the Member States exits.

However, there exist some grey areas in MiFID implementation: territorial scope, classification of clients and third party communications. For example, does MiFID apply to investment services provided by a MiFID firm to non-EEA clients or by a MiFID firm from a non-EEA state to EEA clients? Still, allocation of responsibilities between home and host supervision faces some problems. Art 31(1) regulates home state supervision and Art 31(2) notification requirement, while Art 32(7) stipulates that services provided within the territory of the branch subject to host state supervision. In order to response the guidance request by CESR, the Commission published a response in June, 2007 which suggests effective shared and cooperative supervision of the branches between the home and host competent authorities.

MiFID aims to harmonise investor protection at a higher level. Does MiFID provide for maximum harmonization? Some arguments hold the view that exceptions stated in Art 4 of Commission Directive 2006/73/EC are inconsistent with maximum harmonization unless expressly authorized by MiFID.

1.2 Investment Funds

UCITS are a set of European Union directives, with aim to allow collective investment schemes to operate freely throughout the EU on the basis of a single authorization from one member state. In  16 July 2008, the Commission proposed improved EU framework for investment funds, which provides consumers with access to professionally managed investments on affordable terms. The proposed changes to the UCITS Directive will remove administrative barriers to the cross-border distribution of UCITS funds, create a framework for mergers between UCITS funds and allow the use of master-feeder structures, replace the simplified Prospectus by a new concept of Key Investor Information (KII), and improve cooperation mechanisms between national supervisors. 

First issue is Notification Procedure. Current weaknesses are mainly lengthy and bureaucratic procedures, notification costs and competition with less regulated products. Key objectives of the proposal are to ensure smooth functioning of UCITS passport and reduce UCITS time-to-market while maintaining high levels of investor protection. The proposal simplifies notification by the following procedure: UCITS submits notification letter and required translations to its home authority; home member state verifies file’s completeness, if the file is complete, then home member state transmits it to the host member state and informs UCITS of the transmission date; UCITS can start marketing after transmission with on-going control of compliance with local rules by host member state.

Second issue is Fund Mergers. Current weaknesses are absence of common EU framework for fund mergers which is the main obstacle to further cross-border consolidation and no economies of scale. Fund mergers should be authorized by supervisor of dissolving UCITS and supervisor of receiving UCITS authority has no veto right, while dissolving UCITS depositary check conformity with law and fund rules and independent auditor reports on the assets valuation method and the calculation of the exchange ratio. Information to supervisor include common draft terms of the proposed merger, approval by depositary of draft terms, draft auditor report and information to be provided to dissolving UCITS’ investors.

Third issue is Key Investor Information (KII). The aim of KII is to provide in a short document all key facts to retail investors in a clear and understandable manner, which enable investors to take an informed investment decision.

Fourth is Management Company Passport (MCP). The Commission’s proposal for a directive containing amendments to the UCITS Directive (“UCITS Ⅳ”) did not include any provision on establishing an effective MCP. Therefore, the Commission requested CESR to provide advice. On 31 October 2008, CESR gave the Commission its advice on the UCITS MCP, which believes that full MCP is feasible. It proposed concept, but no draft provisions. On 29 September, French presidency of the Council of the European Union tabled detailed draft provisions, which aims full passport for fund management companies as part of the amendment of the UCITS Directive. UCITS may be managed by a management company established in another member state and authorization of management companies in one member state is valid in all member states. UCITS supervisor has to rely on judgment of management companies’ supervisor that management companies are capable of managing this type of UCITS and has to approve choice of management companies within one month.

Still, there exist non-harmonised investment funds, such as real estate, private equity and hedge fund. Significant amount of fund products are excluded from a European passport and allowed to be marketed only nationally, which prevents asset managers from creating scale efficiencies and restricts investor’s choice. On 12 February 2008, the Commission held an Open Hearing on non-harmonised retail investment funds.

On 13 March, the Commission published an industry report analyzing cross border market access barriers for nationally regulated open ended real estate funds. The report was prepared by the expert group on open ended real estate funds. Common ways are needed to establish, operate and distribute open ended real estate funds on an EU wide basis. The expert group recommended that legislation should be developed to provide a passport for open ended real estate funds. The new regime should be modeled on UCITS. Additional regulatory safeguards are also required due to the nature of “real estate” assets. The first best solution would be to add a chapter describing open ended real estate funds to the existing UCITS Directive. The alternative approach could be to design a new Directive. Financial regulators make authorization and on-going supervision. Depository should ensure open ended real estate funds’ compliance with law and fund rules, thus protect interests of investors.

On 17 July 2008, the Commission published a preliminary impact assessment report on Private Placement. The impact assessment work reveals that EU legislative action would be required to establish an effective and comprehensive EU level private placement regime. This report concludes that further work is needed to measure the overall costs and benefits of introducing EU level arrangements and to determine the appropriate scope of such potential arrangements.

On 18 December 2008, the Commission launched public consultation on hedge funds, in view of developing appropriate regulatory initiative. This consultation will make an important contribution to European and international reflections on whether the approach to the regulation and supervision of hedge funds should be reassessed in light of the financial crisis. In particular, views and evidence are sought in such areas as systemic risks, market integrity and efficiency, risk management, transparency towards investors and investor protection.

2. Retail Financial Services and Retail Payments

2.1 Retail Financial Services

On 30 April 2007, the Commission issued a Green Paper on Retail Financial Services in the Single Market, which seeks to strengthen and deepen our understanding of the problems faced by consumers and industry in the field of retail financial services and to establish the scope for and impediments to further initiatives in this area. The Commission believes that integration in EU retail financial services markets can be further developed by binging about concrete benefits for consumers, enhancing consumer confidence and empowering consumers to make the right decisions for their financial circumstances.

On 20 November 2007, the Commission has published a Staff Working Document on its initiatives in the area of retail financial services, which building on the Commission’s strategy for retail financial services outlined in the Green Paper, identifies several areas where work should be undertaken to improve the competitiveness and efficiency of European retail financial services markets. On 18 December 2007, the Commission adopted White Paper on the Integration of EU Mortgage Credit Markets. It writes that the Commission will finalise a revised European Standardised Information Sheet (ESIS) on Home Loans and test more broadly this revised ESIS with consumers in all member states. On 7 April 2008, the European Council approved the Consumer Credit Directive establishing common rules on consumer credit across Europe. The Directive sets out new requirements specifying the list of items to be provided, including type and duration of credit, APR, borrowing rate, total amount of credit and charges included, amongst others. Pre-contractual information must be provided by means of a Standard European Consumer Credit Information (SECCI) form as set out in the Annex to the Directive. On 8 October 2008, the Commission launched a proposal for a Directive on Consumer Contractual Rights, which embrace a full harmonization approach to consumer protection. There is a general information requirement, which must be respected prior to the conclusion of a contract (if not already apparent from the context). This includes furnishing the consumer with information on the main characteristics of the product, details of the trader, the price, delivery arrangements, existence of the right to withdraw where applicable, and details of any after-sales services or commercial warranties where applicable. On 27 November 2008, the Commission has adopted the Green Paper on Consumer Collective Redress, which sets out 4 options: no immediate action, cooperation between member states extending national collective redress systems to consumers from other member states without such mechanism, a mix of policy instruments to strengthen consumer redress, and binding or non-binding measures for a collective redress judicial procedure to exist in all member states.

Retail financial services occupy a main part in people’s daily life. Under the background of world-wide crisis, it is necessary to make prioritization and give a high level consumer protection. Public authorities should also play their role in enforcing the existing legislation and the dialogue between borrowers and lenders should be kept open, with their voices being reflected on future legislative actions.

2.2 Retail Payments

On 13 November 2007, the European Parliament and the Council adopted Directive on Payment Services in the Internal Market (PSD), which provides the legal foundation for the creation of an EU-wide single market for payments and needs to be implemented by all member states by 1 November 2009. It aims at establishing a comprehensive set of rules applicable to all payment services in the EU and also seeks to improve competition by opening up payment markets to new entrants. Meanwhile it provides the necessary legal platform for the Single Euro Payments Area (SEPA).

The Directive requires countries in the EEA to regulate payment services (for example card payments, direct debits, standing orders and money transfers). There is however a new authorization regime for providers that are neither currently authorized as credit institutions nor e-money issuers. These are called ‘Payment Institutions’. Under this new Directive, customers or payment service users will be good affected as of harmonized customer protection, specification of full transparency of conditions, improved information to be provided, improved refund rights and shortened execution times. Payment service providers will benefit from the creation of a uniform legal framework and also the removal of barriers of entry into new markets within EU/EEA. Banks, although facing an investment challenge, can develop new products and services which can be offered on a pan-European level and expand into new markets without having to establish a physical presence. However, still some unclear points remain to be handled, such as payment accounts.

  While PSD is driven by regulators and provides for the necessary legal framework within which all payment service providers will operate, SEPA is a self-regulatory initiative by the banking sector of Europe (represented in the European Payments Council) which defines the harmonization of payment products, infrastructures and technical standards. There are two major milestones for the establishment of SEPA: Pan-European payment instruments for credit transfers (SCT) started on 28 January 2008. Direct debit (SDD) should go live on 1^st November 2009 (PSD transposition done). Debit cards will be available later (before 2011); at the end of 2010, all present national payment infrastructures and payment processors should be in full competition to increase efficiency through consolidation and economies of scale. The European Payments Council (EPC), which is made up of European banks, is committed to delivering three pan-European payment instruments: for credit transfer SCT; for direct debits SDD; for cards SEPA Cards Framework.

  But, still some major concerns exit. European Central Bank considers the SEPA implementation as too long, the use of SEPA compliant service SCT is very low as compared to what happened during the Euro introduction, the absence of an end-date and a third card scheme. The Commission thinks that SEPA is cooperation between potential competitors and SEPA Cards Framework is not giving satisfaction. Much work needs to be done for SEPA and PSD compliance. Impact assessment of PSD on existing bank processes should be made. Information requirements and information provision to customer are key issues.

3. Financial Supervision and Financial Stability

On 7 April 2008, the Financial Stability Forum (FSF) issued a report on Enhancing Market and Institutional Resilience, which identifies underlying weakness of the crisis and gives recommendations as well as implementation to reform BASEL Ⅱ/CRD. Poor underwriting standards, shortcomings in risk management practices, poor investor due diligence, poor performance by the CRAs (Credit Rating Agencies) and incentive distortions are thought of underlying weakness. Capital requirements for certain complex structured credit products should be raised; capital treatment of liquidity facilities should be strengthened to off-balance sheet conduits; additional capital charges for default and event risk in the trading books of banks and securities firms should be introduced; guidance for supervision and management of liquidity risks should be under way; banks’ risk management practices should be strengthened; disclosure requirements should be strengthened; investors should address their over-reliance on ratings.

  On 14 May 2008, ECOFIN Council of Finance Ministers adopted conclusions on financial supervision and provision of financial stability in the EU. They updated three roadmaps adopted in October and December 2007: the roadmap on responses to the financial turmoil, the roadmap for improving the supervisory arrangements in the financial system and the roadmap for developing the EU arrangements for financial stability and crisis management.

  On 1 November 2008, the Commission adopted a proposal to amend the CRD (Capital Requirements Directive) in certain key areas, which addresses the shortcomings in the current regulatory framework and is a direct response to the financial turmoil. It proposes to improve the management of large exposures, supervision of cross-border banking groups, the quality of banks’ capital, liquidity risk management and risk management for securitized products.

While on the other hand, how to better regulate CRAs is still or more a big issue in EU financial regulation field. On 31 July 2008, the Commission published two consultation documents on CRAs. The first document relates to the conditions for the authorization, operation and supervision of CRAs. The second proposes policy options in order to tackle what is felt to be an excessive reliance on ratings in EU legislation. On 12 November 2008, the Commission adopted proposal to regulate CRAs, which is part of a package of proposals to deal with the financial crisis and adds to Commission’s proposals on Solvency Ⅱ, CRD, Deposit Guarantee Schemes and accounting. The proposal lays down conditions for the issuance of credit ratings which are needed to restore market confidence and increase investor protection. It introduces a registration procedure for CRAs to enable European supervisors to control the activities of rating agencies whose ratings are used by credit institutions, investment firms, insurance, assurance and reinsurance undertakings, collective investment schemes and pension funds. CRAs will have to respect specific requirements that ratings are not affected by conflicts of interest, that CRAs remain vigilant on the quality of the rating methodology and the ratings, that CRAs act in a transparent manner. The proposal also includes an effective surveillance regime so that European regulators will supervise CRAs.

Under such background, we call for better supervisory cooperation more than before. With the promotion and facilitation by Committee of European Banking Supervisors (CEBS), supervisory cooperation practice across EU led to clear results especially in the context of the crisis situation: serving as a facilitator of swift information exchange, developing guidelines on disclosures by banks, providing recommendations on the valuation of assets which become illiquid to banks, providing comments on proposed regulatory changes to the EU Commission, developing a process for delivering periodic risk assessments to the EU institutions, contributing to the development of the 2008 MoU (Memorandum of Understanding on Co-operation between the Financial Supervisory Authorities, Central Banks and Finance Ministries of the European Union on Cross-border Financial Stability). The Memorandum establishes common principles and defines coordination mechanisms including the identification of a national coordinating authority and a cross-border coordinating authority. The cooperation at a cross-border level can be enhanced further by the establishment of Cross-Border Stability Groups.

In order to strengthen banks’ liquidity risk management and improve global supervisory practices, BCBS (Basel Committee on Banking Supervision) published “Principles for Sound Liquidity Risk Management and Supervision” in September 2008. The primary objective of this guidance is to raise banks’ resilience to liquidity stress. The principles underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management process. Key elements of a bank’s governance of its liquidity risk management are emphasized, as well as the importance of supervisors which assess the adequacy of a bank’s liquidity risk management framework and its level of liquidity. Besides, supervisors should take steps if above measures are deemed inadequate. Furthermore, the importance of effective cooperation between supervisors and other key stakeholders such as central banks are emphasized.

Jie LIN：Doctoral Candidate in Wuhan University, International Economic Law and International Financial Law