EUROPEAN FINANCIAL
REGULATION
KU Leuven
Summary European Financial Regulation
This summary is based on the PowerPoint slides of Prof. V. Colaert and notes taken during
class.
Academic year: 2020-2021
0
,Inhoudsopgave
1 INTRODUCTION.......................................................................... FOUT! BLADWIJZER NIET GEDEFINIEERD.
1.1 WHAT IS FINANCIAL LAW? ...........................................................................................................................2
1.2 GOALS OF FINANCIAL LAW ...........................................................................................................................3
1.2.1 Market stability ...........................................................................................................................3
1.2.2 Protection/confidence of retail customers ..................................................................................4
1.2.3 Market integrity ..........................................................................................................................4
1.2.4 Additional ‘European’ goal of financial law ................................................................................5
1.3 SOURCES OF FINANCIAL LAW – WHO REGULATES? ............................................................................................5
1.3.1 International bodies ....................................................................................................................5
1.3.2 European Union ..........................................................................................................................7
1.3.3 National law ................................................................................................................................7
1.4 HISTORIC CONTEXT OF EU FINANCIAL LAW ......................................................................................................7
1.4.1 1985 White paper .......................................................................................................................7
1.4.2 Internal market for financial services ..........................................................................................8
1.4.3 The crisis – development .............................................................................................................8
1.4.4 The crisis – regulatory reaction ...................................................................................................9
1.5 FUTURE OF EU FINANCIAL REGULATION .......................................................................................................10
2 BASIC STRUCTURES OF FINANCIAL LAW IN EUROPE .............................................................................11
2.1 LEGISLATIVE PROCEDURE ...........................................................................................................................11
2.1.1 Background ...............................................................................................................................11
2.1.2 Four level approach ...................................................................................................................11
2.1.3 Establishment of new committees ............................................................................................12
2.1.4 Evaluation .................................................................................................................................13
2.2 SUPERVISION OF THE FINANCIAL SECTOR IN EUROPE .......................................................................................13
2.2.1 Introduction...............................................................................................................................13
2.2.2 Belgian supervisory structure ....................................................................................................14
2.2.3 European supervisory structure ................................................................................................15
2.2.4 Evaluation .................................................................................................................................18
3 STABILITY OF THE BANKING SYSTEM ....................................................................................................20
3.1 REGULATING BANKS .................................................................................................................................20
3.1.1 What?........................................................................................................................................20
3.1.2 Why regulate? ...........................................................................................................................21
3.1.3 How regulate.............................................................................................................................22
3.2 BASEL STANDARDS ...................................................................................................................................22
3.2.1 Basel Committee .......................................................................................................................22
3.2.2 Basel I ........................................................................................................................................23
3.2.3 Basel II .......................................................................................................................................24
3.2.4 Basel III ......................................................................................................................................28
3.2.5 ‘Basel IV’: amendments to Basel III in 2017 ..............................................................................30
3.2.6 Basel III and Sustainable Finance ..............................................................................................30
3.3 EUROPEAN REGULATION OF CREDIT INSTITUTIONS ..........................................................................................30
3.3.1 Introduction...............................................................................................................................30
3.3.2 Differences with the Basel Standards........................................................................................31
3.3.3 Additions to Basel standards .....................................................................................................31
3.3.4 Implementation of Basel Standards ..........................................................................................31
3.3.5 Integrating sustainable finance into CRD ..................................................................................32
3.3.6 Internal market .........................................................................................................................32
3.4 THE BANKING UNION ...............................................................................................................................33
3.4.1 Introduction...............................................................................................................................33
3.4.2 Single Supervisory Mechanism ..................................................................................................34
3.4.3 Single Resolution Mechanism ...................................................................................................35
3.4.4 Deposit guarantee.....................................................................................................................39
1
, 3.4.5 Will the EBU succeed in avoiding future crises? ........................................................................41
4 FINANCIAL PRODUCTS..........................................................................................................................42
4.1 INTRODUCTION .......................................................................................................................................42
4.1.1 Loan...........................................................................................................................................42
4.2 DEPOSITS ...............................................................................................................................................43
4.3 FINANCIAL INSTRUMENTS ..........................................................................................................................44
4.3.1 Money Market Instruments ......................................................................................................44
4.3.2 Securities ...................................................................................................................................44
4.3.3 Investment funds.......................................................................................................................46
4.3.4 Derivatives ................................................................................................................................47
4.3.5 Sustainable finance ...................................................................................................................52
5 RATING FINANCIAL INSTRUMENTS .......................................................................................................54
5.1 BACKGROUND .........................................................................................................................................54
5.1.1 Business of a rating agency .......................................................................................................54
5.2 RATING AGENCY BUSINESS MODEL ..............................................................................................................54
5.2.1 Evolution ...................................................................................................................................54
5.2.2 Conflicts of interest ...................................................................................................................55
5.2.3 Impact of a downgrade .............................................................................................................56
5.2.4 CRAs and information asymmetry ............................................................................................56
5.2.5 Rating agency rating model ......................................................................................................56
5.3 RATING AGENCY LIABILITY ..........................................................................................................................57
5.4 FAILING RATING AGENCIES .........................................................................................................................57
5.5 LEGISLATION APPLICABLE TO CRAS IN EU .....................................................................................................57
5.5.1 IOSCO Code (2004) ....................................................................................................................57
5.5.2 CRA Regulation..........................................................................................................................58
5.6 THE WAY FORWARD .................................................................................................................................60
6 FINANCIAL MARKETS ...........................................................................................................................61
6.1 MARKET REGULATION ..............................................................................................................................61
6.1.1 From markets to venues ............................................................................................................61
6.1.2 Types of venues .........................................................................................................................61
6.1.3 Regulation of markets ...............................................................................................................62
6.1.4 Functioning of markets .............................................................................................................63
6.2 MARKET ABUSE .......................................................................................................................................64
6.2.1 Concept .....................................................................................................................................64
6.2.2 European rules regarding market abuse ...................................................................................65
6.2.3 Market manipulation ................................................................................................................65
6.2.4 Insider dealing ...........................................................................................................................66
2
,1 Introduction
The financial system can be represented as following:
Credit institutions and the markets are essential players in the financial system: they are
circulating money (the primary role of the financial system).
1.1 What is financial law?
Financial law= the law regulating the financial markets in order to ensure their optimal
functioning and pursue a number of predefined goals.
Often, a sectoral description is used on the basis of subsectors:
• Banking law (including law on payment and credit services)
• Securities law
• Insurance law
The function of the financial markets is:
• Money/credit supply
• Channelling the money to where it is needed: the financial markets are channels
through which private savings find their way to industrial and commercial investments.
• Intermediation between excess of money and demand of money:
o Intermediation in the collection of savings, which are invested in credit or other
financial transactions.
2
, o Intermediation by volume: collection of relatively small amounts and supply in
relatively large amount.
• Creation of money:
o E.g. Paul has 10.000 euros; he deposits it at bank 1. Bank 1 keeps 1.000 euros
in cash and lends the other 9.000 euros to Anne. Anne buys a car for 9.000
euros; the auto dealer gets the 9.000 euros and deposits it at bank 2. Bank 2
lends 8.000 euros to Julie who buys an appartement from Luc. Luc deposits the
8.000 euros at bank 3 and so on. In the end Paul, the car dealer and Luc believe
they all have respectively 10.000, 9.000 and 8.000 euros. What started as a
deposit of 10.000 euros ended in several deposits resulting to a sum of 27.000
euros (= creation of money).
o However, this creates a problem when all of the deposit holders come to collect
their money at the same time. The bank does not have it all in cash and can’t
pay them.
1.2 Goals of financial law
In general, the goal of financial law is risk mitigation. The goal can be formulated…
• Negatively: correcting market failures and avoiding excesses/abuse
• Positively: market stability, market integrity and protection of retail customers
An additional goal has been added, namely the ‘European’ goal of financial law: market
integration.
1.2.1 Market stability
Rules to ensure market stability interest the public. Therefore, they are considered ‘macro’-
rules.
Ensuring market stability, means avoiding systemic risk:
• Systemic risk= the risk or probability of breakdowns in an entire system, as opposed
to breakdowns in individual parts or components, and is evidenced by co-movements
(correlation) among most or all parts.
• OR Systemic risk= the risk that an event will trigger a loss of economic value or
confidence in, and attendant increases in uncertainty about, a substantial portion of
the financial system that is serious enough to quite probably have significant adverse
effects on the real economy.
• The elements of systemic risk are:
o First, a big shock…
§ Internal to the financial system (e.g. Lehman Brothers falls)
§ External to the financial system (e.g. a drop of the oil prices)
o Causing a chain reaction…
§ Directly because of interconnectedness (e.g. if one bank fails, other
banks also risk failure because of interbank deposits and loans)
§ Indirectly because of contagion (e.g. if one bank fails, other banks also
risk failure because of a loss of trust and a growing uncertainty)
3
, • That affects economically solvent as well as economically insolvent parties…
• Affecting the real economy.
The larger the bank experiencing the initial shock, the greater the probability, strength and
breadth of contagious systemic risk. Such banks have often been considered to be ‘too big to
fail’ and are called systemic banks.
1.2.2 Protection/confidence of retail customers
Rules to ensure protection of retail customers interest individuals and therefore are
considered ‘micro’-rules.
Regulation to protect customers are not particular to the financial sector but are way more
important in the financial sector than in many other sectors. The need for regulation increases
with:
• The complexity of goods and services: financial services are very complex (credence
goods).
o Search goods: low need of regulation, the customers can check for themselves
whether it is a good product or not.
o Experience goods: intermediate need of regulation, the customer can
experience whether a product is good or not and can get adequate
information.
o Credence goods: high need of regulation, the customer cannot evaluate
whether the product was good and has to trust the supplier.
• Higher stakes: the stakes are high with financial products (e.g. a mortgage on a house).
• Longer duration: (e.g. a loan for 10 years)
Consumer protection and market integrity and stability are as two sides of a coin: public
interest and private interest are hardly separable. We illustrate this with a couple of examples:
• E.g. Bank deposit guarantee fund as a measure to increase market stability through
consumer protection. If a bank fails, the trust of the consumers decreases. If there are
rumours that another bank will also fail, the deposit holders will all run on the bank to
withdraw their money. The bank won’t be able to fund all the withdrawals and will
have to borrow money from other banks (with high interest rates) or sell assets (for a
very low price). To avoid that banks have to take such measures (and ensure market
stability), the deposit guarantee fund has been started up. This is a government fund
financed by banks that ensures deposit holders get paid back (the first €100.000) their
deposits if and when a bank fails.
• Vb. responsible lending as a measure to ensure consumer protection, but also in favor
of market stability. When banks want to grant a loan, they have to figure out whether
the consumer is able to pay it back. If this is not the case, the loan cannot be granted
(consumers, but also market stability, would get into trouble).
1.2.3 Market integrity
A third goal of financial law is market integrity: fair play on the market. This leans close to
consumer protection, but there is a difference:
4
REGULATION
KU Leuven
Summary European Financial Regulation
This summary is based on the PowerPoint slides of Prof. V. Colaert and notes taken during
class.
Academic year: 2020-2021
0
,Inhoudsopgave
1 INTRODUCTION.......................................................................... FOUT! BLADWIJZER NIET GEDEFINIEERD.
1.1 WHAT IS FINANCIAL LAW? ...........................................................................................................................2
1.2 GOALS OF FINANCIAL LAW ...........................................................................................................................3
1.2.1 Market stability ...........................................................................................................................3
1.2.2 Protection/confidence of retail customers ..................................................................................4
1.2.3 Market integrity ..........................................................................................................................4
1.2.4 Additional ‘European’ goal of financial law ................................................................................5
1.3 SOURCES OF FINANCIAL LAW – WHO REGULATES? ............................................................................................5
1.3.1 International bodies ....................................................................................................................5
1.3.2 European Union ..........................................................................................................................7
1.3.3 National law ................................................................................................................................7
1.4 HISTORIC CONTEXT OF EU FINANCIAL LAW ......................................................................................................7
1.4.1 1985 White paper .......................................................................................................................7
1.4.2 Internal market for financial services ..........................................................................................8
1.4.3 The crisis – development .............................................................................................................8
1.4.4 The crisis – regulatory reaction ...................................................................................................9
1.5 FUTURE OF EU FINANCIAL REGULATION .......................................................................................................10
2 BASIC STRUCTURES OF FINANCIAL LAW IN EUROPE .............................................................................11
2.1 LEGISLATIVE PROCEDURE ...........................................................................................................................11
2.1.1 Background ...............................................................................................................................11
2.1.2 Four level approach ...................................................................................................................11
2.1.3 Establishment of new committees ............................................................................................12
2.1.4 Evaluation .................................................................................................................................13
2.2 SUPERVISION OF THE FINANCIAL SECTOR IN EUROPE .......................................................................................13
2.2.1 Introduction...............................................................................................................................13
2.2.2 Belgian supervisory structure ....................................................................................................14
2.2.3 European supervisory structure ................................................................................................15
2.2.4 Evaluation .................................................................................................................................18
3 STABILITY OF THE BANKING SYSTEM ....................................................................................................20
3.1 REGULATING BANKS .................................................................................................................................20
3.1.1 What?........................................................................................................................................20
3.1.2 Why regulate? ...........................................................................................................................21
3.1.3 How regulate.............................................................................................................................22
3.2 BASEL STANDARDS ...................................................................................................................................22
3.2.1 Basel Committee .......................................................................................................................22
3.2.2 Basel I ........................................................................................................................................23
3.2.3 Basel II .......................................................................................................................................24
3.2.4 Basel III ......................................................................................................................................28
3.2.5 ‘Basel IV’: amendments to Basel III in 2017 ..............................................................................30
3.2.6 Basel III and Sustainable Finance ..............................................................................................30
3.3 EUROPEAN REGULATION OF CREDIT INSTITUTIONS ..........................................................................................30
3.3.1 Introduction...............................................................................................................................30
3.3.2 Differences with the Basel Standards........................................................................................31
3.3.3 Additions to Basel standards .....................................................................................................31
3.3.4 Implementation of Basel Standards ..........................................................................................31
3.3.5 Integrating sustainable finance into CRD ..................................................................................32
3.3.6 Internal market .........................................................................................................................32
3.4 THE BANKING UNION ...............................................................................................................................33
3.4.1 Introduction...............................................................................................................................33
3.4.2 Single Supervisory Mechanism ..................................................................................................34
3.4.3 Single Resolution Mechanism ...................................................................................................35
3.4.4 Deposit guarantee.....................................................................................................................39
1
, 3.4.5 Will the EBU succeed in avoiding future crises? ........................................................................41
4 FINANCIAL PRODUCTS..........................................................................................................................42
4.1 INTRODUCTION .......................................................................................................................................42
4.1.1 Loan...........................................................................................................................................42
4.2 DEPOSITS ...............................................................................................................................................43
4.3 FINANCIAL INSTRUMENTS ..........................................................................................................................44
4.3.1 Money Market Instruments ......................................................................................................44
4.3.2 Securities ...................................................................................................................................44
4.3.3 Investment funds.......................................................................................................................46
4.3.4 Derivatives ................................................................................................................................47
4.3.5 Sustainable finance ...................................................................................................................52
5 RATING FINANCIAL INSTRUMENTS .......................................................................................................54
5.1 BACKGROUND .........................................................................................................................................54
5.1.1 Business of a rating agency .......................................................................................................54
5.2 RATING AGENCY BUSINESS MODEL ..............................................................................................................54
5.2.1 Evolution ...................................................................................................................................54
5.2.2 Conflicts of interest ...................................................................................................................55
5.2.3 Impact of a downgrade .............................................................................................................56
5.2.4 CRAs and information asymmetry ............................................................................................56
5.2.5 Rating agency rating model ......................................................................................................56
5.3 RATING AGENCY LIABILITY ..........................................................................................................................57
5.4 FAILING RATING AGENCIES .........................................................................................................................57
5.5 LEGISLATION APPLICABLE TO CRAS IN EU .....................................................................................................57
5.5.1 IOSCO Code (2004) ....................................................................................................................57
5.5.2 CRA Regulation..........................................................................................................................58
5.6 THE WAY FORWARD .................................................................................................................................60
6 FINANCIAL MARKETS ...........................................................................................................................61
6.1 MARKET REGULATION ..............................................................................................................................61
6.1.1 From markets to venues ............................................................................................................61
6.1.2 Types of venues .........................................................................................................................61
6.1.3 Regulation of markets ...............................................................................................................62
6.1.4 Functioning of markets .............................................................................................................63
6.2 MARKET ABUSE .......................................................................................................................................64
6.2.1 Concept .....................................................................................................................................64
6.2.2 European rules regarding market abuse ...................................................................................65
6.2.3 Market manipulation ................................................................................................................65
6.2.4 Insider dealing ...........................................................................................................................66
2
,1 Introduction
The financial system can be represented as following:
Credit institutions and the markets are essential players in the financial system: they are
circulating money (the primary role of the financial system).
1.1 What is financial law?
Financial law= the law regulating the financial markets in order to ensure their optimal
functioning and pursue a number of predefined goals.
Often, a sectoral description is used on the basis of subsectors:
• Banking law (including law on payment and credit services)
• Securities law
• Insurance law
The function of the financial markets is:
• Money/credit supply
• Channelling the money to where it is needed: the financial markets are channels
through which private savings find their way to industrial and commercial investments.
• Intermediation between excess of money and demand of money:
o Intermediation in the collection of savings, which are invested in credit or other
financial transactions.
2
, o Intermediation by volume: collection of relatively small amounts and supply in
relatively large amount.
• Creation of money:
o E.g. Paul has 10.000 euros; he deposits it at bank 1. Bank 1 keeps 1.000 euros
in cash and lends the other 9.000 euros to Anne. Anne buys a car for 9.000
euros; the auto dealer gets the 9.000 euros and deposits it at bank 2. Bank 2
lends 8.000 euros to Julie who buys an appartement from Luc. Luc deposits the
8.000 euros at bank 3 and so on. In the end Paul, the car dealer and Luc believe
they all have respectively 10.000, 9.000 and 8.000 euros. What started as a
deposit of 10.000 euros ended in several deposits resulting to a sum of 27.000
euros (= creation of money).
o However, this creates a problem when all of the deposit holders come to collect
their money at the same time. The bank does not have it all in cash and can’t
pay them.
1.2 Goals of financial law
In general, the goal of financial law is risk mitigation. The goal can be formulated…
• Negatively: correcting market failures and avoiding excesses/abuse
• Positively: market stability, market integrity and protection of retail customers
An additional goal has been added, namely the ‘European’ goal of financial law: market
integration.
1.2.1 Market stability
Rules to ensure market stability interest the public. Therefore, they are considered ‘macro’-
rules.
Ensuring market stability, means avoiding systemic risk:
• Systemic risk= the risk or probability of breakdowns in an entire system, as opposed
to breakdowns in individual parts or components, and is evidenced by co-movements
(correlation) among most or all parts.
• OR Systemic risk= the risk that an event will trigger a loss of economic value or
confidence in, and attendant increases in uncertainty about, a substantial portion of
the financial system that is serious enough to quite probably have significant adverse
effects on the real economy.
• The elements of systemic risk are:
o First, a big shock…
§ Internal to the financial system (e.g. Lehman Brothers falls)
§ External to the financial system (e.g. a drop of the oil prices)
o Causing a chain reaction…
§ Directly because of interconnectedness (e.g. if one bank fails, other
banks also risk failure because of interbank deposits and loans)
§ Indirectly because of contagion (e.g. if one bank fails, other banks also
risk failure because of a loss of trust and a growing uncertainty)
3
, • That affects economically solvent as well as economically insolvent parties…
• Affecting the real economy.
The larger the bank experiencing the initial shock, the greater the probability, strength and
breadth of contagious systemic risk. Such banks have often been considered to be ‘too big to
fail’ and are called systemic banks.
1.2.2 Protection/confidence of retail customers
Rules to ensure protection of retail customers interest individuals and therefore are
considered ‘micro’-rules.
Regulation to protect customers are not particular to the financial sector but are way more
important in the financial sector than in many other sectors. The need for regulation increases
with:
• The complexity of goods and services: financial services are very complex (credence
goods).
o Search goods: low need of regulation, the customers can check for themselves
whether it is a good product or not.
o Experience goods: intermediate need of regulation, the customer can
experience whether a product is good or not and can get adequate
information.
o Credence goods: high need of regulation, the customer cannot evaluate
whether the product was good and has to trust the supplier.
• Higher stakes: the stakes are high with financial products (e.g. a mortgage on a house).
• Longer duration: (e.g. a loan for 10 years)
Consumer protection and market integrity and stability are as two sides of a coin: public
interest and private interest are hardly separable. We illustrate this with a couple of examples:
• E.g. Bank deposit guarantee fund as a measure to increase market stability through
consumer protection. If a bank fails, the trust of the consumers decreases. If there are
rumours that another bank will also fail, the deposit holders will all run on the bank to
withdraw their money. The bank won’t be able to fund all the withdrawals and will
have to borrow money from other banks (with high interest rates) or sell assets (for a
very low price). To avoid that banks have to take such measures (and ensure market
stability), the deposit guarantee fund has been started up. This is a government fund
financed by banks that ensures deposit holders get paid back (the first €100.000) their
deposits if and when a bank fails.
• Vb. responsible lending as a measure to ensure consumer protection, but also in favor
of market stability. When banks want to grant a loan, they have to figure out whether
the consumer is able to pay it back. If this is not the case, the loan cannot be granted
(consumers, but also market stability, would get into trouble).
1.2.3 Market integrity
A third goal of financial law is market integrity: fair play on the market. This leans close to
consumer protection, but there is a difference:
4
