Briefing Note BN011/05
October 2005

This note describes some of the issues arising from a change in the balance of EU regulatory policy-making and activity: a shift from the process of completing European legislation under the Financial Services Action Plan (FSAP) to implementing it; and, related to that, a shift towards the development of EU financial services policy for the period 2005-2010.

This Note:

• outlines the current position on completing the FSAP legislative programme;
• describes the new strategic approaches to regulation put forward by the Commission and the UK (including the FSA); and
• comments on certain issues in the development of EU financial services policy, particularly the Commission's Green Paper on Financial Services Policy 2005-2010.

COMPLETING THE FSAP LEGISLATIVE PROGRAMME

Background

Negotiation of European legislation and, ultimately, its implementation in the UK are responsibilities of HM Government. The vehicle for implementing Directives affecting financial services is (for the most part) FSA rules. For this reason we work very closely with the relevant Government Departments (mainly Treasury) in the relevant EU fora. Our work is guided by the objectives set out in the Financial Services and Markets Act 2000 (FSMA): maintaining confidence in the UK financial system; promoting public understanding of the financial system; securing the appropriate degree of consumer protection; and helping to reduce financial crime. FSMA requires us to take into account the international character of financial services and the UK's competitive position. We aim to promote a well-regulated wholesale market which is efficient, orderly and fair and to help retail consumers achieve a fair deal. We focus predominantly on identifying and mitigating risk where this is cost-effective. We do not have a statutory objective to create a single market, though some single market measures, for example the Capital Requirements Directive and the Reinsurance Directive, also make a significant contribution towards mitigating risk.

The FSAP legislative programme is drawing to an end. It was published by the Commission in May 1999 and endorsed by the Lisbon European Council in March 2000. Its purpose was to produce a set of measures creating a legal and regulatory environment to support the integration of EU financial markets by 2005. It consists of 42 measures, including EU Directives to be transposed into the law of each Member State, and Regulations, which apply directly in all Member States.

The FSAP has three specific objectives:

• to create a single EU wholesale market;
• to achieve open and secure retail markets; and
• to create state of the art prudential rules and structures of supervision.

The FSAP has been accompanied by a new approach to developing and adopting EU financial services legislation (the Lamfalussy approach). This approach was adopted in June 2001 following the recommendations of a committee chaired by Baron Alexandre Lamfalussy. Structures have been established under the Lamfalussy arrangements to make more effective the development, implementation and enforcement of financial services legislation. These include the so-called Level 2 and Level 3 committees.

The role of the Level 2 committees of finance ministries is to agree implementing measures for EU financial services legislation that can more easily be adapted to account for technical or market developments. The Level 2 committees are: the European Banking Committee (EBC), the European Insurance and Occupational Pensions Committee (EIOPC), and the European Securities Committee (ESC).

The Level 3 committees of national supervisory authorities provide the Commission with specialist advice in preparing technical implementing measures for European Directives and promoting enhanced cooperation and convergence of supervisory practices across the EU. The Level 3 committees are: the Committee of European Banking Supervisors (CEBS), the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS) and the Committee of European Securities Regulators (CESR). We are represented at Board level on all three committees.

Significant developments

There has been a number of significant developments in key aspects of the FSAP since our September 2004. A number of these, together with their broad effect on our regulation of financial services, are outlined below.

The Market Abuse Directive (MAD) was implemented in the UK on 1 July this year. The MAD creates an EU-wide regime covering insider dealing and market manipulation. It affects all firms and individuals participating in a regulated market. Implementation has necessitated revisions to our Handbook including redrafting the Code of Market Conduct and Price Stabilising Rules and changes to the Listing Rules and Conduct of Business Rules. The main changes for firms are mandatory suspicious transaction reporting and a preventative requirement for issuers and their advisers to keep lists of staff who have inside information.

We implemented the Prospectus Directive (PD) on 1 July 2005. The PD sets out the initial information and disclosure obligations for issues of securities that are offered to the public or admitted to trading on a regulated market in the EU. This is intended to enhance consumer protection.

The PD is designed also to provide issuers with a 'passport' allowing them to raise capital in the EU on the basis of a single approved prospectus. Previously issuers who made public offers of securities were not required to have their prospectus approved by us.

The Markets in Financial Instruments Directive (MiFID) came into force in April 2004. It will replace the existing Investment Services Directive and regulate the authorisation and conduct of securities firms and markets. The purpose of MiFID is to promote cross-EU provision of investment services while protecting the investor and supporting market integrity.

The MiFID is a 'framework' Level 1-type directive. Work continues on implementing measures (Level 2) to flesh-out the Level 1 framework. We play an active role at Level 2 through CESR, as it frames advice to the Commission on the development of the implementing measures, and provides technical advice to Treasury for their participation in ESC discussions.

The MiFID requires changes to a large number of our Handbook requirements, particularly conduct of business rules. These include the management of conflicts of interest, financial promotions, best execution, commodity derivatives, transaction reporting and pre- and post-trading transparency obligations for exchanges and investment firms. It has wide-ranging implications for a number of markets; we are concerned to facilitate timely and proportionate implementation.

The Commission has announced a planned deferral of the MiFID implementation date by a year from April 2006 to 30 April 2007, allowing national authorities and market participants more time to take account of implementing measures. Our consultation on domestic implementation is planned for the fourth quarter of 2005, with the timetable kept flexible in case of further European developments.

The Transparency Directive (TD) came into force at the start of 2005 and must be transposed into national requirements by January 2007. The TD is intended to enhance transparency in EU financial markets by establishing rules on periodic financial reports and on disclosure of major shareholdings for issuers whose securities are admitted to trading on a regulated market in the EU. It establishes a mechanism for disseminating this information.

The TD requires substantial revisions to our Listing Rules and the expansion of our regulation to include major shareholding disclosures (currently regulated by the DTI). It is a minimum harmonisation Directive, allowing the UK to impose additional requirements as appropriate and where backed by market impact analysis.

The Reinsurance Directive was adopted in June 2005, and is currently being translated prior to publication in the Official Journal of the EU. The Directive is designed to ensure that firms providing reinsurance in the EU are subject to regulation. The Directive is intended to create a single market in reinsurance (similar to that which already exists for direct insurance) and to remove remaining barriers to trade within the EU. It seeks to establish the supervision of reinsurers by competent authorities in their ‘home’ country, based on which they will be able to operate throughout the EU. This Directive will bring EU regulation of pure reinsurers more into line with the existing insurance directives. As reinsurance business in the UK is supervised in broadly the same way as direct insurance, greater changes will be experienced in some other member states.

The Capital Requirements Directive (CRD) is intended to incorporate into EU law the revised Basel Capital Framework (Basel 2) on bank capital adequacy standards, reflecting a more risk-based approach to capital standards attuned to the business models and risk-management practices of modern financial intermediaries. (The original Basel Accord was implemented by EU legislation in the Capital Adequacy Directive.)

We are working closely with the industries affected on a major implementation programme for the CRD. We aim to finalise the relevant changes to our Handbook in reasonable time ahead of the new rules coming into force in early 2007. We published a consultation paper, Strengthening Capital Standards, in January 2005 setting out our overall approach in order to assist the financial services industry in implementing CRD in due course. In September we published a Feedback Statement which contained the results of that consultation. We continue to play a full part in the work of CEBS on the convergence of supervisory requirements and practices relating to the CRD. One element of this work is narrowing the extent to which remaining national discretions might be applied differently by supervisory authorities in the EU, a matter discussed in Strengthening Capital Standards.

The European Parliament adopted amendments to the CRD on 28 September. These amendments had been previously agreed with the Council, so the text of the CRD is now finalised. This compromise text represents a broadly positive outcome. We continue to plan for publication of our second CP and final rules in February 2006.

Formal adoption of the Third EU Money Laundering Directive is expected in November 2005, with an implementation period of 24 months. The Directive updates and strengthens a wide range of standards over fighting money laundering, and provides a common EU framework for applying the revised 2003 Financial Action Task Force Recommendations on Money Laundering. Particular features of the Directive are that it requires firms to pay more attention to the risks of terrorist financing, and it increases their obligations as regards Customer Due Diligence (identifying and building up a good picture of their customers and monitoring the way they use financial products). The Directive will - once implemented in the UK - have significant implications for FSA-regulated firms.

We have worked closely with HM Treasury who have succeeded in negotiating a Directive that is risk-based, effective and proportionate. We will continue to work with them very closely as they come to transpose the Directive into UK law.

Initial work has begun on an Insurance Solvency 2 Directive (Solvency 2), which is intended to develop a new, risk-based capital requirements framework for insurance firms throughout the EU and to promote convergence of supervisory practice among European regulators. It will replace Solvency 1, the existing EU Life and EU Non-Life directives. The Commission intends to carry out a codification of the existing relevant directives (life, non-life, reinsurance, groups etc.) and after this has been agreed, Solvency 2 related changes will be introduced. The adoption of the Solvency 2 framework Directive could take place by mid 2007. Meanwhile, work continues through CEIOPS, in which we play an active part, to advise the Commission on technical issues to form the basis of the measure. CEIOPS forecasts that the Directive will enter into force during 2010.

We support this work, seeing it as a crucial step to promoting adequate consumer protection and stable markets, consistent with our introduction between 2003 and 2005 of a more risk-sensitive regime in the UK.

Clearing and Settlement initiative

The Commission has indicated that any Directive in this area would be intended to liberalise and integrate clearing and settlement in the EU by giving all markets, clearing and settlement service providers and investors full choice on how and where to clear and settle cross-border transactions, by granting all providers of clearing and settlement services rights of access to one another. A Directive would apply a common regulatory framework, and appropriate governance arrangements, to such providers.

The Commission is finalising a regulatory impact assessment to inform its view. Any such Directive may extend beyond the scope of traditional clearing and settlement service providers. We support the objective of promoting safe and efficient cross-border clearing and settlement in the EU and consider that there should be a full market failure and cost-benefit analysis before any legislation is proposed. The report on clearing and settlement adopted by the European Parliament in June 2005 follows a similar approach. We also consider that any decision on whether or not to propose a Directive in this area should be fully informed by a regulatory impact assessment.

Credit rating agencies

The Commission is considering whether or not to proceed to set European requirements for the regulation of credit rating agencies and financial analysts. If it does not propose legislation in these areas, it might propose it in future, if and when market developments suggest such intervention is needed. In our view, legislation is not currently necessary.

Asset management and retail financial services

The Commission has identified asset management and retail financial services as two areas where legislative initiatives might benefit the European economy.

The Commission published a Green Paper on asset management in July proposing measures to improve the effectiveness of existing legislation on Undertakings for the Collective Investment in Transferable Securities (UCITS) that can operate throughout the EU. The essential reason for the proposal is that cross-border sales are constrained by the current legislation, causing difficulties with the 'product passport' such that funds from one Member State cannot easily be marketed in another. Consultation on this Green Paper will close in mid-November.

The Commission considers that there is scope for further integration of European markets in retail financial services. The potential for further integration is being stimulated by the introduction of the Euro, distance-selling via the Internet, consumer mobility and the growing need to complement state welfare provision. Where a case can be made for further integration, the Commission proposes to establish expert groups for specific retail products, representing industry and consumer interests, to identify barriers and examine possible solutions.

Mortgages

The Commission published a Green Paper on mortgage credit in the EU on 19 July 2005, which raised a number of questions about mortgage advice, disclosure, land registries, valuations, access to credit information and so on. This was followed in August 2005 by the publication of a cost-benefit analysis of various types of interventions that might promote the integration of the EU’s mortgage markets. Consultation on the Green Paper will close at the end of November.

The Commission points out that consumers appear reluctant to do business with foreign lenders for mortgage loans. Equally, many foreign lenders have been slow to take up the opportunity offered by the Internal Market to do business in Member States other than those in which they are based. Reasons for this include differences in marketing requirements, difficulties in comparing products across national borders, differences in national legal rules on mortgage products and repossession, and practical difficulties such as the different ways of assessing potential borrowers’ credit-worthiness and of carrying out property valuations across the EU.

NEW STRATEGIC APPROACHES TO REGULATION

There have been developments in strategic approaches to EU financial services regulation since September 2004.

Recent EU developments

Background

In the last three years the Commission has attached increasing importance to better regulation. It adopted an Action Plan in June 2002 for simplifying and improving the regulatory environment, whose key elements include:
• systematic use of impact assessment by the Commission when preparing policy proposals;
• establishment of minimum standards for external consultations carried out by the Commission; and
• a programme to simplify and update the existing body of European law.

The Commission has improved its internal working practices and continues to work on this. An Inter-Institutional Agreement on Better Lawmaking was signed by the Commission, European Parliament and Council in December 2003 which lays the basis for improving the way that they work together in making policy.


Commissioner McCreevy's approach

The Commission's Green Paper on Financial Services Policy 2005-2010 states that a rigorous, better regulation approach will be applied prior to launching any legislative proposals, from policy conception, through the consultation process to thorough economic impact assessments. The Commission will conduct ex-post evaluation as well (see Section D of this memorandum (below)).

Commissioner McCreevy has emphasised recently the importance of 'dynamic' consolidation of FSAP legislation and better regulation in the aftermath of the FSAP, describing these as 'two key concepts' in his speech, The Commission's Financial Services Policy 2005-2010.

Commissioner McCreevy has commented that dynamic consolidation includes the following elements:

• the effective transposition from EU directives to national regulation;
• battling against ‘gold-plating’ of EU measures in the course of transposing them; and
• supervisory co-operation, especially through the work of the Level 3 bodies.

Better regulation, Commissioner McCreevy has said, includes:

• the establishment of openness and wide consultation, to ensure that new legislation adds value and addresses the needs of all market participants; and
• a requirement that 'all concrete new proposals' undergo rigorous impact assessments. The Commissioner will ask the following questions: is there a case for action? Is the EU best-placed to act? Is a regulatory proposal the only solution? Are there less intrusive, less costly alternatives to achieve the same objectives? All these questions are to be answered positively before Commissioner McCreevy will approve new proposals.

Recent UK developments

After the FSAP

In May 2004, the UK authorities – Treasury, the Bank of England and the FSA – set out five UK priorities for guiding further action on EU financial services integration in, After the EU Financial Services Action Plan: A new strategic approach:

• there should be better implementation of EU measures affecting the financial sector, and better enforcement by the Commission against those Member States that fail to implement properly or on time;
• greater consideration should be given to alternatives to EU regulation;
• there should be a better regulation approach, including the use of market failure and cost-benefit analysis, as well as full consultation with financial market participants;
• there needs to be full recognition of the global nature of financial services; and
• the Lamfalussy arrangements now need to be developed to reach their potential.

It is worth commenting further on the last two bullet points. Recognising the global nature of financial services is a key issue in the development and implementation of EU financial services policy. It is important that regulatory dialogues are broadened beyond the EU-US dialogue to include other jurisdictions, such as China, India and Japan. We have conveyed to the Commission our view that the EU's credibility as a regulatory partner in these discussions rests in part on the extent to which EU law is transposed and applied properly by Member States.

As regards developing the Lamfalussy arrangements, we are keen to enhance these over the next two years through:
• better co-ordination between the Level 3 committees;
• peer group review processes of implementation;
• pushing forward with enhanced co-operative arrangements for home host among with relevant regulators; and
• undertaking impact assessments of Level 3 guidance as well as advice on possible Level 2 implementing measures.

The last of these is likely to affect the speed with which Level 3 committees could respond to Commission requests for advice.

Supervisory convergence

The concept of mutual recognition is fundamental to much of the EU legislation on supervising financial services in a single European market and so a convergence of supervisory approaches between Member States is a key element in making the single market a reality. Investors and financial supervisors want supervisory arrangements that can address cross-border risks effectively and efficiently. Market participants and supervisors recognise the need for closer supervisory co-operation and convergence of practice to respond to market trends. Benefits would include a reduction in duplication and a more managed set of regulatory relationships with internationally active firms.

In January 2005, the Bank of England, Treasury and FSA published a joint paper on supervisory convergence, Supervising financial services in an integrated European Single Market: A discussion paper, describing five challenges to be addressed in achieving convergence of supervisory practice and offering proposals for achieving convergence. The five challenges are:
• to ensure the effective, consistent and proportionate implementation and enforcement of EU legislation on financial services;
• to improve cooperation between supervisors;
• to ensure that the supply and sharing of data to, and between, financial supervision authorities is efficient and effective;
• to ensure that financial supervisory authorities, along with central banks and finance ministries, are able to work together to manage financial crises; and
• to continue to develop trust between market participants and supervisors and between supervisors themselves.

Much of this agenda is also now reflected in the Commission’s Green Paper on Financial Services Policy 2005-2010 (see Section D, below). The challenge now is to pursue the agenda within the relevant European fora.

CEBS, for example, published a consultation paper on 8 July 2005 setting out guidelines for establishing an enhanced framework for co-operation between consolidating supervisors and host supervisors (Guidelines for co-operation between consolidating supervisors and host supervisors). In its paper, CEBS illustrates how it envisages enhanced co-ordination and co-operation operating between home and host supervisors. The practical arrangements will be further refined as the proposals are piloted on some internationally-active firms.


DEVELOPING EU FINANCIAL SERVICES POLICY

The period since Mr McCreevy took up his appointment as Commissioner for the Internal Market and Services on 22 November 2004 has been marked by an emphasis on consolidating the legislative phase of the FSAP rather than embarking on numerous new legislative initiatives.

In May 2005, the Commission published its Green Paper on Financial Services Policy, 2005-2010. This sets out for discussion the Commission's agenda for the remainder of the decade. A White Paper is expected from the Commission in November.


The Commission's Green Paper on Financial Services Policy, 2005-2010.

In the Green Paper the Commission states the following policy objectives:
• to consolidate progress towards an integrated, open, competitive, and economically efficient European financial market and to remove the remaining economically significant barriers;
• to foster a market where there are adequate and effective levels of prudential control, financial stability and a high level of consumer protection and where trade in financial services and capital flows take place freely at the lowest possible cost throughout the EU; and,
• to implement, enforce and continuously evaluate the existing legislative framework, to deploy rigorously the better regulation agenda for any future initiatives, to enhance supervisory convergence and strengthen European influence in global financial markets.

The FSA's response to the Commission's Green Paper

We welcome the general approach in the Green Paper. In particular, we welcome the following elements:
• a reaffirmation by the Commission that its key task now is to complete existing legislative initiatives and only to embark on new initiatives where there is strong evidence that they would address market failures cost-effectively;
• a proposal to monitor regularly EU requirements and modify or repeal EU measures which do not deliver the economic benefits expected of them;
• the Commission's commitment to ensure that EU obligations are transposed correctly and applied properly by national competent authorities;
• the objective of ensuring more rigorous enforcement by supervisory authorities;
• a proposal to subject existing directives to continuous ex-post evaluation;
• the Commission's continued view that supervisory convergence should be taken forward as a key function of the Lamfalussy process, exploiting existing supervisory tools and the potential of CEBS, CEIOPS and CESR 'to the maximum extent';
• the emphasis on the need for better regulation in line with the importance that the UK Presidency attaches to effective better regulation and the better regulation agenda (this is also in line with the Six Presidency Better Regulation Initiative); and
• the Commission's view that goldplating should be avoided and not be used as a protectionist device. (When implementing directives our policy is not to impose new requirements that go beyond those contained in a Directive unless the imposition is strictly necessary and the super-equivalent requirements can be justified on cost-benefit grounds.)

There are, however, some areas where in our response to the Green Paper we highlighted some concerns and other risks that need to be addressed.
Significant risks

In the event that the European Constitutional Treaty is not ratified, we consider it essential to give priority to settling the question of the Parliament's role in relation to delegated Level 2 legislation, either in the context of comitology generally or the Lamfalussy arrangements specifically, in order that relevant provisions in the various Lamfalussy directives can be renewed.

The Green Paper mentions a range of initiatives in the area of corporate governance. These fall outside the scope of financial services but nonetheless lie in areas where we have a keen, albeit indirect, interest. Our main concern is that principles-based approaches adopted in some Member States, including the UK, might be undermined incrementally by a succession of more detailed, specific EU requirements. Rising levels of prescription will not necessarily prevent future abuse, especially if the requirements are not risk-based.

The Green Paper refers to the idea of a '26th regime' – a regime, separate from Member States' regulation, to regulate a limited range of products such as life assurance and savings. In concept, such a regime would be optional (active cross-border consumers, for example, might wish to choose it). The Commission proposes to launch a feasibility study. There is a risk that such a regime could create potential for greater regulatory cost and duplication. We consider that proper cost-benefit analysis would be required before any such regime were proposed.

The Green Paper proposes a simplification and consolidation of all relevant European and national financial services rules. We do not consider that this would appreciably assist in either achieving the goal of a single market or helping to manage risks to consumers. Furthermore, a full consolidation exercise might mean little without changes to contract and insolvency law. The fact that EU retail markets are not converged would reduce the benefit of a consolidated rulebook; indeed, the variation observed in the structure and operation of individual EU retail markets necessitates different requirements in different Member States in order to protect consumers properly. A proper impact assessment would also be necessary before undertaking simplification and consolidation. Recently Commissioner McCreevy has referred to consolidating EU-wide texts into a single financial services rulebook, i.e. providing for greater internal consistency and coherence within the body of EU law, rather than harmonising national rulebooks as well. We welcome this more modest, but still ambitious, aspiration.