The bank of the future: an update March 2010 Contents

Introduction 3

Capital 5

Liquidity 10

Accounting 12

‘Too big to fail’ 15

Resolution arrangements 17

Cross-border issues 20

Corporate governance 22

Remuneration 24

Securitisation 28

Derivatives 30

Hedge funds and the unregulated sector 35

Competition policy 38

Tax havens 41

Glossary 43

Contacts 47

About Freshfields Bruckhaus Deringer 48

The bank of the future: an update 3

Introduction

Four months have passed since The bank of the future was published. In it we set out to assist those who are concerned with decisions affecting banks and other financial institutions in the current, uncertain regulatory environment by pulling together the diverse and complex range of proposals for regulatory change across a range of areas. We also provided some background to the wider debate on policy and the public interest. Since then, events have moved on apace with decision making bodies at all levels developing existing policy proposals and issuing new ones, with potentially wide-ranging consequences.

Four months is a long time in the fevered world of post-financial crisis regulatory change and this update provides a summary of the principal developments during that period at global, European and UK level. The position in the US is in a particular state of flux at the moment, and so we have decided to defer commenting on those changes until they are more settled.

As we go to press, the Basel Committee on Banking Supervision (BCBS) and the European Commission are engaged in important consultations on changes to the capital adequacy regime, the implementation of liquidity ratios and countercyclical buffers, and the application of leverage limits, which will have enormous consequences for the banking industry. Detailed proposals to reform the regulation of the hedge fund and insurance sectors are drawing closer to completion. It is important that industry professionals understand and engage with these processes because policies that do not take into account the commercial realities of the markets in which they operate could be disastrous, not only for the financial services industry but for the wider economy.

Jean-Laurent Bonnafé, the chief executive of BNP Paribas Fortis, has warned that ‘the full application of the rules proposed… by the regulators will reduce GDP by five or six percentage points over three years. Put another way, it is the equivalent of the loss of 1.5 per cent per annum growth for three years, with all of the consequences which that implies for employment’.

Christine Lagarde, the French finance minister, voiced a similar view: ‘I understand the regulators of the Basel Committee, who want to prevent such a crisis from recurring, but their recommendations on liquidity and capital are severe and taken together, risk seriously threatening the financing of the economy’.

This update should be read in conjunction with The bank of the future, a report published by Freshfields Bruckhaus Deringer that describes the regulatory debate on a number of key areas affecting the banking industry and states the position as at November 2009. The full report and related client guides and briefings can be obtained from the following website: www.freshfields.com/microsites/bankofthefuture/?id=bouverie (if prompted for one, the password is ‘bouverie’).

The bank of the future: an update 5

Capital

Introduction The bank of the future highlighted the range of measures proposed to increase the capital strength of banks. Since then, more detailed proposals have emerged to implement those measures, most notably those published by the Basel Committee on Banking Supervision (BCBS) in the BCBS December 2009 Consultative Document, and by the European Commission in February 2010 in a working document setting out further possible changes to the Capital Requirements Directive (CRD), referred to as ‘CRD IV’. These contain nothing that is radically new, and largely flesh out in more detail the general policy direction that had already been articulated.

Changes at global level The proposed amendments to Basel II in the BCBS December 2009 Consultative Document have a much wider scope than those published in July 2009, which focused on the capital treatment of the trading book and complex securitisation exposures, as well as raising the standards for Pillar II processes and Pillar III disclosures. The main proposals, which elaborate on policy statements by the BCBS’s oversight body, are summarised below.

Raising the quality, consistency and transparency of the capital base The focus here is on increasing the overall amount of capital, and increasing the proportion of capital taking the form of common equity and retained earnings. Regulatory adjustments and filters (such as deduction of goodwill) will in future be applied at the common equity level, so as to reduce Core Tier 1 capital – at present some jurisdictions allow deduction from total Tier 1 capital or from a combination of Tier 1 and Tier 2 capital.

Common equity and retained earnings must in future be the ‘predominant’ form of capital (but see ‘Accounting’ on page 12 for the proposals contained in CRD IV to adjust earnings to exclude certain gains and losses). The only other permissible components of Tier 1 will be instruments that are subordinated, have fully discretionary non-cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. Innovative hybrid capital instruments with an incentive to redeem through features such as step-up clauses, currently limited to 15 per cent of the Tier 1 capital base, will be phased out of Tier 1. The requirements for Tier 2 capital will be clarified, there will no longer be a distinction between upper and lower Tier 2, and the concept of Tier 3 capital will be abolished. In this context, the BCBS is also reviewing the role of contingent and convertible capital instruments. The intention is to introduce these changes in a way that is not disruptive to capital instruments already in issue, but it is not yet clear exactly what the transitional and grandfathering arrangements will be.

Enhancing risk coverage A number of changes are being made to strengthen the capital requirements relating to counterparty risk arising from banks’ derivatives and securities financing activities (see ‘Derivatives’ on page 30). In particular:

„„ counterparty credit risk will need to be assessed using stressed inputs, and there will be a capital charge for mark-to-market losses due to counterparty credit deterioration (in addition to outright counterparty defaults); 6 Freshfields Bruckhaus Deringer LLP

„„ more exacting standards are being imposed in respect of collateral management for derivatives exposures;

„„ higher capital requirements for bilateral over-the-counter (OTC) derivatives exposures, coupled with a zero risk weight for exposures to central clearing counterparties, will incentivise greater use of central clearing;

„„ risk weights for exposures to financial institutions will be raised (reflecting the closer correlation between exposures to the financial sector compared with exposures to the non-financial sector); and

„„ standards are being raised for the treatment of ‘wrong way risk’ – ie situations where exposure increases when the counterparty’s credit deteriorates. Further guidance is to be introduced for back-testing of counterparty credit exposures.

Some preliminary steps have been taken to reduce the reliance of the Basel II framework on external credit ratings. The BCBS is also undertaking a fundamental review of the use of external ratings in the treatment of securitisations and the standardised approach to credit risk assessment.

Leverage ratio A non-risk-adjusted leverage ratio is being introduced as a supplement to Pillar I risk-based capital requirements. The aim is to put a cap on the build-up of leverage in the banking system, and also to guard against model error and other forms of mis-assessment of risk inherent in any ‘risk‑based’ system.

The leverage ratio will include some off-balance-sheet exposures in full, will give no credit for collateral, netting and other risk mitigation, and will be adjusted to take account of differences between accounting standards (eg differences between International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP) in the treatment of netting of derivatives and repos). The particular impact on derivatives is discussed in ‘Derivatives’ on page 30.

Mitigating pro-cyclicality; capital buffers The BCBS is proposing various measures designed to mitigate banks’ tendency to behave in a pro-cyclical manner, and to amend aspects of the current regulatory regime that may amplify that tendency. Specifically, the BCBS is intending to:

„„ dampen any excess cyclicality of the minimum capital requirement. The BCBS is assessing whether the existing regulatory treatment of credit risk is too pro-cyclical and whether changes are needed to the way in which the probability of default (PD) is determined, so as to avoid a repeat of the situation in the period leading up to August 2007, when models were showing very low PD at a time when huge risks were building within the system. In particular, it is conducting impact assessments on two particular PD alternatives for any given class of exposures: using the highest average PD estimate used by a bank historically for that class of exposures as a proxy for downturn PD; and using an average of historic PD estimates for that exposure class; The bank of the future: an update 7

„„ promote more forward-looking provisioning for losses. The BCBS supports the acceptance by the International Accounting Standards Board (IASB) of the need, in relation to banks, to move to an ‘expected loss’ provisioning model approach (as opposed to the current ‘incurred loss’ approach). It is also amending supervisory guidance to be consistent with an expected loss approach and providing incentives for stronger provisioning in the regulatory capital framework (eg by requiring a full deduction from Tier 1 capital of expected losses that have not been provided for). The BCBS’s oversight body stressed the importance of this issue and outlined a number of key objectives for a new provisioning approach in its January 2010 press release. It said that there will be recognition for approaches that promote the build-up of provisions when credit exposures are taken on in good times that can be used in a downturn. This is dealt with in more detail in ‘Accounting’ on page 12;

„„ conserve capital to build buffers at individual banks that can be used in periods of stress. To this end, the BCBS proposes to introduce a framework for restricting distributions of capital (whether in the form of dividends, share buy-backs or bonus payments) as a bank’s capital falls towards the regulatory minimum. The smaller the amount of excess capital, the stronger the distribution restrictions would be (unless the bank chooses instead to counterbalance distributions by raising new capital); and

„„ achieve the broader macro-prudential goal of protecting the banking sector from periods of excess credit growth. The main proposal here, which is at an early stage of development, is that the capital conservation buffers referred to above should be increased when there are signs that credit has grown to excessive levels.

Addressing systemic risk and interconnectedness The BCBS paper contains particular proposals relating to capital requirements for banks that are ‘too big to fail’. (See ‘Too big to fail’ on page 15.)

Impact assessment and calibration A major BCBS project is under way during the first half of 2010 to assess the likely impact of its proposals. The BCBS will consider the minimum overall capital ratio, as well as the minimum levels of Core Tier 1 and total Tier 1, in the light of this assessment, with a view to formulating fully calibrated proposals by the end of the year. These would then be phased in as economic conditions improve, with the aim of full implementation by the end of 2012. Grandfathering and transitional arrangements will also be considered as part of this process.

Changes at EU level The proposals published by the Commission in CRD IV are closely aligned with the BCBS proposals referred to above.

Capital ratios and the definition of capital The Commission intends to introduce higher minimum ratios of Core Tier 1, Tier 1 and total capital to risk-weighted assets. The new ratios will be determined by means of impact assessment and calibration work. 8 Freshfields Bruckhaus Deringer LLP

Various changes to the definition of capital have already been made by CRD II, adopted in 2009, and are due to come into force from 31 December 2010. This harmonises the treatment of hybrid capital instruments at EU level (belatedly implementing the BCBS’s 1998 ‘Sydney Press Release’). The Committee of European Banking Supervisors (CEBS) has subsequently published guidance on these new provisions, as well as a consultation paper on Core Tier 1 instruments, with the intention that this new guidance should also take effect from 31 December 2010.

In line with the BCBS’s proposals, the Commission is now proposing to eliminate dated and hybrid instruments altogether from Tier 1. The Commission is still considering how to ensure that other non-Core Tier1 instruments can be relied on to be loss-absorbing in a going concern situation: it is consulting on a mandatory write-down or conversion feature with a pre-specified objective trigger (eg a fall in a capital ratio to a particular level). The Commission is also considering restrictions on issuer call options and buy-backs for these instruments.

The rules governing Tier 2 capital are to be changed to do away with the distinction between upper and lower Tier 2 capital. The Commission is also considering whether to do anything to prevent the combination of an issuer call option and the five-year amortisation period (for regulatory capital purposes) resulting in redemptions before the start of the amortisation period. It is also thinking about a mandatory lock-in clause that would enable the bank or supervisor to prevent redemptions in times of stress.

In line with the BCBS proposals, the prudential filters and deductions (eg of goodwill) are to be made at Core Tier 1 level. The concept of Tier 3 capital is to be abolished.

Besides the potential role of a mandatory write-down or conversion feature in non-Core Tier 1 capital instruments (referred to above), the Commission is also considering the potential role of contingent capital at the Tier 2 level and in meeting capital buffer requirements.

The Commission is considering changing the basis on which large exposures are recognised, and the large exposure limits, so that they are calculated by reference to Tier 1 capital rather than total capital (as at present). There is a recognition that the current 10 per cent and 25 per cent large exposure thresholds might need to be reviewed if this change were made.

Consistent with the BCBS’s programme, the Commission intends to phase in the CRD IV rules, with the aim of full implementation by the end of 2012. There is little clarity at present on what transitional or grandfathering arrangements might be made.

Leverage ratio The Commission’s proposals for a non-risk-adjusted leverage ratio are similar to those of the BCBS, referred to above.

Counterparty credit risk The counterparty credit risk proposals are also very similar to those of the BCBS. The bank of the future: an update 9

Countercyclical measures The Commission is looking at the tendency of risk-based capital requirements to be pro-cyclical, and two possible countercyclical measures to address this: through-the-cycle provisioning for expected credit losses; and capital buffers.

The debate about the most appropriate basis for banks to make provisions for expected credit losses continues. The Commission believes that provisioning should be countercyclical and should be based on existing Basel II internal ratings-based (IRB) approaches to the maximum extent possible. A technical group established by the Commission is now focusing on the extent to which the form of expected loss provisioning on which the IASB is currently holding a consultation (referred to as ‘expected cash flow’) meets the objective of being countercylical, as well as approaches that apply ‘through the cycle’. (The IASB has said that through-the-cycle or dynamic provisioning will not be permissible under their proposed provisioning method, seeming to rule out the Spanish model on which the Commission consulted in 2009.)

The Commission’s proposals for capital buffers contain the same two elements as those of the BCBS, namely a capital conservation framework to constrain capital distributions in good times, and a specifically countercyclical element that would increase the size of the capital buffer by reference to a macro variable such as credit growth.

Single rulebook The Commission reports that its 2009 consultation on limiting national options and discretions under the CRD met with strong support. However, some respondents believed it was important that national supervisors retained the ability to impose stricter national standards in the interests of financial stability. The Commission is now seeking evidence on how far that is really necessary and how far supervisory concerns can be addressed under the Pillar II process instead. Work is continuing on further harmonisation of the treatment of real estate lending.

Changes in the UK In December 2009, the Financial Services Authority (FSA) published a consultation paper on UK implementation of CRD II (referred to above) and CRD III (dealing with capital requirements for the trading book and resecuritisation). The FSA is again adopting an ‘intelligent copy-out’ approach to implementation with few proposed instances of ‘super-equivalence’. An FSA policy statement setting out the FSA’s approach on these issues is expected in the third quarter of 2010. The FSA also anticipates issuing a further consultation paper on strengthening capital standards in the third or fourth quarter of 2010.

The FSA also consulted in December 2009 on clarification of its approach to capital planning buffers under Pillar II. The industry is urging the FSA not to pursue this until the international approach has become clearer. 10 Freshfields Bruckhaus Deringer LLP

Liquidity

Introduction In The bank of the future, we noted that there is increasing international agreement on the appropriate framework for regulating bank liquidity. This covers both the qualitative elements (such as systems and controls) and the more specific quantitative elements (the ratios and other tests that are to be used to ensure that banks maintain appropriate liquidity buffers and prudent funding profiles).

Since then, more detailed proposals have emerged at both global and EU level, focusing mainly on quantitative elements and, in particular, the means of establishing liquidity buffers, the maintenance of a prudent funding profile and the metrics for monitoring a bank’s liquidity position.

These changes and other key developments affecting liquidity regulation are summarised below.

Changes at global level The BCBS December 2009 Consultative Document proposes measures to improve the resilience of banks to liquidity stresses and increase international harmonisation of liquidity risk supervision. The proposals include:

„„ a requirement for banks to maintain a minimum liquidity coverage ratio, which essentially requires that the bank maintains a stock of high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon, under an acute liquidity stress test scenario specified by supervisors. The eligibility criteria to determine what will count as ‘high-quality liquid assets’ are still under consideration. Cash, reserves held with central banks and certain high-quality sovereign debt will qualify but the Commission is still considering whether to permit a proportion of creditworthy corporate bonds and other assets (subject to haircuts) within this category;

„„ the introduction of a ‘net stable funding ratio’, with the effect of requiring banks to fund their activities over a one-year time horizon with a minimum acceptable amount of stable funding. The net stable funding ratio will be sensitive to the liquidity characteristics of assets held by the bank and the ‘stickiness’ or otherwise of its liabilities; and

„„ proposed monitoring metrics (looking at contractual maturity mismatches, concentration of funding, available unencumbered assets and employing market-related monitoring tools) that are aimed at capturing specific information related to a bank’s cash flows, balance sheet structure, available unencumbered collateral and certain market indicators. These metrics will have to be applied on an ongoing basis and calculated and reported at least monthly.

The consultation period closes on 16 April 2010, with final proposals to be agreed by the end of 2010 and implemented from 1 January 2013. The bank of the future: an update 11

Changes at EU level CRD II contained amendments to those elements of the CRD dealing with qualitative aspects of liquidity risk management that are due to take effect from 1 January 2011. CEBS published some guidelines on liquidity buffers in December 2009 that address certain quantitative issues. These guidelines are due to take effect from June 2010, although they will eventually be superseded by CRD IV, when implemented.

The Commission’s CRD IV proposals were published in February 2010 and it is no coincidence that the proposals relating to liquidity are closely aligned to those of the BCBS, including provision for a liquidity coverage ratio and net stable funding ratio on very similar terms, and a set of monitoring metrics that are identical to those proposed by the BCBS.

CEBS acknowledges that any harmonised approach to liquidity buffers at EU level will need to take account of the specific local characteristics of certain categories of retail deposits as components of the bank’s funding.

The new requirements are proposed to apply at the level of legal entities within European groups so long as constraints on the transferability of assets, mutual support commitments and central liquidity risk management within groups continue to apply.

CEBS guidelines on liquidity cost allocation The CRD II enhancements to the liquidity risk management requirements of the CRD include a requirement that a bank should have adequate mechanisms for allocating liquidity costs, benefits and risks among its business lines and group entities. The objective is to create appropriate incentives for business lines to manage and mitigate these risks. In March 2010, CEBS published guidelines on mechanisms for making these allocations.

Branch liquidity CEBS also recommends that responsibility for branch liquidity of banks with significant branches or cross-border services in another member state should lie with the home state regulator, ‘in close collaboration with the competent authorities of the host member states’ and provided a harmonised set of liquidity rules is in place. This would be a very significant change to the current division of supervisory responsibilities and is indicative of the Commission’s attempts to strengthen the European single market further in the face of strong national pressures for greater host state powers.

Changes in the UK Although the UK’s new liquidity rules, published in October 2009, predated the international and EU developments referred to above, the FSA does not appear to think that any changes are needed to the UK rules. In its liquidity FAQs published in March 2010, it stated that the UK bank liquidity regime ‘is flexible enough to incorporate emerging international standards’, although ‘where necessary, this will be subject to consultation’. It has also confirmed that it will not be increasing its quantitative liquidity requirements in the immediate future; it will consider the matter further later in the year with a view to making a further announcement in the fourth quarter of 2010. 12 Freshfields Bruckhaus Deringer LLP

Accounting

Introduction Although it seems clear that accounting standards were not the root cause of the financial crisis, the financial crisis exposed weaknesses in accounting standards and their application. These shortcomings were sufficiently important to attract the attention of political leaders, prompting considerable discussion and debate. This led to calls for rapid progress towards internationally harmonised accounting standards, a reassessment of the appropriate limits of the scope and application of ‘fair value’ accounting, and significant changes in the rules relating to consolidation, derecognition and loss provisioning.

Changes at global and EU level Much of the discussion in The bank of the future concerned the need for international convergence of accounting standards and the appropriate application of fair value accounting. In those areas, the IASB and Financial Accounting Standards Board (FASB) continue to make progress with proposed changes to accounting standards for financial instruments.

Much of the immediate focus is directed to the question whether accounting standards should be adjusted for banks, to reflect the concerns of prudential regulators about pro-cyclicality. Any answer to this question is bound to challenge the widely held view – referred to in a recent interview with Lord Turner, the chairman of the FSA (Banks are different: should accounting reflect that fact?, Financial Times, 21 January 2010) – that accounting standards are ‘designed to reflect today’s already observable facts – and to limit the role of judgement as to future possible events’. Prudential regulators and central banks take the opposing view. They say that because accounting standards were among the factors contributing to the crisis, inducing pro- cyclicality in credit provision and pricing, they must now be adjusted to reflect those concerns and become, in some respects, forward looking.

The IASB has, to some degree, acknowledged that accounting standards must reflect the concerns of prudential regulators. The FASB, on the other hand, has advocated a more ‘traditional’ approach to accounting standards, ie that ‘accounts are for investors only’. And indeed there are respects in which this approach is acknowledged by the Commission in proposals contained in CRD IV, which would override the accounting treatment by adjusting the earnings that can be taken into account in calculating a bank’s Core Tier 1 capital to exclude gains and losses resulting from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk. This divergence in approach, coupled with the increased politicisation of the accounting standard-setting debate, will impede attempts to achieve convergence of international accounting standards by June 2011. The IASB’s oversight board recently recognised this, seeking to ‘emphasise that convergence is a strategy aimed at promoting and facilitating the adoption of IFRS, but it is not an objective by itself’. The bank of the future: an update 13

In The bank of the future, we noted that accounting rules on provisioning were in the process of being reviewed by the IASB, with a view to enabling banks to make provision for expected losses instead of having to wait for losses to be ‘incurred’. The ‘incurred loss’ approach assumes that loans are fully recoverable until the occurrence of an impairment indicator or triggering event, and results in loan loss provisions that vary markedly during the cycle. Its application meant that banks were able to record profits from loans they knew would in all probability turn bad. When economic times were good, loss expectations would be low. In a downturn, loss expectations would naturally rise – the effect of which is to exacerbate boom and bust cycles where appropriate provision has not been made against earlier income.

Shortly after The bank of the future went to press, the IASB published an Exposure Draft on the amortised cost measurement and impairment of financial instruments, which is intended to address these issues.

In the Exposure Draft, the IASB proposes an ‘expected cash flow’ approach, whereby credit losses would be recognised at an earlier stage by the reporting of more forward-looking information than is currently the case. This approach would report losses expected throughout the life of a financial asset that is measured at amortised cost. Proponents of the new approach argue that it avoids the inherent mismatch brought about by the incurred loss model, which front-loads interest revenue and recognises an impairment loss only after a loss event has been identified.

In principle, the new approach has some merit, but the devil will be in the detail, given the sensitivity associated with the quantification of losses generally – not just ‘expected losses’. Lord Turner has suggested that the new proposal could actually be more pro-cyclical than before, particularly if expected losses are calculated by reference to current market expectations of future losses. Also, if expected losses are calculated by reference to market prices or quoted spreads, then we may be teetering on the edge of applying a mark-to-market evaluation to what is a banking book asset, potentially increasing rather than reducing pro-cyclicality. On the other hand, if (as prudential regulators might generally prefer) the calculation of expected loss is based on a judgement about possible future losses, informed by historical experience, trends or by formulae that link provisions to broad indicators of likely future credit problems (such as the pace of credit growth on which the Spanish dynamic provisioning approach is based), there will inevitably be some concern as to whether such judgements (by the regulator or otherwise) are properly based on fact and transparent.

As KPMG’s Colin Martin has noted, ‘the judgments involved in predicting expected losses will be hugely subjective’. Sir David Tweedie, Chairman of the IASB, is acutely aware of the pitfalls in applying an expected loss approach and said, when releasing the Exposure Draft in November 2009, ‘the challenges in applying an expected loss approach should not be underestimated… for this reason the IASB will tread carefully’. 14 Freshfields Bruckhaus Deringer LLP

Across the Atlantic, the FASB is considering a modified version of the expected loss model proposed by the IASB, but has not, as yet, presented its own final proposals. The FASB’s model is based on the calculation of losses that are reasonably expected to occur in the foreseeable future, based on currently known conditions. Commentators have predicted that the FASB’s proposal will recognise losses sooner than under the current incurred loss approach, but not as soon as using the IASB’s expected loss approach.

The expected loss model, if implemented, should go some way in addressing the pre-financial crisis behavioural implications arising from unrealistically high declared profits. It should also provide investors with a more realistic picture of underlying profit, which is another step in the right direction. The bank of the future: an update 15

‘Too big to fail’

Introduction The debate over what to do about banks that are perceived to be too big (or too interconnected or systemically important for other reasons) to be allowed to fail is still continuing and there is little clarity as to where it will end up. Paul Volcker’s proposals, announced in January 2010, to prevent commercial banks from owning, investing in or sponsoring hedge funds and private equity funds, and from engaging in proprietary trading operations unrelated to serving their customers, are widely seen as having changed the terms of the debate globally.

Changes at global level The BCBS December 2009 Consultative Document was largely concerned with strengthening capital and liquidity rules for banks generally. The specific proposal to increase the capital requirements for exposures of other banks to large financial institutions (by increasing the asset value correlations for such exposures, under the IRB approach to banking book capital calculations) will have an impact on those larger institutions, including in terms of increased cost of funds. But the BCBS clearly envisages going further for systemically important banks. In particular, it is considering imposing capital and liquidity surcharges for these banks, as well as using ‘other supervisory tools’. The BCBS has said that it will review specific proposals on this issue in the first half of 2010.

The Standing Committee on Regulatory and Supervisory Cooperation of the Financial Stability Board (FSB) is also looking at how to deal with large systemically important institutions, with a view to making recommendations in time for the G20 summit in Seoul in November 2010. Besides considering a capital surcharge for these banks, the FSB is also considering:

„„ using resolution and recovery plans to encourage banks to structure themselves into separable legal entities, whether by geography (separate national subsidiaries) or by function (separate subsidiaries for deposit- taking and trading activities); and

„„ restrictions on the breadth of activities that different types of banks can perform.

Developments concerning resolution arrangements for internationally active banks are considered elsewhere (see ‘Resolution arrangements’ on page 17).

Changes at EU level Like the BCBS and the FSB, the Commission is still considering what to do about systemically important banks (and other systemically important institutions), over and above its proposals in CRD IV for strengthening capital and liquidity rules generally. Specifically, it is considering the nature and potential effect of possible restrictions on the scope of permissible activities for banks. The Commission appears to have ruled out size restrictions, saying that applying a size limit without regard to whether the particular bank has and is abusing a dominant market position would not be consistent with the EU approach. 16 Freshfields Bruckhaus Deringer LLP

Changes in the UK The debate has continued in the UK, although without reaching any clear conclusions so far. An important step has been the launch of an inquiry into this subject by the House of Commons Treasury Select Committee, which has been taking evidence since January 2010.

The government continues to support proposals for stronger capital requirements for banks, and the Financial Services Bill currently going through parliament would oblige the FSA to make rules requiring financial institutions to create and maintain recovery and resolution plans that can be activated if they become financially vulnerable. There is little indication that the government has any enthusiasm for structural reforms such as restrictions on banks’ permitted activities.

The Bank of England continues to press for an open and wide-ranging debate. The governor favours a ‘three-legged stool’ approach to the problem, consisting of: reform of capital and liquidity requirements; improved resolution arrangements (of which the special resolution regime under the Banking Act 2009, and recovery and resolution plans, both form part); and structure. He believes that many structural issues need to be considered – the purpose is to create firewalls so that if (as is inevitable) banks do fail, they will not risk bringing down the rest of the system. One possible means of implementing this is to require international banks to operate through local subsidiaries (rather than branches) – the governor seems to believe that host state regulators will have little alternative but to adopt this type of solution. Another is restricting permissible bank activities, of which the Volcker proposals are an example.

Lord Turner, the chairman of the FSA, also believes that the narrow banking debate is important, but appears to place more stress on increased capital requirements for trading activities than on structural solutions. In particular, he has said that limiting banks’ involvement in proprietary trading activities is more likely to be achieved by radical reform of the trading book capital regime than by legislative distinctions. The bank of the future: an update 17

Resolution arrangements

Introduction In The bank of the future, we mentioned that the Cross-border Bank Resolution Group of the BCBS had published in September 2009, for consultation, a report that included recommendations for authorities on effective crisis management and resolution processes for large cross-border institutions. In March 2010, the BCBS released its final version of this report. However, no material changes have been made to the report in the interim period.

Changes at EU level We also noted that, in October 2009, the Commission had published a communication on an EU framework for crisis management in the banking sector that considered early intervention, resolution arrangements and insolvency. No further proposals have been made by the Commission to date. Recent discussions at EU level show that the topic of cross-border crisis management in the banking sector is still very much at the forefront of the collective EU consciousness, although a universal solution has yet to be reached.

Changes in the UK The resolution regime set out in the Banking Act 2009 and described in The bank of the future, applies in respect of deposit-taking institutions with the effect that investment firms that are commonly referred to as ‘banks’ or ‘investment banks’ but that are not deposit takers, fall outside the provisions of the Act and are subject instead to the regime for ordinary commercial companies. For example, Lehman Brothers International (Europe) was not a deposit taker and therefore the Act, had it been in force at the time, would not have applied to it. The failure of an investment bank brings with it its own specific and complex problems, for which the standard insolvency regime is ill-equipped. For example, investment banks are likely to hold money and assets on trust for clients and also as collateral in addition to their own proprietary assets, making it difficult to work out the precise ownership status of the assets. There are also potential difficulties in establishing final positions given the complex financing arrangements entered into by investment banks. The UK government has therefore proposed, in a consultation paper published in December 2009, to put in place a resolution regime applicable to certain types of non-deposit-taking investment firms (broadly those that hold client assets and deal in investments as principal and agent). It is not, however, clear at this stage how the regime would apply to deposit-taking investment banks that also fall within the scope of the Banking Act 2009.

The proposals include:

„„ special administrative regime: this would comprise special objectives for administrators to follow, with a view to prioritising the return of client money and assets; ensuring continuity of services; engaging with market infrastructure bodies and the authorities; and winding up the investment bank in the best interests of creditors as a whole. The government is also considering introducing a special defence for administrators, or 18 Freshfields Bruckhaus Deringer LLP

barring actions by creditors in certain circumstances, to seek to address administrators’ concerns about incurring personal liability when returning assets to creditors;

„„ management for failure: the government has proposed a number of measures to be implemented by investment banks to prepare for their own resolution and to assist administrators. These include designating an individual at board level to have responsibility for any potential resolution process; drawing up recovery and resolution plans (effectively, practical plans for recovery of the bank and any winding down); producing business information packs to enable administrators quickly to understand the bank and its business; and putting in place arrangements with key employees and suppliers to ensure continuity of service during an administration;

„„ distribution of client assets and money: the government is currently considering requiring risk warnings to be included in client agreements that provide for rights of rehypothecation or for assets to be held in omnibus client accounts. Requirements to make daily reports to clients on the status and location of client money and assets are also being considered, as well as the removal of the custodian’s right of lien and set-off in respect of client accounts. The establishment of bankruptcy- remote special-purpose vehicles to hold client assets separately from the investment bank has also been suggested. A proposal has also been made that any shortfalls in client omnibus accounts should be shared between clients pro rata, to increase certainty regardless of whether particular clients can trace their own assets in the account; and

„„ unsettled trades: the government is considering extending protections to multilateral trading facilities, similar to those in the Companies Act 1989 allowing certain exchange and clearing house rules to take precedence over the application of insolvency rules, as well as allowing unsettled trades in the CREST settlement system to be frozen permanently so that they would never settle.

Implications

„„ Although the government has said that it is not seeking to undermine the fundamental commerciality of client documentation, the proposed requirement to include risk warnings is likely to alter the relationship between investment banks and clients. Investment banking clients generally have access to sophisticated legal advice and should be well aware of the issues surrounding rehypothecation and omnibus accounts. An obligation on an investment bank to warn a client of the implications of such arrangements could potentially increase the investment bank’s liability to its clients, as well as affect its negotiating position. It also appears to suggest a move towards increasing product regulation.

„„ Removal of the custodian’s right to a lien over custody assets and to set off accounts may lead to increased costs for investment banks and for custody clients as the custodian seeks to protect itself against its increased risk exposure. The bank of the future: an update 19

„„ A number of the proposals will increase the administrative burden for investment banks, with accompanying cost implications, such as the proposed requirement to establish recovery and resolution plans and business information packs as well as the client reporting requirements.

„„ The proposals in respect of omnibus accounts mean that clients are more likely to seek to have their assets held in a segregated client account, which will increase the administrative burden for investment banks and make the provision of custody services and the holding of client assets potentially more expensive.

„„ Any requirement to ensure that key employees and suppliers will continue to provide their services during an administration will almost certainly require investment banks to renegotiate existing employment and supply contracts. In addition, banks will need to maintain a ring-fenced operational reserve to enable those employees and suppliers to continue to be remunerated. 20 Freshfields Bruckhaus Deringer LLP

Cross-border issues

Introduction Progress on the development of cross-border structures and institutions has continued. Inevitably, where international co-operation, and particularly the delegation of national autonomy, is required progress is often slow. Indeed, it is clear from some developments, notably the Volcker proposals, that countries will pursue domestic regulatory reform independently of the global agenda. Moreover, as the focus moves to the development and implementation of detailed rules, the role of some supranational bodies, such as the G20, has shifted to oversight and monitoring of developments and away from agenda-setting.

Changes at global level The FSB has continued its work on the establishment and monitoring of international standards: it has established an Implementation Monitoring Network to monitor national implementation of the G20 and FSB recommendations, to highlight cross-country differences and to propose policy changes to address them.

In January 2010, the FSB published its Framework for Strengthening Adherence to International Standards, which sets out the framework the FSB employs for monitoring compliance by its members with international standards, including peer review of members’ compliance. The Framework also describes the steps the FSB proposes to take to promote global adherence to those standards.

Of particular concern to the FSB is the adherence of countries to international co-operation and information exchange standards in the financial regulatory and supervisory area (these standards include the BCBS Core Principles for Effective Banking Supervision). In March 2010, it launched an initiative to encourage the adherence of all countries to international standards of co‑operation and information exchange, by identifying non-compliant countries and helping them to improve their adherence.

Changes at EU level The Commission’s proposals to establish a European Systemic Risk Board and European Supervisory Authorities (ESAs) are currently progressing through the first stage of the EU legislative process.

The European Parliament (EP) is in the process of producing its report on the proposals for the ESAs. The report on the proposed EU Banking Supervisory Authority is due to be adopted by the Committee on Economic and Monetary Affairs in May 2010, and debated in a plenary session of the EP in June 2010.

The current draft report on the EU Banking Authority contains a large number of amendments that strengthen the original proposals in relation to the power of the EU Banking Authority (and also the EP), in particular:

„„ the EP wants the Authority to have responsibility for directly supervising banks with an EU dimension, in which case national supervisors will act as the agents of the Authority (it is not clear what the criteria will be for determining whether a bank has an ‘EU dimension’); The bank of the future: an update 21

„„ the EP wants the Authority, rather than the Commission, to have the power to determine whether an emergency situation has arisen, as a result of which the Authority could exercise emergency powers to direct national regulators; and

„„ the EP amendments also provide for the establishment of an EU-wide deposit protection scheme, the European Financial Protection Fund, for banks with an EU dimension, that would cover such banks in place of national deposit schemes.

Given the likely level of opposition among some member states to enhanced supervisory powers for the ESAs, it is probably unlikely that the EP’s amendments will survive into the final text of legislation.

Changes in the UK The UK has continued to participate in developments at a global and European level, while at the same time the debate about the regulatory structure in the UK is still very much a live issue. However, in a recent speech, Hector Sants, the chief executive of the FSA, delivered an interesting comment on the possible future for any UK regulator, whether the FSA or otherwise, highlighting the potentially diminishing importance of the UK regulatory structure in light of the developments at the EU level: ‘Furthermore, the extent to which any regulatory structure in the UK in practice will have any meaningful discretion looks to be highly problematic. The new European regulatory structure will mean that in future policy and rules will be determined in Europe, and the FSA, or any successor organisation, will be a locally-based supervisor delivering European rules’. 22 Freshfields Bruckhaus Deringer LLP

Corporate governance

Introduction The various regulatory work streams on corporate governance identified in The bank of the future have continued to clarify what is expected of firms and their shareholders in this area. At the global level, the new Organisation for Economic Co-operation and Development (OECD) and BCBS papers referred to below are important for those jurisdictions that do not already have governance codes incorporating those recommendations. Little new has emerged from the EU, while in the UK the FSA continues to clarify its expectations, and the Financial Reporting Council is consulting on the Stewardship Code for institutional shareholders.

Changes at global level In February 2010, the OECD Steering Group on Corporate Governance published the third in a series of reports on corporate governance in light of the financial crisis. This third report contains a set of comments and emerging good practices (complementary to the OECD Principles referred to in The bank of the future) that could help companies and regulators overcome the identified weaknesses in corporate governance. Besides governance of remuneration (see ‘Remuneration’ on page 24), the report covers three other main areas: governance of risk management; improving board practices; and the exercise of shareholder rights.

This was followed in March 2010 by the BCBS’s publication for consultation of revised principles for bank corporate governance, designed to address deficiencies that became apparent during the crisis. The principles cover:

„„ the role of the board, which includes approving and overseeing the implementation of the bank’s risk strategy, taking account of the bank’s long-term financial interests and safety;

„„ the board’s qualifications – for example, the board should have adequate knowledge and experience relevant to each of the material financial activities the bank intends to pursue to enable effective governance and oversight of the bank;

„„ the importance of an independent risk management function, including a chief risk officer or equivalent with sufficient authority, stature, independence, resources and access to the board;

„„ the need to identify, monitor and manage risks on an ongoing firmwide and individual entity basis. This should be based on risk management systems and internal control infrastructures that are appropriate for the external risk landscape and the bank’s risk profile; and

„„ the board’s active oversight of the bank’s compensation system design and operation, including careful alignment of employee compensation with prudent risk-taking, consistent with the FSB’s principles. The bank of the future: an update 23

Changes in the UK The final version of the Walker Review was published in November 2009. A number of relatively minor changes were made from the preliminary version. The scope of several of the recommendations was amended so that they apply only to a narrower range of larger banks. Some aspects of the shareholder engagement proposals were also amended, in part to reflect a recognition that not all fund managers have an investment style for which active stewardship is relevant. The recommendation to split the Combined Code into separate codes dealing respectively with the internal operations of companies and the responsibilities of shareholders has remained, but the latter is now being called the ‘Stewardship Code’.

The Financial Reporting Council has agreed to take responsibility for the Stewardship Code, subject to ensuring that such a code can be operated effectively. It launched a consultation in January 2010 on the policy objectives for the Stewardship Code, and on whether the Code on the Responsibilities of Institutional Investors, published by the Institutional Shareholders Committee in November 2009, is a suitable basis for it. It is also seeking views on which categories of institutional investors and asset managers should be encouraged to adopt the Stewardship Code and how this might best be done.

The FSA is intensifying the way it reviews governance of regulated firms as part of its ongoing supervisory activities, and has said (in a consultation paper published in January 2010) that it will consider the following in particular:

„„ the practical effectiveness of board, management and organisational structures including shareholder relationships, particularly looking for evidence of depth of understanding and effective discussion, challenge and risk-based decision making in practice;

„„ the formulation of strategy and determination of risk appetite, and the subsequent monitoring of performance against strategy/appetite, including the role of the key control functions;

„„ the quality of the reporting and analysis of management information and reporting to the board and evidence that it is understood and gives rise to feedback and actions; and

„„ the key factors, such as incentives and culture, that support and enable robust governance, building on the work already taking place to verify compliance with the FSA’s new code of remuneration practice.

The consultation paper also contains more information on how the FSA is going about assessing the competence and capability of applicants for board‑level roles (or other ‘significant influence functions’) in regulated firms. 24 Freshfields Bruckhaus Deringer LLP

Remuneration

Introduction Remuneration in the financial sector remains firmly in the spotlight. The effective oversight of executive remuneration remains a key challenge, and remuneration practices need to be consistent with effective risk management and promote the long-term interests of the company.

Although we have seen a raft of national and international measures in this area since publication of The bank of the future, the overall ‘direction of travel’ has been fairly uniform.

Changes at global level In January 2010, the FSB launched a peer review of the global application of its April 2009 Principles for Sound Compensation Practices and its September 2009 Implementation Standards. The endorsement of the Principles and Standards by the G20 leaders acknowledged the need for a consistent international approach to reforming remuneration practices. In their Pittsburgh statement, the G20 leaders tasked the FSB ‘to monitor the implementation of FSB standards and propose additional measures as required by March 2010’.

The peer review will focus on the steps being taken or planned by FSB member jurisdictions to ensure effective implementation of the Principles and Standards, as well as progress to date in implementation by significant financial institutions. The initial review is to be completed during March 2010.

In February 2010, the OECD published a paper produced by its Steering Group on Corporate Governance, setting out conclusions and emerging good practices relating to corporate governance and the financial crisis. The paper states that the OECD Principles on Corporate Governance provide a good basis to address the concerns raised and that the OECD’s priority should be to support the implementation of agreed international and national corporate governance standards, including the OECD Principles. The paper recognises the need for improved governance of the remuneration process, recommending in particular the introduction of mechanisms that link remuneration and the long-term interests of the company, such as multi-year performance-based vesting conditions, deferral, clawback and risk adjustment.

Changes at EU level The EP announced in October 2009 that it had adopted a resolution on the agreement reached at the G20 Pittsburgh summit in September 2009. With regard to bonuses, the resolution calls on the Commission to ‘transpose quickly’ the G20’s commitments into EU legislation and urges the G20 ‘to give more teeth to their proposals in terms of… reforming compensation practices and to ensure a consistent approach by supervisors worldwide when it comes to sanctions’. The bank of the future: an update 25

In December 2009, the European Economic and Financial Affairs Council (ECOFIN) published its conclusions on financial stability arrangements and crisis management in the financial sector. ECOFIN stressed that public assistance and bank profits should be used to build up capital buffers, but not to increase bank dividends or compensation. ECOFIN called on member states and the financial sector to implement the FSB Principles as a matter of urgency.

Changes in the UK There have been some important UK developments since publication of The bank of the future, notably:

„„ the publication of the Financial Services Bill and draft regulations relating to executives’ remuneration reports;

„„ the implementation of a one-off bank payroll tax;

„„ the publication of the final recommendations of the Walker Review; and

„„ the Financial Reporting Council’s consultation on its review of the Combined Code.

The following paragraphs look at each of these in turn.

The Financial Services Bill The Bill contains important provisions on remuneration matters. First, it gives statutory weight to FSA powers on remuneration. Section 11 of the Financial Services Bill will, if enacted, insert a new section 139A into the Financial Services and Markets Act 2000. Section 139A will require the FSA to make rules requiring each authorised person (or each authorised person of a specified type) to have, and abide by, a remuneration policy that regulates the remuneration of specified officers, employees and ‘other persons’. The rules must require any remuneration policy to be consistent with the effective management of risks and the FSB Implementation Standards. The rules may also prohibit persons being remunerated in a specified way, and provide that a term of any agreement that breaches such a prohibition is void, and provide for recovery of any payment made under such a void term.

In anticipation of the Bill’s enactment, the government has published draft regulations relating to executives’ remuneration reports. These give effect to the disclosure regime recommended in the Walker Review. Walker recommended banded (not named) disclosure of aggregate remuneration by reference to ‘total expected value’ of high-end employees (ie those who perform a significant influence function or whose activities have ‘a material impact on the risk profile of the entity’ in line with the FSA Remuneration Code) on a statutory basis (not ‘comply or explain’). The draft regulations are somewhat tougher than Walker – notably having a £500,000 earnings threshold, rather than the £1m envisaged in Walker. They apply to ‘relevant banking institutions’ (ie those with 1,000 or more employees and balance sheet assets of more than £100bn or a member of a financial group with aggregate assets of £100bn) and their ‘relevant executives’ (ie those who are employed by a relevant banking institution whose aggregate remuneration is more than £500,000). 26 Freshfields Bruckhaus Deringer LLP

The table below illustrates what the aggregate remuneration disclosure might look like.

Relevant earnings band

Category 0.5m-£1.0m £1.0m-£1.5m £1.5m-£2.0m [Intermediate bands]1 £7.0m-£8.0m

Number of relevant executives in band 300 200 100 10

Salary, bonus, etc £x £x £x £x

Long-term incentives received/receivable £x £x £x £x

Options granted £x £x £x £x

Pension contributions £x £x £x £x

Total <£300m <£300m <£200m <£80m

1 The intermediate bands are: £2.0m-£2.5m; £2.5m-£3.0m; £3.0m-£3.5m; £3.5m-£4.0m; £4.0m-£4.5m; £4.5m-£5.0m; £5.0m-£6.0m; and thereafter in successive bands of £1.0m.

Bank payroll tax Bank payroll tax is a one-off 50 per cent tax, payable by ‘taxable companies’, on bonuses over £25,000 awarded to certain employees in the period from 9 December 2009 to 5 April 2010. The chancellor’s 2010 Budget confirmed that the bank payroll tax will not be extended beyond 5 April. The government’s stated aim in introducing the tax was to encourage banks to consider their capital position and make appropriate risk adjustments when setting bonus levels this year. It is a one-off measure designed to bridge the gap until banking remuneration practices are changed by other measures (eg the FSA Remuneration Code and the relevant provisions of the Financial Services Bill).

Walker Review The final recommendations of the Walker Review were published in November 2009 and are relevant in three main areas. First, there are recommendations relating to disclosure, but these are now largely reflected in the draft Executives’ Remuneration Report Regulations described above.

Second, there are recommendations on operation and coverage of financial institution remuneration committees that will result in a significantly increased workload:

„„ remuneration committees will be required to have some degree of responsibility for a wider population. Listed company remuneration committees have traditionally focused on executive director pay and largely left the rest to management. Following Walker, they will be required to oversee ‘remuneration policy and outcomes’ for high-end employees. In addition, for all employees, the committee must have a ‘sufficient understanding of the company’s approach to pay and employment conditions to ensure that it is adopting a coherent approach to remuneration’; The bank of the future: an update 27

„„ remuneration committees will need to get to grips with new pay structures, especially the relationship between pay and risk adjustment – whether by deferral of payment or the use of performance targets that price for risk by imputing a proper cost of capital in calculating the incentive. The relationship between the risk committee and the remuneration committee will need to be formalised; and

„„ remuneration committees will be required to articulate their work – both in terms of having a written remuneration policy and in dealing with the much tougher disclosure regime envisaged by the Walker Review and Executives’ Remuneration Report Regulations.

Third, the Walker Review recommends important changes to the structure of remuneration that are envisaged to be implemented in a revised version of the FSA Remuneration Code. Its recommendations envisage that:

„„ deferral should provide the primary means of risk adjustment, with at least half of variable pay awarded as a long-term incentive, vesting over three and five years;

„„ annual bonuses should be payable over three years, with only one third in the first year; and

„„ provision should be made for clawback in circumstances of misstatement and misconduct and that there should be greater use of retention mechanisms (eg maintenance of shareholding).

Review of the Combined Code In December 2009, the Financial Reporting Council published the final report on its 2009 review of the Combined Code (to be renamed the UK Corporate Governance Code) that applies to all listed companies. It contains a new ‘supporting principle’ requiring performance targets to be stretching, and designed to align executive interests with those of shareholders, and to promote the long-term success of the company. In addition, incentives should be compatible with risk policies and systems, and the criteria for paying bonuses should be risk-adjusted, provision should be made for clawback in circumstances of misstatement and misconduct, and payouts or grants under all incentive schemes (by implication, therefore, both annual and long-term) should be subject to challenging performance criteria reflecting the company’s objectives, including non-financial performance metrics (such as strategic performance). 28 Freshfields Bruckhaus Deringer LLP

Securitisation

Introduction In The bank of the future, we noted that although securitisation has been criticised as one of the causes of the financial crisis it is broadly recognised as a desirable funding tool that is in need of better regulation.

Reforms are being implemented in four key areas: first, originators and sponsors are being required to increase the transparency of asset-backed securities (ABS) by providing better disclosure on individual issues of securities and on their use of securitisation as a whole. Second, banks and other financial institution investors must carry out much more thorough due diligence of investments in ABS and demonstrate that they understand the risks implicit in those investments. Third, those investors must ensure that the interests of originators and investors are aligned by buying ABS only where the originator or sponsor has disclosed that it will retain a material net economic interest in the transaction. Fourth, regulatory capital charges against some ABS asset classes are to be significantly increased.

The thrust of the reforms remains unchanged and they are progressively being crystallised through detailed proposed regulations. The first three areas have already been addressed by the changes in the CRD contained in CRD II, and are described in The bank of the future. The fourth will be addressed by the changes to the CRD contained in CRD III. Those changes and other key developments affecting the securitisation industry are summarised below.

Changes at global level The BCBS has said that it is conducting a more fundamental review of the securitisation framework, in particular the reliance on external credit ratings, and this could lead to further significant changes to the regulatory capital regime.

Changes at EU level

The implementation of CRD III The proposed directive commonly known as CRD III will implement a number of changes in the European regulatory capital regime that have been included in Basel II since July 2009:

„„ regulatory capital charges for resecuritisation-type ABS (such as collateralised debt obligations (CDOs) of ABS) will increase (the lowest possible risk weighting for a resecuritisation will be 20 per cent compared with 7 per cent for standard ABS); and

„„ the regulatory capital treatment of ABS held in the banking book and the trading book will be equalised so that there is no longer any advantage in holding such assets in the trading book.

It is quite possible that when CRD III is debated by the EP there will be a renewed push for still more onerous measures, particularly on resecuritisations.

The Commission has expressed its intention to finalise CRD III by the end of this year, so as to apply to new securitisations from 1 January 2011. The bank of the future: an update 29

The implementation of CRD IV CRD IV does not deal directly with securitisation. However, ABS are singled out for individual treatment in a number of areas, which may have further implications for the securitisation industry. For example, it is proposed that, in determining the regulatory capital treatment of a collateralised transaction, collateral consisting of ABS will be treated less favourably for regulatory capital purposes than collateral consisting of other debt securities; and that collateral consisting of resecuritisation-type ABS will bring no regulatory capital benefit at all. This restriction on the value of ABS as collateral may affect their pricing going forward.

European securitisation industry Pillar III disclosure proposals In January 2010, four industry bodies, including the European Banking Federation and the Association for Financial Markets in Europe, published updated guidelines that give a detailed framework for how banks should disclose their involvement in securitisation transactions (for the purposes of Pillar III of the Basel II framework) in a range of capacities, including as originator, investor, liquidity provider or hedge counterparty.

CEBS has observed in relation to an earlier manifestation of these guidelines that ‘Banks that have followed the industry good practice guidelines as the basis for preparing the securitisation disclosures, have on the whole provided more comprehensive and understandable information’.

Tightening of European Central Bank (ECB) eligibility criteria One consequence of the financial crisis has been that, while the public securitisation markets have largely been closed, institutions have originated ABS on a ‘retained’ basis to use as collateral to obtain funding from central banks and government-backed programmes. The eligibility criteria for these programmes have become steadily more demanding as the crisis has receded (although in some cases criteria have initially been tightened and then relaxed again). For example, the ECB has changed its rules so that it now requires at least two credit ratings for all ABS issued on or after 1 March 2010. From 1 March 2011, the requirement to have at least two ratings will be applied to all ABS, regardless of their date of issue. Accordingly, any ABS with a single rating currently repo’d with the ECB will have to be refinanced or re-rated before 1 March 2011.

Changes in the UK

Proposed UK implementation of CRD II and III In December 2009, the FSA published a consultation paper setting out its proposed implementation of a number of directives, including CRD II and CRD III, even though the latter has not yet been finalised.

The FSA has employed an ‘intelligent copy out’ approach in relation to the EU legislation and as such the uncertainties contained in that legislation have not been clarified by the proposed implementing rules. However, they do give some guidance on the interpretation of certain provisions, such as the definition of resecuritisation and its application to asset-backed commercial paper conduits. 30 Freshfields Bruckhaus Deringer LLP

Derivatives

Introduction Since publication of The bank of the future, more flesh has been put on the bones of the proposed regulatory changes for derivatives, in particular the way in which additional capital will be required to deal with liquidity and counterparty credit risk, and the treatment of derivatives under the proposed leverage ratio.

Changes at global level The BCBS December 2009 Consultative Document proposed increasing the capital required to take into account various aspects of counterparty credit risk, liquidity ratios and a leverage ratio.

In addition, the derivatives industry has been active in promoting reforms, particularly on the operational side, and in relation to industry infrastructure, with a large number of initiatives completed and many under way (eg the ‘commitment letters’ published by the International Swaps and Derivatives Association, Inc (ISDA), such as the one sent in March 2010 to the president of the Federal Reserve and others setting out the industry’s reform objectives and achievements).

Changes at EU level CRD IV contains a significant number of proposals, including those relating to the maintenance of liquidity buffers, that will have the effect of increasing the capital charges for derivatives. As noted in ‘Liquidity’ on page 10, these substantially reflect the proposals in the BCBS December 2009 Consultative Document. We highlight below their particular impact on derivatives.

Central clearing counterparties Overall, the regulatory changes are directed at ‘encouraging’ the use of central clearing counterparties (CCPs), by increasing capital charges on derivatives not cleared through CCPs.

Although the initial proposals implied that a single or a few very large CCPs would be likely, it became clear that this would give rise to what was described as ‘the mother of all ‘too big to fail’ institutions’. As a result, the relative safety (but inefficiency) of multiple, smaller CCPs is likely to be the route followed, with the markets choosing which CCPs will be used. Enhanced capital requirements have been proposed for CCPs to ensure inter-operability (the ability of one CCP to connect with another, thereby enhancing netting). There is a concern that, without enhanced capital requirements, there would be a domino effect with the failure of one CCP bringing down others.

Liquidity standards The minimum liquidity coverage ratio (see ‘Liquidity’ on page 10) aims to match net cash outflows during a 30-day period of acute stress with a buffer of high-quality liquid assets. There are particular rules for the way in which cash flows under derivatives, repos and securities lending arrangements will be taken into account in the 30-day cash flow stress test. The bank of the future: an update 31

In particular:

„„ in the case of repos and securities lending of assets, cash inflows and outflows (in the case of outflows, determined by reference to the earliest possible call or termination date of the funding) falling in the 30-day period will be included unless the assets are eligible to count as high‑quality liquid assets for the purposes of the liquidity buffer, in which the assets held may be included as part of the buffer, at the relevant percentage, in place of the cash inflows (receivables due from the counterparty); and

„„ in the case of derivatives:

„„ scheduled cash flows (eg fixed or floating payments) in the period will be included;

„„ a deemed cash outflow will be included, equal to the liabilities in respect of collateral calls that would arise on a downgrade of up to three notches;

„„ there will be a deemed cash outflow of 20 per cent of the valuation changes on non-cash collateral or non-high-quality sovereign debt collateral securing derivatives; and

„„ the treatment of market value changes on derivatives that would result in additional collateral being posted is currently under consideration. Any treatment ought to take into account the enhanced capital requirements for counterparty credit risk (see below) to avoid double counting of risks of movements in market values, both in respect of the capital add-on for CVA risk (see below) and the capital add-ons for extended close-out risk.

Under the net stable funding ratio (see ‘Liquidity’ on page 10), assets currently funded and contingent contractual and non-contractual obligations to fund have to be matched, to a predetermined extent depending on their liquidity profile at a one-year time horizon, with sources of funding that can be considered stable over the same time horizon (one year). Assets such as derivatives, whatever their maturity it would seem, will be included at 100 per cent of fair value unless (i) they are held in trading book, (ii) their fair value can be determined based on inputs that are quoted prices (unadjusted) in active markets for identical assets at the date of measurement, (iii) they are traded in deep active markets with low levels of concentration risk and have had a bid/offer spread that has not exceeded 50bps in the last 10 years and (iv) they are listed on a recognised exchange in multiple time zones and included in a main index, in which case they can be included at 50 per cent of fair value.

Leverage ratio One of the most significant implications of the proposal for a leverage ratio (see ‘Capital’ on page 5) relates to the way in which repos, securities lending and derivatives are treated in calculating the ratio. It is proposed that the leverage ratio will be calculated as the ratio of Tier 1 Capital (or possibly Tier 1 and Tier 2, depending on the outcome of the consultation) to total exposure (on- and off-balance-sheet). The effect of the ratio will critically depend on what is included in ‘total exposure’. In addition, the Commission 32 Freshfields Bruckhaus Deringer LLP

proposes that the items included in total exposure should be measured using accounting values, with no exemptions and on a gross basis. For credit derivatives, the notional amount would be included as part of the total exposure. For other derivatives, the value to be included would be the gross positive fair value of the derivatives contract or (the Commission’s preference) the replacement cost calculated using the mark-to-market method set out in Annex III of part 3 of the CRD.

In each case, there would be no recognition of credit risk mitigation, such as collateral, netting and synthetic securitisation. The non-recognition of credit risk mitigation is considered ‘appropriate’ by the Commission ‘as it would provide a better reflection of underlying leverage’. It is also likely significantly to reduce bank capacity for derivatives (see ‘Implications’ below).

Counterparty credit risk It is under this heading that the Commission plans significantly to increase the capital required to deal with risks not previously captured. These include:

„„ risk of credit migration: a capital charge to take account of the risk of possible credit migration of counterparties (referred to as a credit value adjustment, or CVA, charge). Looking at losses that arose during the financial crisis, according to the Commission, approximately one-third have been due to default of counterparties; the remaining two-thirds have arisen from changes in value of derivatives due to the reduced creditworthiness of counterparties, and the Commission considers that this has not previously been captured in capital charges. The capital charge would be calculated by reference to a notional bond equal to the expected exposure at default of the counterparty over a one-year time horizon and the counterparty’s credit default swap (CDS) spread;

„„ general wrong way risk: a capital charge is to be made for ‘general wrong way risk’. General wrong way risk is the risk that the PD of counterparties is highly correlated with market risk for the derivative (eg the PD of monoline insurers is highly correlated with the financial assets they guarantee). The proposal is that rather than using a capital add-on based on effective expected positive exposure (EPE) over a three-year timeframe, banks should use a stressed version of EPE. EPE is, essentially, the weighted average over time of the in-the-money value of a derivative contract, based on volatility, etc of the relevant contract;

„„ specific wrong way risk: a capital charge is to be made for ‘specific wrong way risk’. Specific wrong way risk arises where there is a legal relationship between the counterparty and the underlying obligation (eg as in the case of a self-referenced credit derivative). Again, the capital charge would be calculated by reference to a notional bond, as described in ‘Risk of credit migration’ above. The exposure at default (and therefore the notional bond) would be assumed to be the notional amount of the CDS (in the case of a credit derivative) and the value of the equity derivative (in the case of an equity derivative);

„„ increased PD of highly leveraged counterparties: where a bank is using the IRB approach, a qualitative requirement would be applied to deal with the PD for highly leveraged counterparties, which is intended to reflect the performance of their assets in a stressed period; The bank of the future: an update 33

„„ inconsistency in determining Alpha: where a bank uses its own estimates of Alpha, there would be strengthened review of it by the regulators – or alternatively this would not be permitted and banks would be required to use the Alpha proposed by the regulators. The aim is to produce greater consistency, or at least prevent mis-application;

„„ increased correlation with financial sector counterparties: risk weights would be increased for transactions with financial institution counterparties to address the systemic risk within the financial sector. This would be done by applying a multiplier to the asset value correlations in the existing Basel II framework. The interaction with increasing the PD for highly leveraged institutions is yet to be addressed;

„„ increased period for margin at risk for certain collateralised counterparties: the period within which margin calls are agreed and paid varies; the current Basel II framework assumes margin is posted within, generally, two days. However, in times of stress this period increases, as it does where there is a significant number of open positions or where illiquid assets are used as collateral. To address this, the Commission proposes to extend the period to 20 days where the number of trades exceeds 5,000 or the collateral includes illiquid assets. In addition, where there is a history of disputes between counterparties (more than two over two quarters), the period to be used would be doubled;

„„ increased haircut for securitisations used as collateral: eligible securitisation positions used as collateral are regarded as more volatile than other assets, so it is proposed to double the current haircuts. Resecuritisations (eg CDOs of ABS) would be ignored altogether for collateral purposes;

„„ improved calculation of Exposure at Default (EAD): various additional changes to calculating EAD are proposed. In particular, the use of credit triggers for collateral would be excluded in EAD calculations. Also, there would be greater control regarding the rehypothecation of collateral and a focus on enhancing the operational performance of collateral departments;

„„ enhanced counterparty credit risk management requirements: a number of detailed proposals are put forward by the Commission to enhance counterparty credit risk management, including, for institutions using the IRB approach, increased stress testing for counterparty credit risk and revising the model validation standards for those using internal model methods; and

„„ increased capital for exposure to CCPs not using the new enhanced criteria of the International Organization of Securities Commissions (IOSCO), the Committee of European Securities Regulators (CESR) and CEBS: exposure at default to central counterparties is currently generally zero. The Commission has requested views as to whether, going forward, only those CCPs that meet the enhanced standard of IOSCO-CPSS (the Committee on Payment and Settlement Systems) should be allocated an EAD of zero, with others treated as bilateral exposures. It seems that it will be difficult for stakeholders to express views on this question, given that IOSCO-CPSS has not yet published guidance on how to apply its existing CCP recommendations to CCPs for OTC derivative activities, although they will no doubt be influenced by the OTC derivatives CCP criteria published 34 Freshfields Bruckhaus Deringer LLP

by CESR and CEBS in May 2009: Recommendations for Securities Settlement Systems and Recommendations for Central Counterparties in the European Union.

Changes at UK level In December 2010, the FSA and HM Treasury jointly published a paper entitled Reforming OTC Derivative Markets – A UK Perspective that, while generally supportive of international initiatives, such as the standardisation of derivatives contracts and increased capital charges for non-centrally cleared trades, included some criticism, eg on the systemic importance of CCPs and the proposed use of exchange trading as a substitute for OTC contracts.

Implications The additional capital required for liquidity and counterparty credit risk will increase the cost of derivatives to banks. Whether we will see a move to include increased costs provisions similar to those commonly seen in bank lending documents is not yet clear, though some are currently seeking to include them – the effect, of course, being to pass the increased costs on to the end-user.

More problematic is the leverage ratio. By ignoring collateral and netting while including the gross fair value of in-the-money positions (or the notional amount for credit derivatives) in total exposure (in effect ignoring hedges of those in-the-money positions), the effect is likely to reduce the balance sheet capacity of banks for derivatives. Constraining capacity will mean that banks are faced with a choice between volume-constrained (by the leverage ratio), low-margin business for traditional hedging products as against low- volume, higher-margin business for more exotic products. Although this may assist in driving portfolio compression to reduce the gross fair value of outstanding trades and may drive transactions onto CCPs, it also means that the current high-volume, low-margin business of basic hedging for end-users will become less attractive. Either margins will rise or end-users wanting simple hedging products will be pushed elsewhere, for example, dealing directly with CCPs, with the result that they will be required to margin their derivatives, making hedging more expensive and therefore less attractive. This might result in more risk being retained in the corporate sector, possibly not a desirable result in the longer term. The bank of the future: an update 35

Hedge funds and the unregulated sector

Introduction The role of hedge funds and the unregulated sector in the financial system continues to be debated. Although there is an acknowledgement that the impact of the sector is largely beneficial to the markets in which it operates, concerns remain that the sector may spread or amplify risks to the financial system in times of crisis. At a technical level, the mercurial nature of the sector’s business and the variety of entities involved poses an exceptional challenge to the competence of regulators. The technical debate has, however, been overshadowed by the politicisation of many issues. Although some might see the recent movements in risk premiums on Greek sovereign debt as a logical outcome of the crisis in Greece’s public finances, the sight of investors profiting from these movements has again sharpened the criticisms voiced by the sector’s detractors.

Changes at EU level The Spanish presidency published the latest draft of the proposal for a directive on alternative investment fund managers (Directive) in March 2010. The Directive applies to managers (AIFM) of alternative investment funds (AIF) (other than UCITS funds) that are collective investment undertakings that raise capital from a number of investors, with a view to investing it under a defined investment policy for the benefit of those investors. Following extensive public and industry criticism, the current draft contains significant changes to original text reported on by Jean-Paul Gauzès in November 2009:

„„ scope: member states may exempt from the Directive AIFM with assets under management of less than €500m (without leverage) where investors are locked in for at least five years, and AIFM with assets under management of less than €100m (with leverage). Key exceptions have also now been included for holding companies and securitisation special‑purpose entities;

„„ non-EU managers: in contrast to the previous prohibitions on non-EU managers marketing their funds in the EU, under the current proposals member states may allow AIFM established outside the EU to market their AIF to professional investors in that member state, subject to appropriate co-operation arrangements being in place. The definition of ‘marketing’ has been modified to make clear that only actions at the initiative of the AIFM or on behalf of the AIFM are caught and therefore EU investors are no longer precluded from approaching managers outside the EU;

„„ AIF outside the EU: of critical importance to the sector, member states may now permit AIFM to manage and/or market to professional investors AIF not established in the EU, provided appropriate co-operation arrangements are in place and certain conditions are met, in particular, using a depositary authorised under the Directive;

„„ leverage limits: the limitations on leverage contained in the original draft have been removed;

„„ eligible depositaries: the class of eligible depositaries for AIF is expanded from EU credit institutions to include EU investment firms authorised to provide safekeeping and custody services, and other categories of 36 Freshfields Bruckhaus Deringer LLP

institutions subject to prudential regulation, thereby safeguarding the role of non-banks as providers of prime brokerage services. In the current draft, depositaries are required to be established in the home member state of the AIF appointing them – which would appear to disqualify a number of major non-EU custodians from acting for AIF – however, we understand that the presidency has proposed to amend this requirement, subject to a test of equivalence. Depositaries remain liable for the acts of any sub-custodian that breach the depositary’s duties under the Directive;

„„ depositaries’ duties: the duties of depositaries are extended to ensuring that issues and redemptions by AIF and the valuation of an AIF’s units are carried out under the AIF’s rules and applicable law; any trades with the AIF are settled in the usual time limits; unlawful transactions are not carried out by the AIFM; and the AIF’s income is applied under the AIF’s rules and applicable law;

„„ delegation: AIFM may delegate their functions to appropriate persons (other than the depositary) and, in the case of risk management or portfolio management, to other entities authorised or registered for this purpose or as otherwise approved by the competent authorities of the AIFM’s home member state. Delegates from outside the EU must be in jurisdictions with appropriate co-operation arrangements;

„„ reporting: AIFM will be required to report their portfolios regularly to competent authorities, including aggregated trading and exposures information and, for each AIF it manages, the portion of illiquid assets held, its risk profile, liquidity arrangements, categories of investments, use of short selling, the results of stress tests, leverage and the extent to which its assets are subject to rehypothecation/rights of use;

„„ remuneration: the Directive has retained the requirements limiting the remuneration policies of AIFM and requiring that guarantees are used only exceptionally, are limited to new hires and may apply for one year only; payment of up to 60 per cent of variable compensation is deferred over a period appropriate to the life-cycle of the fund; and variable compensation may only vest if justified on the basis of the performance of the business unit, the AIF and the individual. Anti-avoidance provisions prevent individuals from protecting their future entitlements through hedging or insurance; and

„„ securitisation: in line with the CRD, the Directive further leaves open the possibility that, as a condition to their right to invest in securitisations, AIFM will be required to ensure that originators retain a net economic interest of not less than 5 per cent.

Under the original timetable, the Directive was to be adopted by the EP at first reading in June or July 2010. Following the UK’s request that work on the draft directive be deferred until after the May elections, it remains to be seen if the original timetable can be achieved. There are still significant issues to be resolved. In March 2010, the Permanent Representatives Committee The bank of the future: an update 37

of the European Council published a statement highlighting the absence of a qualified majority supporting an overall compromise over the following three points:

„„ the exemption from the scope of the Directive for AIFM with assets under management of less than €500m/€100m (with leverage) that some member states would like to see removed to ensure universal application;

„„ the choice of eligible depositaries limited to entities in the same member state is considered by many to be too narrow (particularly for private equity funds), as is the scope for delegation; and

„„ in relation to non-EU AIFM marketing within the EU, the application of EU-wide standards is seen as protectionist.

In addition, significant minorities object to the proposals on remuneration, valuation and the reporting obligations.

Implications

„„ The business of the City of London will be disproportionately affected by the outcome of the Directive in comparison to other EU economies. The Commission estimates that approximately €2,000bn is invested in AIF with between 60 per cent and 80 per cent of certain types of fund (by value) managed from London.

„„ For banks providing custody services to AIF, the Directive threatens significant disruptions to the current business model as a result of the geographical restrictions on establishment and the additional duties imposed on depositaries.

„„ For hedge fund managers, the acceptability or otherwise of the proposals is likely to focus on the extent to which the proposals on remuneration, leverage and reporting align with their existing business models and ethos. The choice of moving business out of the EU is not one that will be taken in isolation: increases in rates of personal taxation and the suitability of non-EU jurisdictions are likely to be significant contributing factors to any decision. 38 Freshfields Bruckhaus Deringer LLP

Competition policy

Introduction The financial crisis led to numerous collision points between competition law and the financial services sector.

In some areas, processes are still playing out, for example, in the restructurings required by the state aid rules. Other new issues may also be arising, not least if concerns about reduced competition due to bank retrenchment to core markets (both in terms of products and geographies) get traction with the authorities.

Changes at EU level

A new commissioner The early part of 2010 saw the installation of a new Commission, with the job of competition commissioner moving from Neelie Kroes, who had been in the post throughout the financial crisis, to Joaquin Almunia.

Mr Almunia was formerly the commissioner responsible for economic and monetary affairs, so is intimately acquainted with recent developments in the European banking sector.

There are early signs that the stance of the new incumbent at DG Competition will not be significantly different from that of Neelie Kroes – who was generally viewed as pursuing a tough approach to the application of competition rules. In his pre-appointment hearings, Mr Almunia indicated that he supported the policy of requiring banks that have received state aid to undergo a restructuring process. The Commission’s practice since his appointment indicates that it will continue to be demanding.

UK financial institutions complete approval of restructuring plans – but many other banks still going through the process With the approval of the restructuring plans for Dunfermline Building Society and Bradford & Bingley Building Society in early 2010, the Commission commented that this represented the ‘closing of the chapter of UK bank restructuring prompted by State aid in the context of the financial crisis’. In several cases, of course – most notably Royal Bank of Scotland and Lloyds Banking Group – the restructuring is still being implemented.

The same is true of institutions across Europe, with some still in negotiations with the Commission as to their restructuring obligations.

The past few months have also seen the first court challenges to measures required by the Commission. ING, for example, has brought a challenge against the ‘price leadership’ ban imposed on it by the Commission (that prohibited it from offering products in the top three in certain markets). Although it seems unlikely that there will be a cascade of challenges, this development will certainly be at the back of the Commission’s mind as it assesses the outstanding cases.

Review of potentially unfair commercial bank practices In late 2009, a different directorate within the Commission – DG Internal Market – published a study commissioned from external consultants on product tying and ‘other potentially unfair commercial practices’ by retail The bank of the future: an update 39

banks in Europe. The practices examined included cross-selling, conditional provision of services (such as requiring that a salary be paid into a current account) and steering customers to higher-cost products.

Although the study was from an external source, the Commission has stated that it is committed to taking it into account in formulating future policy. Moreover, although it was commissioned by DG Internal Market, it can be expected to influence policy across the Commission.

Previous action by DG Competition in the banking sector (through its retail banking sector inquiry, launched in 2005) ended up with relatively limited proposals for change. With support from DG Internal Market, however, there could be an impetus for wider and more invasive action, with potential impact across Europe.

The interest of DG Internal Market in banking is also important because of its attachment to the single market. The Commission has long sought to encourage greater cross-border competition in banking, with only limited success. The financial crisis has led to some surprising successes on this front (the spread of Santander’s business, for example), but its overall effect seems more likely to have been a geographic retrenchment by banks. There must be a risk that, in combination, DG Internal Market and DG Competition will take the view that the potential reduction in competition needs to be examined.

Changes in the UK

Office of Fair Trading (OFT) indicates ‘significant improvements’ in bank practices In December 2009, the OFT lost a Supreme Court case on the application of consumer rules to unarranged overdraft fees, which was seen as a setback for its strategy in the financial services field. Nevertheless, in March 2010, the OFT announced that it considered there had been ‘significant improvements’ in the practices of banks – with particular reference to unarranged overdraft charges – and that it expected further positive developments over the next few months.

Those developments seem to have persuaded the OFT to pause for breath on this specific area. It has indicated that it will keep overdraft charges under review over the next two years, and report back in 2012 – a more light-touch approach than might have been expected a few months ago. However, banks are by no means out of the woods on current account charges: the OFT underlined that if there is no progress (or if the expected changes do not emerge) it will consider further and more direct intervention.

Review of barriers to entry in the UK personal current account market In the same announcement, the OFT also opened a new front. It announced it would be undertaking a rapid review of barriers to entry in the UK personal current account market.

It is unlikely to be coincidental that this review takes place at the same time as the divestment of large numbers of branches by Royal Bank of Scotland and Lloyds Banking Group, under their restructuring plans agreed with the Commission. The UK government has insisted that those branches should be 40 Freshfields Bruckhaus Deringer LLP

sold to a new entrant or smaller player in the market. The OFT has explained that its focus is on ‘whether there are any obstacles to entrants providing a competitive stimulus’, and can be expected to want to report back quickly on this.

A full Competition Commission market investigation There also remains a real possibility that a much more extensive review of the UK banking sector may be in prospect. In summer 2009, George Osborne, the shadow chancellor, indicated that he planned to ask the Competition Commission to conduct a full market investigation into the UK banking sector and, in particular, to advise on how the government should deal with its holdings in Royal Bank of Scotland, Lloyds Banking Group and Northern Rock. He repeated that proposal in March 2010, telling a newspaper that ‘the banking system has become far too consolidated and you’re not getting the kind of competition you need’.

In the past, the competition authorities have shown a reluctance to engage in full-scale market investigations when a sector is in a state of flux, but ministers have the power to direct the Competition Commission to undertake a market investigation at any time. Whether George Osborne will be in a position to do so depends, of course, on the outcome of the general election. Were Labour to retain power, a review may be less likely. Lord Myners, the present financial services secretary to HM Treasury, has indicated that he does not think that a market investigation is necessary.

OFT investigation into investment bank fees Philip Collins, the chairman of the OFT, indicated in March 2010 that investment banks will face an inquiry into the fees they charge clients.

His comments were made at a meeting of The Future of Banking Commission in response to a question from Vince Cable, Treasury spokesman for the Liberal Democrats, but he did not elaborate on the point.

The move would be a very important expansion of the OFT’s interest in the banking sector, which has to date focused much more strongly on retail banking than on investment banking. The involvement of a national regulator in such an international business is likely to cause comment, but the OFT has not shied away in the past from controversial investigations. The bank of the future: an update 41

Tax havens

Introduction We explained in The bank of the future how the financial crisis gave fresh impetus to long-running OECD work aimed at improving certain jurisdictions’ standards of tax transparency and exchange of information. In addition, in their September 2009 communiqué, the G20 leaders said they were prepared to adopt anti-tax haven ‘countermeasures’ in their own jurisdictions from March 2010.

In 2009, we saw a step-change in progress towards adoption of the OECD’s internationally agreed standards of tax transparency and exchange of information, but it is generally recognised that more needs to be done to secure effective implementation of those standards.

A number of G20 states, including France and Germany, have adopted measures more or less directly targeted at so-called tax havens. There are also proposals in the UK. Some of these countermeasures have proved to be more symbolic than real: no jurisdictions remain on the OECD’s ‘black list’ of non- co-operative states, and so provisions framed around that list currently have no application. But other changes are very significant and indeed go well beyond tax havens in their scope – the recently enacted US Hiring Incentives to Restore Employment Act being a prime example.

We set out below a brief update on these and other related matters discussed in The bank of the future.

OECD work on tax transparency and exchange of information As noted above, there has been considerable progress made here – albeit generally by reference to the rather rudimentary criterion for distinguishing between ‘white list’ and ‘grey list’ territories.

„„ The OECD defines ‘substantial implementation’ of the agreed tax standards by reference to whether a jurisdiction has information exchange arrangements in place with at least 12 other countries. On that basis, more than 20 jurisdictions, including Switzerland, moved from the grey list to the white list in 2009.

„„ There have been some instances of agreements being signed between grey list territories – the utility of which would seem rather questionable. But these seem to be only a small minority (around 10 per cent of the 300-plus Tax Information Exchange Agreements and double tax treaties signed or amended by the relevant jurisdictions in 2009).

„„ The OECD is now moving forward with a peer review process to monitor the implementation of these agreements, and is also working to develop multilateral information exchange arrangements. The latter could make a material difference to the rate of progress – it is worth noting that the 84 territories surveyed by the OECD could sign upwards of 3,000 bilateral agreements entirely among themselves. 42 Freshfields Bruckhaus Deringer LLP

US Hiring Incentives to Restore Employment Act The US has just adopted an additional withholding tax regime that will impose full 30 per cent withholding tax on payments to financial institutions (as broadly defined to include investment funds as well as banks) that do not disclose information about payee accounts. The regime, primarily directed against tax avoidance by US residents, generally will apply after 2012. Implementing regulations can be expected to cause significant changes in international payments practices.

Other countermeasures Provisions according prejudicial treatment to dealings with tax havens – for example withholding (or increased withholding) coupled with non‑deductibility for outbound payments, and taxability by default of inbound payments – have been enacted or proposed in a number of G20 states.

„„ In some instances (under the German Act for Combating Tax Evasion, for example), the prejudicial treatment can be avoided by complying with disclosure (or increased disclosure) requirements.

„„ The list of ‘non-co-operative’ territories to which the rules apply has tended to be quite restricted: for example, in the case of the rules adopted under the French Amended Finance Act for 2009, it is a subset of those on the grey list, but in Germany, there are currently no territories to which the new rules apply. (Italy has existing anti-tax haven rules that are being re-cast so as to focus on exchange of information rather than the tax rate per se.)

„„ The UK government has announced plans to increase the tax-geared penalties for culpable errors in individuals’ tax returns where offshore arrangements are involved, and the territory concerned does not have automatic information exchange arrangements in place with the UK.

Although not specifically tax haven-related, we mentioned in The bank of the future that the UK government was also consulting on a code of practice on tax for banks. That code has now been finalised with minor modifications. (One favourable change is that while the draft code would have required a bank to consult with the Revenue in advance of implementing tax planning arrangements, if it was in doubt as to whether their tax effects were in accordance with the ‘intentions of Parliament’, the code as finalised says merely that the bank may do so.) Adoption of the code remains voluntary, and it appears that the Revenue will monitor compliance with it as part of their usual taxpayer risk assessment procedures. The bank of the future: an update 43

Glossary

ABS Asset-backed securities: securities whose value and income payments are derived from and collateralised by a specified pool of underlying assets. AIF An alternative investment fund: a collective investment fund other than a UCITS, such as hedge funds, private equity funds, real estate funds and investment trusts. AIFM An alternative investment fund manager: a manager of an AIF. Basel II The revised Basel Framework for measuring capital adequacy and the minimum standard to be achieved for internationally active banks, published by the BCBS in 2004. BCBS The Basel Committee on Banking Supervision: a forum for regular co- operation on banking supervisory matters, the members of which come from 20 major industrialised economies. BCBS December 2009 Consultative Document The BCBS consultative documents published in December 2009 that propose wide-ranging changes to the Basel II capital requirements and harmonised international rules to improve the resilience of banks to liquidity stresses. CCP Central clearing counterparty: a central counterparty that clears transactions by acting as buyer to every seller and seller to every buyer. CDO Collateralised debt obligation: a type of asset-backed security of which the underlying assets are typically a pool of bonds or loans that, if not static, are managed within certain investment parameters. CDS Credit default swap: a type of derivative transaction under which one party makes periodic payments to the other in return for a substantial payment if there is a default on a specified underlying financial instrument. CEBS The Committee of European Banking Supervisors, consisting of high-level representatives from the banking supervisory authorities and central banks of the EU. CESR The Committee of European Securities Regulators, consisting of high-level representatives from the securities industry supervisory authorities of the EU. Combined Code The Combined Code on Corporate Governance: a set of principles of good corporate governance and a code of best practice for UK listed companies that are overseen by the Financial Reporting Council (an independent regulator whose aim is to promote confidence in corporate reporting and governance). 44 Freshfields Bruckhaus Deringer LLP

Commission The European Commission (unless the context requires otherwise). Core Tier 1 Ordinary share capital and retained earnings are now commonly referred to as ‘core’ Tier 1 capital. Core Tier 1 together with other qualifying Tier 1 capital securities make up Tier 1 capital. CRD The Capital Requirements Directive: the name given to the amendments made to Capital Adequacy Directive and the Banking Directive to incorporate Basel II into EU legislation. The term is sometimes used more widely to refer generally to the Capital Adequacy Directive and those aspects of the Banking Directive dealing with capital requirements. CRD II A set of amendments to the CRD made by means of directives adopted in 2009 relating to large exposures, hybrid capital instruments, colleges of supervisors, liquidity risk management and securitisations (among other things). CRD III A set of amendments to the CRD proposed by the Commission in July 2009 relating to capital requirements for the trading book and for resecuritisations, and the supervisory review of remuneration policies. CRD IV The Commission Services Staff Working Document ‘Possible Further Changes To The Capital Requirements Directive’ published in February 2010, proposing wide-ranging changes to capital and liquidity requirements. ECB The European Central Bank. ECOFIN The Economic and Financial Affairs Council of the EU, composed of the economics and finance ministers of the member states. EP The European Parliament. ESAs The three European Supervisory Authorities, namely the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority. Exposure Draft ED/2009/12, Financial Instruments: Amortised Cost and Impairment, November 2009. FASB The Financial Accounting Standards Board: the designated organisation in the private sector for establishing standards of financial accounting and reporting in the US. The bank of the future: an update 45

Financial Reporting Council The Financial Reporting Council is the UK’s independent regulator responsible for promoting confidence in corporate reporting. Financial Services Bill The Financial Services Bill introduced into the UK Parliament in November 2009. FSA The Financial Services Authority: the UK financial sector regulator. FSB The Financial Stability Board: the successor to the FSF, the FSB has an expanded membership and a broadened mandate to promote financial stability. G20 The Group of Twenty: a group comprising the finance ministers and central bank governors of a number of systemically important industrialised and developing economies to discuss key issues in the global economy. GAAP Generally Accepted Accounting Principles: the national standards, conventions and rules used for financial accounting in a particular jurisdiction (eg ‘US GAAP’). IASB The International Accounting Standards Board: the independent standard-setting body of the International Accounting Standards Committee Foundation. IFRS International Financial Reporting Standards: financial accounting standards published by the IASB. IOSCO The International Organization of Securities Commissions: a worldwide association made up of the regulators of the world’s major securities and futures markets. IRB The Internal Ratings Based (IRB) approach to capital requirements for credit risk. ISDA International Swaps and Derivatives Association, Inc. Member state A member state of the European Union or the European Economic Area, as the context requires. OECD The Organisation for Economic Co-operation and Development: a forum for discussion and co-ordination of policy approaches to economic and other issues, whose membership comprises 30 democracies committed to free market principles. 46 Freshfields Bruckhaus Deringer LLP

OECD Principles The OECD Principles of Corporate Governance issued in 1999. OFT The Office of Fair Trading: the organisation set up to police competition legislation and to protect the rights of consumers in the UK. OTC ‘Over-the-counter’: in other words, not traded on any exchange or formal market. PD The probability of default. Pillar II One of the three main elements of Basel II, setting out a framework for supervisory review of banks’ risk management, including review of banks’ own assessment of their capital needs over and above Pillar I requirements. Pillar III One of the three main elements of Basel II, setting out a framework for market discipline, to promote greater stability in the financial system. The bank of the future The bank of the future is a report published by Freshfields Bruckhaus Deringer that describes the regulatory debate on a number of key areas affecting the banking industry and states the position as at November 2009. The full report and related client guides and briefings can be obtained from the following website: www.freshfields.com/microsites/ bankofthefuture/?id=bouverie (if prompted for one, the password is ‘bouverie’). Tier 1 The ‘highest’ form of capital in the hierarchy of capital types recognised for regulatory capital adequacy purposes, which includes items such as fully paid-up ordinary share capital and retained earnings. Tier 2 Tier 2 is a bank’s supplementary capital and includes revaluation reserves, general provisions and some classes of subordinated debt. Tier 3 Tier 3 includes a greater variety of subordinated debt than Tier 2 capital and can only be set against trading book risk and is limited to a proportion of the Tier 1 capital held. UCITS Undertakings for collective investment in transferable securities: a form of retail collective investment fund that complies with the requirements of the UCITS Directive. Walker Review An independent review of corporate governance in UK banks and other financial institutions, commissioned by the UK government and conducted by Sir David Walker, published for consultation in July 2009. The final version of the Walker Review was published in November 2009. The bank of the future: an update 47

Contacts

UK Royce Miller China Michael Raffan T +852 2846 3498 Financial services regulation F +852 2810 6192 T + 44 20 7832 7102 E [email protected] F +44 20 7108 7102 E [email protected] Philippe Goutay France Simeon Rudin T +33 1 44 56 44 89 Derivatives and structured finance F +33 1 70 39 44 89 T + 44 20 7832 7368 E [email protected] F +44 20 7108 7368 E [email protected] Alexander Glos Germany Ian Falconer T +49 69 27 30 85 05 Securitisation F +49 69 23 26 64 T + 44 20 7832 7087 E [email protected] F +44 20 7108 7087 E [email protected] Raffaele Lener Italy Simon Priddis T +39 06 695 33312 Antitrust, competition and trade F +39 06 695 33800 T + 44 20 7832 7259 E [email protected] F +44 20 7108 7259 E [email protected] Naoki Kinami Japan Simon Evans T +81 3 3584 8510 Employment, pensions and benefits F +81 3 3584 8501 T + 44 20 7832 7358 E [email protected] F +44 20 7108 7358 E [email protected] Mikhail Loktionov Russia Paul Davison T +7 495 785 3020 Tax F +7 495 785 3001 T + 44 20 7427 3226 E [email protected] F +44 20 7108 3226 E [email protected] Javier Gomez-Acebo Spain Worldwide T +34 91 700 3718 F +34 91 308 4636 Friedrich Jergitsch E [email protected] Austria T +43 1 515 15 218 Robert ten Have F +43 1 515 15 408 Netherlands E [email protected] T +31 20 485 7602 F +31 20 517 7602 Charles-Antoine Leunen E [email protected] Belgium T +32 2 504 7036 Brian Rance F +32 2 404 7036 US E charles-antoine.leunen T +1 212 277 4080 @freshfields.com F +1 646 521 5680 E [email protected] 48 Freshfields Bruckhaus Deringer LLP

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