This article was written by Joe McHale and Christian Benson, Regulatory Affairs Specialists at Bloomberg.
The lack of internationally coherent rules regarding the financial stability of financial institutions was badly exposed by the financial crisis over a decade ago. In response, there has been a concerted effort to ensure that standards are agreed and implemented at an international level, rather than just leaving it to countries or regions to go their own way. The Basel III reforms finalized in late 2017 aim to mitigate risk by ensuring a more resilient and well-capitalized banking sector. In similar fashion, the transition away from LIBOR requires an internationally coherent approach and effective regulatory partnerships across borders to ensure that global financial stability is not compromised during the “changing of the guard” of such highly sensitive benchmarks.
The EU is expected to propose rules concerning prudential capital requirements as part of the international Basel III banking reforms later this autumn via the third Capital Requirement Directive (CRD III). However, certain Member States are fighting to thin down proposals to moderate the minimum capital floor that makes it harder for banks to use their own internal calculations to decide the size of their capital base.
The EU is set on implementing the reporting element of its minimum capital requirements for market risk (fundamental review of the trading book – FRTB) in September 2021. The full implementation of FRTB will occur when the Basel capital requirements are introduced, and though this is currently planned for January 2023 it may be subject to delay.
On the LIBOR transition, the EU recognizes that the role of benchmarks in the pricing of financial instruments and measuring investment fund performance makes them an intrinsic part of financial markets. Amendments to the EU Benchmarks Regulation in February gave the EU the power to mandate the use of a replacement rate for any outgoing critical or third-country benchmark that is to be discontinued in the bloc. In June, the EU Commission, the ECB, EBA and ESMA took the decision to issue a joint statement encouraging market participants to significantly reduce their exposure to LIBOR rates ahead of its upcoming expiry at the end of 2021.
In contrast to the EU’s staggered approach to implementation, HMT recently announced that the UK’s FRTB SA reporting requirements will be implemented alongside any changes to FRTB revisions to Pillar 1 capital requirements. Revisions to both the reporting and capital elements are expected to take effect simultaneously in January 2023. This will follow a consultation scheduled for Q4 2021 and a final policy statement due in Q3 2022.
On LIBOR, the UK made the critical decision last year to pursue a ‘synthetic’ LIBOR approach to tackle so-called tough-legacy contracts and ensure an orderly wind-down. This means that the FCA – under its new powers in the Financial Services Act – would have the ability to compel the administrator of LIBOR (ICE Benchmark Administration) to continue to publish LIBOR under a changed methodology. The FCA has already consulted on its new powers to permit ‘legacy’ use of critical benchmarks such as LIBOR and to restrict new usage, and will issue a follow-up consultation by the end of this quarter to set out precisely which legacy contracts will be permitted to use any synthetic LIBOR rate.
But importantly, we now know that the FCA intends to use its new powers to implement synthetic LIBOR rates for the remaining 6 sterling and yen LIBOR settings (1 month, 3 months, and 6 months settings) at the end of the year. Final decisions should be confirmed as soon as feasible in Q4.
To complement the FCA’s work, HM Treasury is preparing further legislation to address potential risks of contractual uncertainty and disputes for tough legacy contracts, particularly where the FCA compels publication of synthetic LIBOR, when Parliamentary time allows.
Finally, on Solvency II, a recent speech from a senior Bank of England official confirmed that the UK will not seek to gold plate EU regulations on policyholder protections, as many in the industry feared. It has been established that stress testing of insurers will become an increasingly important supervisory tool. In its recently published response to feedback, the UK Government confirmed that it would be introducing a more proportionate prudential regulatory regime following a quantitative impact study this study, which will inform a comprehensive package of reforms for consultation in early 2022.
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