A New European System of Financial Supervision
European Commission proposes changes to the powers, governance and funding of the ESAs
At the end of September, the European Commission recommended a package of proposals to amend the regulations establishing the European Supervisory Authorities (ESAs) and the European Systemic Risk Board (ESRB), along with associated changes to the Solvency II and MiFID II Directives.
While the proposals are likely to be modified as the Commission negotiates these with the European Council and European Parliament, as drafted, they would make substantial changes to the powers, governance and funding of the ESAs. This would effectively restructure the European supervisory framework, shifting the balance of involvement in supervision towards the ESAs from national competent authorities (NCAs). The Commission has called for the European Parliament and Council to discuss and agree the proposals “as a matter of priority” with a view to their entry into force before the end of the current legislative term of the Parliament in 2019.
Overview of proposals
The Commission has proposed a number of changes that will affect the structure and role of each of the ESAs:
• All three ESAs will assume responsibility for monitoring, on an on-going basis, third-country equivalence decisions and will submit a confidential report on their findings to the Commission on an annual basis.
• The ESAs will monitor firms that intend to make extensive use of outsourcing, delegation and risk transfer (back-to-back business or fronting) in third countries with the intention of benefitting from market access through the EU passport while essentially performing substantial activities or functions outside the EU.
• The ESAs’ top level governance is being reshaped with the creation of an Executive Board for each ESA. The Executive Board is intended to be independent and is composed of full-time, externally appointed members. The powers of the Executive Board include the monitoring of firms’ outsourcing, delegation and risk transfers to non-EU countries. In sum, the proposals appear to transfer some powers away from national representatives to a smaller group of independent members.
• Financial services firms will have to contribute directly to the funding of the ESAs, replacing funding currently provided via NCAs.
Further changes have also been made to alter or introduce new responsibilities specific to individual ESAs. The most significant of these concerns the role of the European Securities and Markets Authority (ESMA). ESMA will:
• Be responsible for the direct supervision of EuVECAs, EuSEFs, ELTIFs, critical benchmarks and third-country benchmark administrators and data reporting service providers (in addition to the Commission’s June 2017 proposal to give ESMA enhanced supervisory powers for EU and third-country CCPs).
• Receive transaction data directly from market participants.
As regarding changes to EIOPA’s remit, it will have a greater role in the authorisation of insurers’ internal models. This is intended to avoid divergence in standards and outcomes, and EIOPA’s role will include issuing opinions on individual internal model applications.
Regarding the ESRB, the Commission is proposing to make permanent the existing arrangement that the ESRB is chaired by the President of the ECB. The proposal also modifies the composition of the ESRB to add the Single Supervisory Mechanism (SSM) and Single Resolution Board (SRB) as voting members of the ESRB General Board, among other changes intended to take account of changes to the macro-prudential framework and regulatory developments that have taken place since the ESRB was established, and to improve the ESRB’s efficiency and effectiveness.
The ESAs will be required to monitor the regulatory and supervisory developments as well as enforcement practices in third-countries in order to verify whether the criteria for equivalence are still fulfilled. For the purpose of obtaining information for monitoring purposes, the ESAs will also develop administrative arrangements with third-country competent authorities. As a result, existing and new equivalence decisions will come under enhanced scrutiny and could be subject to higher risk of being withdrawn, if the ESAs find that the criteria for equivalence are no longer fulfilled.
Oversight of outsourcing, delegation and material risk transfer
It will become the ESAs’ responsibility to monitor firms’ outsourcing, delegation and risk transfer (back-to-back business or fronting) in third-countries, in order to prevent circumvention of rules or prevent effective supervision or enforcement by firms performing substantial activities or functions in third-countries while making use of the EU passport for market access. NCAs will be required to inform the ESAs of firms’ outsourcing, delegation and material risk transfer notifications on a semi-annual basis. The ESAs can in turn issue recommendations to NCAs to review a decision or to withdraw an authorisation. This means that delegation, outsourcing and material risk transfer activities will be subject to greater scrutiny by the ESAs, and could potentially lead to a withdrawal of authorisation at their recommendation.
ESMA: new powers for direct supervision of capital markets participants
ESMA’s role will significantly expand for certain capital markets participants. As proposed, harmonised collective investment funds (EuVECA, EUSEF and ELTIF), data reporting services providers, critical benchmarks and third-country benchmark administrators will face direct supervision by ESMA. The supervision of certain types of prospectuses will also be transferred to ESMA. The proposals also make it explicit that MiFIR intervention powers cover the marketing of UCITS and AIFs, and ESMA will therefore be also able to use its intervention powers to restrict or prohibit the marketing, sale or distribution of units or shares in UCITSs or AIFs.
ESMA: enhanced coordination role
Since the coordination function of ESMA will be extended to include market abuse investigations, ESMA will have a critical role in initiating and facilitating such investigations. By maintaining a pan-European data hub to collect all relevant information from NCAs, ESMA will also have increased analytical capabilities in assessing potential regulatory breaches. Firms will also need to be aware of any enhancements to their surveillance systems that need to be made.
ECB/SSM: supervision of large investment firms
ESMA’s expanded role will also be complemented by the forthcoming Commission legislative proposals to review the prudential treatment of investment firms, expected by the end of 2017. The Commission has stated its intention to propose to “align the regulatory and supervisory treatment of certain large investment firms with the one applying to large credit institutions”. As such, large investment firms established in Member States participating in the Banking Union “can become subject to supervision by the European Central Bank in its supervisory capacity, the Single Supervisory Mechanism”.
EIOPA AND ESMA: stress testing
The EIOPA and ESMA Regulations will be aligned with the EBA Regulation in this area. In addition, with the intention of improving transparency, the stress test results of individual firms can be made public at the discretion of the relevant ESA under the new regime. The new Executive Board will be in charge of decisions on the initiation, coordination and approaches to communicating the outcomes of stress tests, and will consider the need for a stress test on an annual basis.
EIOPA: internal models for insurers
EIOPA will be informed and may be involved in the review of insurers’ internal model applications, with the aim of fostering supervisory convergence. While approval will continue to be granted by NCAs, EIOPA may issue opinions on internal model applications, on its own initiative, on a comply-or-explain basis. EIOPA will report annually on issues that NCAs have dealt with in approving internal models, and will submit an opinion on internal models to the Commission by 1 January 2020, including an assessment of divergences. The Commission will advance legislative proposals by 1 January 2021 if appropriate.
Settlement of disagreements
Upon request and at their own initiative, the ESAs can act and intervene in settlements of disagreements between NCAs. The proposals are intended to ensure that, when such disagreements exist, the ESAs may act and intervene decisively.
Collection of information
Enhanced supervisory and enforcement powers over access to firms’ data will be given to the ESAs. The ESAs will be able to address a request for information directly to a firm where, for example, a NCA does not, or cannot, provide such information in a timely manner. The ESAs will also have the power to impose fines and penalty payments on firms to ensure compliance with a request to submit information. As proposed, the European Court of Justice (ECJ) will also have unlimited jurisdiction regarding the ESAs’ decisions to impose fines or penalty payments. Firms will have to prepare to comply with the ESAs’ requests to provide information on a timely basis.
Guidelines and recommendations
As responses to the consultation highlighted the need for the ESAs to remain within their remit of competence, the proposal sets out that the ESAs can be challenged by the ESA Stakeholder Groups if they are considered to have exceeded their competences. When developing guidelines and recommendations, the ESAs will be required to carry out a cost-benefit analysis. Each ESA’s Stakeholder Group will be allowed to issue an opinion if two thirds of their members consider that the ESA has exceeded its competence. In such instances, the Commission has the power to require the ESA to withdraw the guidelines or recommendations concerned.
Other new tasks and objectives
Other new tasks and objectives set out for the ESAs mean that firms should have greater clarity from the ESAs on their supervisory objectives. The ESAs will also have greater power in tackling breaches of EU law and settling disagreements between NCAs.
• The ESAs will set EU-wide priorities for supervision in the form of a “Strategic Supervisory Plan” against which all NCAs will be assessed.
• The EBA will be required to develop a supervisory handbook in the area of resolution. All three ESAs will develop a supervisory handbook intended to further develop a common supervisory culture across supervisory authorities.
• The ESAs will gain access to all relevant information to pursue breaches of EU law, such that they will be able to address a request for information to NCAs or firms. NCAs will also assist the ESAs to collect the information needed from firms.
• The ESAs will be required to take specific account of technological innovation in carrying out their supervisory tasks. The Commission has stated that “the regulation and supervision underlying the Banking Union and Capital Markets Union must be technology-neutral and proportionate”. The Commission will present in early 2018 an EU Action Plan setting out the detailed actions to be taken for a more integrated market for digital financial services.
• The ESAs will be required to take into account risks related to environmental, social and governance factors in carrying out their responsibilities.
New governance structure
Restructuring of decision-making powers and bodies
In a new governance structure that seeks to ensure that “effective, impartial and EU-oriented decisions” are made, a new Executive Board will replace the current Management Board of each ESA.
The main function of the Executive Board will be to prepare decisions to be taken by the Board of Supervisors, with the intention of quicker and more streamlined decision-making by the Board of Supervisors. The Board of Supervisors will remain as the main body in charge of the overall guidance and decision-making of each ESA. However, the Executive Boards will be entrusted with direct powers over certain “non-regulatory issues” such as independent reviews of NCAs, dispute settlements and breach of Union law. The Executive Board will also be in charge of monitoring outsourcing, delegation and risk transfer arrangements to third countries and decisions in relation to requests for information. In these areas, the Executive Board “shall be competent to act and to take decisions” and “keep the Board of Supervisors informed of the decisions taken”. This reflects a shift to concentrating power in the Executive Board, which effectively becomes a parallel decision-making body to the Board of Supervisors.
Whereas the Management Board is composed of the Chairperson and of representatives of national supervisory authorities, the Executive Board for each ESA will consist of the Chairperson and a number of full-time members (3 for EBA, 3 for EIOPA and 5 for ESMA), who “on the basis of merit, skills, knowledge of financial institutions/market participants and markets, and of experience relevant to financial supervision and regulation” will be nominated by the Commission (with nominations approved by the Parliament) and appointed by the Council. The members of the Executive Board are expected to “act independently and objectively in the sole interest of the Union as a whole” and should not take instructions from any government of a Member State. Their term of office is 5 years and renewable once.
New funding structure
In addition to contribution from the EU and fees from directly supervised entities, indirectly supervised financial institutions will also need to contribute directly to the ESAs’ annual budgets. This means firms will have to pay fees directly to the ESAs. The Commission will be required to adopt a delegated act that will provide for criteria for the calculation of the individual annual contribution to be paid by each firm.