8449 - FINANCIAL INSTITUTIONS AND MARKETS LAW - Prof. A. Giannelli C. Mosca 15/02/2010 Why Regulation?

History proves that regulation of financial markets is needed since they are not able to self-regulate themselves. There exists and information gap and a cultural gap among different type of investors (retail vs. Institutional) and among investors and financial institutions, so that regulations are necessary to protect weaker investors. Moreover, regulation is needed to prevent market failures and for this reason, rules on financial markets and intermediaries have became more stringent after each financial crisis e.g. after 1929, in the US was established the Securities and Exchanges Commission (SEC), after 2008 crisis, a flow of new regulation not yet terminated, has started in both Europe and US, as it has became clear that past rules were not sufficient to prevent market failures. Years ago, a number of corporations filed for bankruptcy, as a consequence new rules to protect retail investors and savings were introduced. One of the main goal of markets regulations is to prevent the domino effect, whereby the insolvency of one player of the market gives rise to the insolvency of other players or to the market as a whole. How regulation of financial markets has been addressed in the EU?

Regulation of European Financial Markets started with the Treaty of Rome in 1960, and have been modified during the years, in particular the Treaty of Amsterdam introduced some important principles: Art. 43 Freedom of Establishment: any individual or company, duly established in one Member State is entitled to move or expand its operations in all the other countries of the EU. Art. 49 Freedom to provide services: one entity can provide its services in other countries of the EU, and compete with other service providers in that country. Art. 5 Principle of Subsidiarity: regulations at EU level must intervene only if it is required to achieve the objective of the EU when domestic rules are not sufficient to achieve that objective. aimed to address the relationship between domestic rules and supranational rules and to find a balance between those principles

GOAL: create a common market

Harmonization or Regulatory Competition?

Harmonization: setting up rules at EU level to provide a single environment in order to facilitate the freedom of establishment and the freedom to provide services. Minimun Harmonization: decision at EU level is to choose the harmonization approach, but mitigated by the principle of subsidiarity Mutual Recognition: there is no need to verify in each country if a company has the requirements to operate in that field once it has been authorised by its home-country authority EU Passport 19/02/2010 The Lamfalussy Process

The Committee of Wise Men was appointed in 1999 to report on the status of financial market regulation in Europe to the European Commission and to make suggestions in order to further improve the set of rules. They suggested a procedure, the so called Lamfalussy Process that is still applied in the building and implementation of financial market rules. The Committee clearly believes that regulation of financial markets in Europe is extremely important and consequently the suggestions of the Committee produced an increase in the flow and in the level of details of EU regulations. Benefits of regulation of financial markets: 1) Regulations help improving the efficient allocation of capital, by reducing transaction costs, increasing the market liquidity and creating more investment opportunities; 2) Regulation gives rise to a more efficient intermediation of savings, thus increasing competition and efficiency; 3) Clear rules would help to attract capital from investors outside the EU. The Committee believes that there is a close link between better regulation and the growth of the European Capital Markets and thus the growth of the entire European economy. Financial markets integration will be beneficial for Small & Medium Entreprises (SMEs), which will have better opportunity of financing at lower cost. Also blue chip companies will benefit from a reduction in the cost of capital, which is actually larger in EU if compared with the US. The Committee of Wise Men gives suggestions to streamline the rule making process in EU, which is slow, complex and not able to achieve consensus among Member States: their advices can be summed up in the so-called Lamfalussy Process, which claims the use of Regulations instead of Directives. Directive: act that is binding for the Member State and must be implemented by a specific deadline, stated in the Directive, but it needs a domestic law to be enforceable

Regulation: is enacted at EU level and once it is translated enters directly in to the law system of each Member State. Lamfalussy Process: Level 1: General legal framework for regulating a specific area. Level 2: More detailed rules which have the scope to apply the general Level 1 principles. Level 2 rules requires a certain timeframe to be prepared and so between level 1 and level 2 acts two Committees (so called comitology), that are in charge of preparing the new rules. Since Level 2 Directives provide detailed principles, they are usually enacted as Regulations, in order to avoid different implementation in the Member States. Usually there is on Level 1 framework Directive and a number of Level 2 Regulations. The new approach introduced by the Lamfalussy Committee is to decide at centralized level also the detailed rules. In order to mitigate the centralization, this process is carried out with the collaboration of the Member States, which are involved through the Committees and the consultations with the EU Parliament and the EU Commission. From MINIMUM to MAXIMUM HARMONIZATION. Financial Supervision in Europe

INSTITUTIONAL APPROACH: Given supervisory authority for each player in the financial market (e.g. Bank of Italy supervises banks, independently of the range of activities they are engaged to). In Italy this approach applies for banks and insurance companies, through Bank of Italy and ISVAP. FUNCTIONAL APPROACH: reduces the risks associated with the institutional approach. It gives the supervision to the authority which has the best knowledge about a specific area (securities, bank activity, market regulation, etc.). Under the functional approach, each financial intermediary is supervised by different authorities. 22/02/2010 The disclosure based model

Supervision is a decentralized activity carried out by different authorities for each Member State and this is why supervision has different features across Europe. Different models could include the centralization in a EU agency of the supervision of some areas of activity, but there are some cases against the latter solution: e.g. the Treaties of Rome and Amsterdam set an institutional limit according to which is not possible to set up other supranational bodies other than the ones established by the Treaties (Parliament, Commission, Central Bank, etc.) One of the way to avoid new financial crises is to create new rules in step with the times. Usually after financial crises there is a huge flow of regulations. What type of regulations should be implemented now?

All regulations that have been set in the 1990s where based on the disclosure paradigm. It is a model in which the way to avoid problems in financial markets is to provide the maximum level of disclosure in relation to e.g. governance, prices, transactions, securities, etc. According to this model, as far as information are available, investors can take the best investment decisions. The problem is related to the rational investor model underlying the disclosure paradigm. This principle had been strongly supported until 1990s, when all financial legislation was guided by it (e.g. rules on insider trading). Also the approach to the conflict of interest is based on the disclosure model. It has been clear over the past years that in complex markets conflicts of interests are frequent within the same institution. One of the solutions could be to divide entities which perform different activities (commercial vs. Investment banking, for example). In EU was implemented a mild solution: since conflicts of interests are unavoidable, they should be at least mitigated. This mitigation has been done through the imposition of disclosure: for example, clients should be informed of possible conflict of interests within banks. Some experts think that disclosure is not the solution to guarantee the proper functioning of financial markets. Notwithstanding it is important to ensure the correct working of markets, it is not the only principle to be implemented. If you look at the transactions that are at the basis of financial markets (securitization, subprime mortgages), they were properly disclosed: this is why disclosure is not the only possible approach. In fact, investors are sometimes not rational and not able to use information correctly: sometimes financial instruments are so complex that neither the sophisticated investors can understand the information related to those instruments. For this reason, a number of local supervisory authorities imposes that prospectuses show also financial simulations of a security in different scenarios. Markets are also affected by some psychological factors (e.g. herding behaviour, irrational exuberance) that cannot be addressed using only disclosure. 26/02/2010 The Prospectus Directive The Prospectus Directive is one of the most important directives set out under the Lamfalussy Process. The idea underlying this Directive is to provide a common standard for disclosure in the issuing of securities. One of the problem to overcome is the national interference which brings competition in the regulatory environment and could lead to a race to the bottom in regulation. Providing common rules for disclosure is a way to set a minimum level of disclosure in all countries. Harmonization in relation to prospectuses has an additional benefit: if the scheme and the contents of prospectuses are the same in all Member States it will be much easier for market players to find the relevant information. It follows that disclosure is the basic principle underlying the Directive, which aims at protecting investors and by this protection contributing to the proper functioning and development of securities markets in Europe.

According to the Directive, the best way to provide clear, complete and comprehensive information is to provide a prospectus to investors. Investment in securities involves risks and the more information is provided, the better will be the assessment of these risks. Information should regard the financial position of the issuer, the rights attaching the securities and so on. Those information should be provided in an analysable and comprehensible form. The Directive wants to harmonize the requirements for the drawing up of prospectuses, the approval by the authorities and their distribution to the investors. Prospectuses are required for both offering of securities to the public and admission to trading. One of the drawbacks of the Directive is the definition of securities, which is very narrow and does not cover all the instruments traded in the market (e.g. derivatives), thus the harmonization is incomplete.

01/03/2010 Collective Investment Schemes

The area of collective investment schemes was one of the first field in which EU harmonized regulations were introduced. Despite this early effort, the current situation of collective investment schemes is far to be optimal. Collective investment schemes are referred to as UCITS (Undertaking for Collective Investment in Tradable Securities). UCITS provide a mechanism through which investors can invest their savings in a common scheme. There exist three alternative structure for UCITS: 1. Common/ Investment Funds Pool of assets without legal personality, which require a fund manager. Investors invest in the pool of assets by purchasing units or percentages of the fund. There is a full and complete segregation among the funds under the same fund manager, and also between the fund manager and the funds (i.e. the bankruptcy of the fund manager does not affect the funds). The basic advantages of common/investment funds are 3: a. By gathering funds from many investors, the fund manager can benefit from economies of scale due to the bigger volume reachable by the fund, b. The fund manager is a sophisticated investor and so the funds are managed by an expert, c. Diversification of risk

2. Investment Trusts The trust is a UK concept, which provide for a pool of assets (the trust) managed by a trustee on behalf of the final beneficiaries to which the assets included in the pool belong to. As Investment Funds, the trust does not have legal personality and can act only through the trustee. 3. Investment Companies The assets in this case are directly owned by the company and investors purchase the shares. There is no distinction between the fund and the fund manager within the company. Investors buy shares of the company and the funds raised through equity issues are invested in securities according to an investment policy agreed with the shareholders. Thus the investors, being shareholders, have voting rights and can influence the investment policy of the company. Role of the Depositary Bank as Custodian and Controller

The depositary bank holds, on behalf of the fund manager, the securities which are managed by the fund manager or are property of the investment company. Both securities and cash must be deposited in the bank, which acts as third party between fund managers/investment companies and investors. The depositary bank acts also as custodian of the assets and controls the activity of the fund manager/investment company, so double-checking if the fund manager/investment company is making investments in compliance with its investment policy.