EU Committee: Alternative Investment Fund Managers

Lord Tunnicliffe Excerpts

Tuesday 6th July 2010 Lords Chamber

[Lord Tunnicliffe]

My Lords, I, too, thank my noble friend Lady Cohen for initiating this debate. We should all be particularly grateful to the European Union Committee for its report—more grateful than usual, as it has had to deal with a moving target. As the letters to the noble Lord, Lord Roper, from the noble Lord, Lord Myners, and from the Vice-President of the European Commission clearly demonstrate, improvements to the directive are still being made. It is clear that the committee has made a valuable contribution to the improvement of the directive, on which it is to be congratulated. I believe that everyone now welcomes the directive’s goal of providing a coherent regulatory framework, particularly for hedge funds and private equity firms. Indeed, this goal has been endorsed by the G20. The difficulty has been in agreeing what exactly a coherent framework would look like.

The committee’s report provides a useful overview of the tortuous history of the directive. I do not intend to go into all the political cross-currents that seem to have contributed to the lengthy saga. Instead, I shall concentrate on four areas that are important in going forward. First, is the report’s analysis entirely satisfactory and do any deficiencies in that analysis detract from the conclusions? Secondly, is the general criticism of the one-size-fits-all approach of the directive still valid? If so, what is to be done about it? Thirdly, are the conditions for passporting non-EU alternative investment fund managers now satisfactory? Fourthly, what can be learnt from the history of this directive for future regulatory reform?

I turn first to the analysis. The report devotes itself almost entirely to the impact of the directive on hedge funds and on private equity firms. The report accepts the widespread position that hedge funds did not cause the financial crisis, but I am not at all sure that that is correct. It should be remembered that the crisis at Bear Stearns, the first major investment bank to encounter serious difficulties, was precipitated by the collapse of two hedge funds that the firm owned. Even if we leave those direct losses aside, it is inconsistent for the report to accept the argument that hedge funds contribute significantly to the liquidity of markets but not to take into account the devastating role that hedge funds played in the downward spiral of prices once deleveraging had begun.

On the same theme, it is worth pointing out that the report’s acceptance of the argument that hedge funds’ contribution to price discovery is valuable activity is not now universally shared. Hedge funds’ trading may help to make a price, but the link between that price and wider economic efficiency is now recognised to be tenuous at best. Hedge funds are contributors to systemic risk—that is, the risk inherent in the structure of the financial system as a whole—and it is right that they should be incorporated in new attempts to mitigate systemic risk. Perhaps the report takes too benign a view of hedge fund activities in this respect.

With regard to private equity firms, the report is surely right to focus on leverage. However, it is not the leverage of the private equity firms themselves that is the relevant issue but the actions of those private equity firms that pursue a strategy of leverage buyout, leaving the firms that they buy burdened with excessive levels of debt. It would have been useful to have had the committee’s views on the economic value of this sort of activity. It would be helpful if the Minister would, when he sums up, comment on the Government’s attitude to leveraged buyouts and their impact on stability and growth.

Next, I come to the criticism of one size fits all. One of the oddities in earlier versions of the directive was the presentation of relatively precise regulatory controls on disclosure, capital requirements and independent valuation that were to be applied to firms with very different business models The consequence was not only a number of anomalies but the general feeling that the directive was not well fitted to any particular business model. Significant progress has been made since the early drafts of the directive to remove such anomalies and perhaps the committee’s conclusion on this point has been overtaken by events.

The position taken by the Commission, as outlined in the letter of the Vice-President of the Commission to the noble Lord, Lord Roper, is that,

“the all-encompassing scope of the Directive is a prudent approach to the regulation of a sector in which business models are diverse and fluid. An alternative approach based on rigid definitions of business models would not respond comprehensively to risk and would create real risks of circumvention”.

This is surely right. Moreover, it is in tune with the British approach to principles-based regulation. The issue, then, is whether the directive in the compromise form developed by the Spanish presidency is really playing that tune or whether it is a discordant cacophony of principles and rules. It would be helpful if the Minister could tell us whether the Government now feel that the key problems of one size fits all have been overcome and whether the directive has now assumed the flexible form that the Vice-President of the Commission suggests.

Finally on this topic, the report does not deal with the impact of the directive on investment trusts. These are peculiarly British institutions, which play an important part in the UK savings and investment industry. Is the Minister content with the application of the directive to investment trusts? It would be helpful if he could give us the Government’s assessment of the impact of the directive on the UK investment trust industry.

I turn now to the conditions for passporting non-EU firms. The report is surely right to argue that passporting should be available to all fund managers operating in well regulated, although not necessarily perfectly equivalent, jurisdictions. However, it was not clear whether the report supported one important aspect of the directive—the need for reciprocity between jurisdictions allowed passports into EU markets. Will the Minister help us on this point when he sums up? Are the UK Government wedded to the notion of reciprocity?

Finally, I turn to the question of what lessons can be learnt about future regulatory reform from this episode. The obvious first lesson is that, given the central role of the UK financial services industry in the economy of the UK, and indeed the economy of the European Union, it is vital that the UK authorities should be in the forefront of regulatory reform. In this respect, I must take issue with one of the report’s conclusions:

“The Government should ensure that EU regulation is in line with, and complements, global arrangements. We believe that the Government should not agree the Directive unless it is compatible with equivalent legislation with regulatory regimes in third countries and in particular in the United States, in order to avoid a situation in which the EU AIFMs lose competitiveness at a global level”.

That conclusion was rendered out of date by the Toronto G20 summit. At that summit, the consensus that had until then characterised the international reaction to the financial crisis substantially evaporated. Of course, we all hope that the G20 meeting in Seoul in November will reinvigorate a common approach to regulatory reform. However, it would be a serious mistake to allow the search for consensus to be an excuse for inaction.

The United States has already indicated by its actions—notably the passing of Senator Dodd’s Bill by the Senate—that it intends to pursue its own interests in the first instance. We should do the same—not to try to create division but to set the agenda and lead constructive thinking on reform. The most damage that the directive, with its tortuous history, could do would be if it were to stifle European, and more especially British, regulatory initiatives. On this count, it is disturbing that the committee established to consider the future of the banking system will not report until September 2011—10 months after the Seoul meeting. Will the Minister assure us that the Government will not be waiting for international consensus to publish their reform proposals?

This is a valuable report both because of its detailed assessment of the directive’s impact and because of the light that it sheds on the process of regulatory reform and the necessity for that reform to proceed with some dispatch. It is for the Government to lead in the development of financial regulation in Europe and the world. To do otherwise would be a grave disservice to this crucial British industry.