TRANSILVANIA University, Braov Faculty of Economic Science Business Administration 1st year, 8892 group

EUROPEAN FINANCIAL SYSTEM

(general aspects) - Business Law paper 2009
Student: TEODORA CRISTINA STAN

Business Law Paper European Financial System Teodora Cristina Stan @ 2009

Teacher: ALEXIS DAJ

CONTENTS
I. DEFINITION AND GENERAL CHARACTERISTICS................................3 1.1. DEVELOPMENT..............................................................................3 1.2. EVOLUTION.....................................................................................3 1.3. EVALUATION..................................................................................4 1.4. STRUCTURE....................................................................................4 1.4.1. FINANCIAL MARKET..........................................................4 1.4.2. FINANCIAL INSTITUTIONS...............................................5 1.4.3. FINANCIAL INSTRUMENTS..............................................7 II. THE TRANSFORMATION OF THE EUROPEAN FINANCIAL SYTEM.7 2.1. INTRODUCING THE EURO: CONVERGENCE CRITERIA........8 III. RATING AGENCIES...................................................................................9 IV. BASEL II AND THE CAPITAL REQUIREMENTS DIRECTIVES..........10 V. THE PRESENT FINANCIAL CRISIS..........................................................11 VI. BIBLIOGRAPHY.........................................................................................13

Business Law Paper European Financial System Teodora Cristina Stan @ 2009

I. DEFINITION AND GENERAL CHARACTERISTICS

The International Financial System can be defined as an assembly of norms and techniques settled and accepted on a background which contains institutional regulations that coordinate and organize EUs members behavior in the financial and monetary, international domain generated by the commercial and non-commercial operations. It can be seen also as the set of markets, institutions, instruments, and financial flux which assure the movement in time and space of the capital resources from the creditors (or the international investors) to the debtors (or the financing beneficiary). EUs financial system is based on the following juridical norms: treaties provisions, private law provisions and provisions regarding agreements between institutions. The most important one is mentioned in European Community Treaty. Some provisions are related to budget domain that was modified through Maastricht Treaty (1st of November 1993). European Financial System has a major impact over the economical development and its main roles are: Financial resources transfer (from those that have surplus funds to those that have deficit funds) Promotes economical efficiency (low risks and costs) Puts good use on investments opportunities (funds transfer: low productivity sector-> high productivity sector) Unwind of payments and incomes flux Stimulates investments and economies level 1.1. Development EFS development was amplified by the economical growth, necessity of taking risks, temporal variation of consumption and separation of business property administration over the capitals. 1.2. Evolution The evolution steps of International Financial System are the following: Bretton Woods Agreement (1944) Crises period (1960-1970) Smithsonian Agreement or Free Flotation (1973) 3

Business Law Paper European Financial System Teodora Cristina Stan @ 2009 Kingstom Jamaica Agreement (1972-1976) Modification of the art. IV Principles adopted in 1977: - Each member has to avoid monetary market interventions to prevent a possible BPE lack of balance or to obtain an unfair advantage within the frame of international commercial exchanges - Each member can try to diminish the possible BPEs crises - If monetary market changes, its mandatory to take into consideration members interests Plazza Agreement (1985) Louvre Agreement (1986)

At the moment, EFS is a combination of currency systems (The European Central Bank (ECB) is responsible for the monetary system of the European Union and the euro currency.). 1.3. Evaluation A short evaluation of EFS shows us that: - Free flotation hasnt generated a diminished of international commerce and investments - Free flotation doesnt mean a quick setting of commercial fluxes - Changing rates remain extremely volatile in EFS - Crises remain pretty frequent and strong - Weak national currency systems can be absorbed by those that are more powerful 1.4. Structure EFS have a main, simple structure which consists of financial transactions on financial markets and through financial institutions, between government, private and population. 1.4.1. Financial Market (primary market=new issues of a security are sold to initial buyers, secondary market=security can be resold by the investors for cash) is divided into: Money Market (very liquid, transactions with credit instruments, small fluctuations for

Business Law Paper European Financial System Teodora Cristina Stan @ 2009 the securities prices which implies a low risk) and Capital Market (low liquid, transactions with debt and equity securities, higher fluctuations => high risk). Credit instruments: commercial papers, bankers acceptance, credits etc Debt and Equity instruments: common stocks, preferred stocks1, bonds, investment funds participations, insurance policies, pension funds policies, derivatives. Between the investor and debtor can be established 2 types of financial relation: direct financing or indirect financing (through intermediaries). Advantages for indirect financing: a good information about capital resources; lower risks (some institutions share or cover the financial risks); financing consultancy; financing facilities; different financing alternatives; financing condition imposed by the financial institutions; lower transaction costs. higher operational costs; inexistence of a direct contact with financial markets; historical relations with a financial institution.

Disadvantages for indirect financing:

1.4.2. Financial Institutions (Financial Bodies) - Services provided by financial institutions

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selling and buying financial securities; international payments; international financing (incl. export financing); financial consultancy; international markets surviving (rating agencies); insurance against financial risks; guarantees for financial transactions; managerial expertise; companies surviving (competitors, clients);

Common stock usually entitles the owner to vote at shareholders' meetings and to receive dividends. Preferred stock generally does not have voting rights, but has a higher claim on assets and earnings than the common shares. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.

Business Law Paper European Financial System Teodora Cristina Stan @ 2009 portfolio management; investment funds management.

a.) European Investment Bank. Its job is to lend money for projects of European interest (such as rail and road links, airports, or environmental schemes), particularly in the less well-off regions, candidate countries and the developing world. It also provides credit for investment by small businesses. The EIB: - is a non-profit, policy driven bank. Unlike commercial banks, the EIB does not manage personal bank accounts, conduct over-the-counter transactions or provide private investment advice - makes long-term loans for capital investment projects but does not provide grants - is owned by the Member States of the European Union. They subscribe jointly to its capital, each countrys contribution reflecting its economic weight within the Union - does not use any funds from the EU budget. Instead, it is self-financing, borrowing on the financial markets - is the majority shareholder in the European Investment Fund. b.) European Investment Fund. It was set up to help small businesses. The EIF: - is not a lending institution (it does not grant loans or subsidies to businesses, nor does it invest directly in any firms) - works through banks and other financial intermediaries. It uses either its own funds or those entrusted to it by the EIB or the European Union. - is active in the member states of the European Union, in Croatia, Turkey, Iceland, Liechtenstein and Norway c.) European Central Bank (ECB). Its job is to manage the euro the EUs single currency. The ECB: - is also responsible for framing and implementing the EUs economic and monetary policy - works with the other national banks of each of the EU members to formulate monetary policy that helps maintain price stability in the European Union (with the objective of sustained employment and non-inflationary growth) - ensures the smooth operation of payment systems - manages the foreign reserves of member countries

Business Law Paper European Financial System Teodora Cristina Stan @ 2009 - it revenue is derived from interest on investments in foreign-reserve assets, money-market instruments, and securities, as well as from the allocation of euro banknotes in the EU. 1.4.3. Financial Instruments is a contract between lender and borrower, and it can have a direct (includes money and capital market) or indirect character (includes investment funds participations, insurance policies, pension funds participations). This particular contract establishes (mainly): the financing mechanism; the role of each institution / participant in the mechanism; the amount; the maturity; the currency; the financing cost (interest rate) and the payment method; the risk allocation between the participants; the payback of the loan;

II. THE TRANSFORMATION OF THE EUROPEAN FINANCIAL SYTEM

The European financial landscape has changed dramatically over the last couple of years and the pace of change appears to have moved into a higher gear with the establishment of Economic and Monetary Union (EMU). However, although EMU and the introduction of the euro have played a pivotal role in the changes the European financial system has been undergoing, a host of other factors can be identified that in parallel with the euro contributed to the transformation of the European financial system. First, progressive steps in the process of European economic integration have laid the foundations for financial market integration. In addition, the European financial system has witnessed a number of remarkable structural changes that partially can be considered as related to or triggered by the European financial integration process, but to some extent are also exogenous or part of global developments. A good example are changes that were made possible because of the pace of technological development, which has, globally, probably been the most important factor affecting developments in financial markets over the past decades. Examples of endogenous changes are: national mergers and acquisitions in banking, the increasingly blurring distinction

Business Law Paper European Financial System Teodora Cristina Stan @ 2009 between traditional financial products and financial institutions and, in line with this development, the establishment of financial conglomerates2. 2.1. Introducing the Euro: convergence criteria The convergence criteria are presented in Article 121(1) of the Treaty establishing the European Community (EC Treaty). There are four of them (price stability, government finances, exchange rates and long-term interest rates): a.) Price stability. The Treaty stipulates: "The achievement of a high degree of price stability [] will be apparent from a rate of inflation which is close to that of, at most, the three bestperforming Member States in terms of price stability." In practice, the inflation rate of a given Member State must not exceed by more than 1 percentage points that of the three bestperforming Member States in terms of price stability during the year preceding the examination of the situation in that Member State. b.) Government finances. The Treaty stipulates: "The sustainability of the government financial position will be apparent from having achieved a government budgetary position without a deficit that is excessive " In practice, the Commission, when drawing up its annual recommendation to the Council of Finance Ministers, examines compliance with budgetary discipline on the basis of the following two criteria: the annual government deficit: the ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding financial year. If this is not the case, the ratio must have declined substantially and continuously and reached a level close to 3% (interpretation in trend terms according to Article 104(2)) or, alternatively, must remain close to 3% while representing only an exceptional and temporary excess; Government debt: the ratio of gross government debt to GDP must not exceed 60% at the end of the preceding financial year. If this is not the case, the ratio must have sufficiently diminished and must be approaching 60% at a satisfactory pace (interpretation in trend terms according to Article 104(2)). c.) Exchange Rates. The Treaty stipulates: "the observance of the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other Member State." The Member State must have participated in the exchange-rate mechanism of the European monetary system without any break during the two years preceding the examination of the situation and
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There are differing perceptions as to what exactly constitutes a financial conglomerate. To a large extent, these perceptions are dependent upon custom and practice in different countries, but they are also influenced by the existence, in some countries, of rules or laws governing, not only the ownership of banks, but also the activities in which banks can become involved.

Business Law Paper European Financial System Teodora Cristina Stan @ 2009 without severe tensions. Also, it must not have devalued its currency on its own initiative during the same period. After transition to stage three of EMU, the European Monetary System was replaced by the new exchange-rate mechanism (ERM II). d.) Long-term interest rates. The Treaty stipulates: "the durability of convergence achieved by the Member State ... being reflected in the long-term interest-rate levels". In practice, the nominal long-term interest rate must not exceed by more than 2 percentage points that of, at most, the three best-performing Member States in terms of price stability (that is to say, the same Member States as those in the case of the price stability criterion). The period taken into consideration is the year preceding the examination of the situation in the Member State concerned.

III. RATING AGENCIES

Rating agencies assess the financial strength of companies and governmental entities, both domestic and foreign, particularly their ability to meet the interest and principal payments on their bonds and other debt. Rating agencies also carefully study the terms and conditions of each specific debt issue. The rating for a given debt issue reflects the agencys degree of confidence that the borrower will be able to meet its promised payments of interest and principal as scheduled. The rating for a given debt issue may differ somewhat from the overall credit rating for the issuer, depending on its specific terms. Debt issues with the highest credit ratings from the agencies will incur the lowest interest rates. Investors confidence in borrowers ability to meet their payment obligations is highly influenced by the rating agencies analyses. Meanwhile, the interest rate demanded by investors on a given debt issue is inversely correlated with the creditworthiness of the borrower: stronger borrowers pay less, weaker borrowers pay more. The credit rating agencies perform similar work to consumer credit bureaus. The credit scores that the latter produce for individuals similarly influence the rates of interest at which individuals may borrow.

Business Law Paper European Financial System Teodora Cristina Stan @ 2009

IV. BASEL II AND THE CAPITAL REQUIREMENTS DIRECTIVES

Rules on capital requirements are designed to protect savers and investors from the risk of the failure or bankruptcy of banks. They ensure that these institutions hold a minimum amount of capital. The Capital Requirements Directives were adopted in 2006 and are currently under review. Capital adequacy rules set down the amount of capital a bank or credit institution (CI) must hold. This amount is based on risk. There are all sorts of financial instruments available by which credit institutions can guard against risk, such as derivatives, futures, corporate bonds and asset-backed securities. The rules are enforced by supervisors who check on how much risk is being run and measure how much capital is required to underwrite that risk. Once each bank has been assessed by the supervisors it is given a risk profile. Internationally, rules are set by the Basel committee, part of the Bank for International Settlements (BIS). On this committee sit representatives from Belgium, France, Germany, Italy, Luxembourg, Netherlands, Spain, Sweden, Switzerland, UK, Canada, Japan and US. The first set of international rules was known as Basel I. In June 2004, the Basel committee agreed updated rules - Basel II. These had to be applied in the EU and in July 2004, the Commission set out proposals for a new Capital Requirements Directive (CRD) which would apply Basel II to all banks, CIs and investment firms in the EU. The current EU regime is contained in two directives: Directive 2006/48/EC on the taking up and pursuit of the business of credit institutions and Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions. The European Commission in October 2008 presented a review of the rules in place. The proposed changes request banks to hold a higher amount of capital against the risk of failure and introduce a new coordinated, although cumbersome, supervisory process for cross-border EU banks. According to EU official figures, in October 2008 there were in Europe 44 crossborder institutes, holding two thirds of total EU bank assets.

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Business Law Paper European Financial System Teodora Cristina Stan @ 2009 The proposal has been agreed by the European Parliament in May 2009 and later by the Council. Even before the vote in the Parliament, the Commission proposed a new review of the directives to take into account risks related to trade books, securitization and managers' remunerations. The unusual move reflected the particular conditions of international financial markets hit by the worst crisis since the '30s. While the initiative still waits for a green light from member states, the Council has proposed tougher rules for granting loans in periods of economic growth, in order to allow banks to have higher "liquidity buffers" in new crisis.

V. THE PRESENT FINANCIAL CRISIS

The present financial crisis is the outburst of tensions accumulated in time in the banking and financial systems. For a considerable time, the financial world has experienced a certain degree of stability, allowing financial intermediaries to perform in a relatively undisturbed environment. But reaching stability on financial markets means an undivided attention to all the details concerning institutions, markets, infrastructure, and environment. The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets 3 have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out4 their financial systems. Most of the 20th century crisis may be set in the following framework: 1. Expectations of interest rates increase. According to adverse selection and moral hazard, debtors engaging in risky projects are the most inclined to accept high interest rates. As interests start having an upward trend, either because of a shrink in the loan supply or as a result of an increase of loan demand, borrowers engaging in low risk investments will renounce contracting loans, while high risk investors will continue to increase their demand for high interest loans, jeopardizing the financial position of the banks. 2. Decline of stock prices. A decline in the assets market value means a decline of the value of collateral, impeding the lending activity of banks. Banks become reluctant to grant loans
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stock market (stock exchange) = a place where stocks, bonds, or other securities are bought and sold. 4 bail out is a term used to describe a situation where a bankrupt or nearly bankrupt entity, such as a corporation or a bank, is given a fresh injection of liquidity, in order to meet its short term obligations.

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Business Law Paper European Financial System Teodora Cristina Stan @ 2009 bearing low value collateral thus raising the cost of lending. As a consequence, investments and consumption shrink reducing the economic activity. Moreover, the low level of assets means a decline in the stocks price high risk borrowers being induced to accept, as an alternative, high interest loans. 3. Unanticipated reduction of prices inducing a reduction of assets value, housing and mortgage and to increasing the cost of debts. 4. Increase of uncertainty. The bankruptcy of financial institutions determines a stock crunch and the inability of lenders to judge the quality of borrowers. The impossibility to solve moral hazard problems leads to more expensive loans reducing investments and aggregate economic activities. 5. Bank panic. Under bank failure the intermediation shrinks, savings are withdrawn, reducing the available lending funds and restraining the economic activity. Though the economic financial crisis is far from being solved, and no obvious solutions can be given until the last part would have been played, it is mandatory that the international community (governments, international financial institutions, market regulators, monetary authorities) must cooperate. The present crisis determinants are located in a worldwide scenario and are connected in their mostly recurrent part to the unsolved monetary issues. The financial crisis began in the credit markets, and eventually it will end there. But as the financial industry leaves behind one of the most wrenching years in its history, bankers and policy makers are struggling to see the way out of this mess.

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Business Law Paper European Financial System Teodora Cristina Stan @ 2009

VI. BIBLIOGRAPHY
Books: ENCICLOPEDIA UNIUNII EUROPENE, EDITURA MERONIA, BUCURETI, THE POST-EURO FINANCIAL SERVICES MARKET IN EUROPE, N.WALTER,

2007 2000 THE ROMANIAN ECONOMIC JOURNAL THE CURRENT FINANCIAL CRISIS REVISITED, LILIANA EVA DONATH, LAURA MARIANA CISMAS (ONLINE Web Support: http://209.85.129.132/search? q=cache:x8w3L0Q_BToJ:www.finint.ase.ro/Masterate/Master_Rodica/Curs_1_Introducere %2520in%2520Sistemul%2520Financiar %2520European.ppt+sistemul+financiar+european&cd=1&hl=ro&ct=clnk&gl=ro http://facultate.regielive.ro/referate/finante/elemente_de_sistem_financiar_public-92197.html http://www.ecb.int/ (European Central Bank) http://www.euractiv.com/en/financial-services/basel-ii-pital-requirements-directives/article141423 (Basel II & CRD) http://62.1.43.74/7Omilies-parousiaseis/UplFiles/omilies/secgen/Gortsos13-9-2004.pdf http://www.scribd.com/doc/8439019/PptWorld-Economics-Crisis (Present Financial Crisis) http://www.answers.com/topic/european-central-bank http://europa.eu/legislation_summaries/index_en.htm (EU Legislation)
BOOK)

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Business Law Paper European Financial System Teodora Cristina Stan @ 2009 http://financecareers.about.com/od/ratingagencies/a/ratingagencies.htm (Rating Agencies) http://encyclopedia.thefreedictionary.com/

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