Introduction
Few domestic financial markets in the world show such rapid and far-reaching changes in their legal framework as the German capital markets currently do. On the one hand, the European liberalization and harmonization process with regard to banking and financial services, particularly in the area of regulatory law, required and continues to require the implementation of various EC directives into German national law. On the other hand, the German government, realising the increasing competition between financial centres around the world, attempts to promote Germany, and especially Frankfurt, as its financial centre by abolishing unnecessary statutory and administrative restrictions and by a perceptible orientation towards international capital markets standards.
The forthcoming amendment to the Banking Act and the proposed new Financial Market Enhancement Act, which are discussed in this report, supply impressive evidence for the legal adaption of Germany’s financial and capital markets. This adaption, however, should not be misunderstood as a mere liberalization or even deregulation of such markets’ legal framework. The sheer volume of the relevant legislative measures the draft Financial Market Enhancement Act, for example, comprises 392 pages, the initial draft of the amendment to the Banking Act more than 800 pages – indicates that a rather heavy burden is placed on banks, financial institutions and other market players when it comes to implementing and complying with the new rules. It is therefore to be hoped that the positive effects of the new or revised laws will not be strangled by increased bureaucracy.
Sixth amendment
Currently, the Sixth Amendment to the German Banking Act, implementing the EC Investment Services Directive (93/22/EEC, “ISD”), the Capital Adequacy Directive (93/6/EEC, “CAD”), the BCCI Directive (95/26/EC) and the Netting Directive (96/10/EC) into German law, is in the legislative pipeline. The enactment of this amendment will lead to substantial changes and a broadening of the regulatory framework for banks and investment service providers on the German capital markets. Currently, the government hopes that the various parts of the Sixth Amendment will become effective between January and August 1998.
Banking licence
requirement broadened
Under German law, “banking business” as defined in sec. 1 para. 1 sentence 2 of the Banking Act may only be conducted by credit institutions licensed by the Federal Banking Supervisory Office. Until now, neither the underwriting and issuing of securities nor the issuance of pre-paid cash cards or the creation and administration of artificial currency units in computer networks constitute such banking business. This will be changed by the Sixth Amendment to the Banking Act; underwriting business, pre-paid cash cards issuing business, and cyber-cash business will become part of the list defining banking businesses requiring a banking licence.
In addition, the statutory definition of deposit business will be clarified; and securities business as defined in the Banking Act will be renamed “financial commission business”, then also including transactions relating to money market instruments, forex, and derivatives.
Financial services institutions
The most significant regulatory change introduced by the forthcoming Sixth Amendment to the Banking Act will be the introduction of a separate licence requirement for “financial services institutions”; the responsible authority will be the Federal Banking Supervisory Office. In this context, financial services are:
* agency business relating to investments;
* buying and selling financial instruments in the name and on behalf of a client;
* the management of portfolios of financial instruments on behalf of a client;
* proprietary trading;
* agency relating to deposit transactions with enterprises outside the European Economic Area;
* money transfer services;
* transactions in foreign notes and coins (all these services are to date still unregulated).
Financial enterprises
However, some types of services will remain unregulated. “Financial enterprises” will not be required to obtain a licence if their main activity consists of:
* the purchase of equity interests;
* the purchase of pecuniary claims;
* the closing of leasing contracts;
* the issuance and administration of credit cards or traveller cheques;
* proprietary trading in financial instruments;
* the provision of investment advice;
* the consultative services to enterprises with respect to capital structurings, strategies for a particular industry, and any related questions as well as advice and related services with respect to the merger and acquisition of enterprises;
* money brokerage.
Trading book
Another important matter introduced by the Sixth Amendment to the Banking Act will be the definition of the “trading book”, being the statutory link for the implementation of the CAD provisions (ie the requirements relating to market risks assessment as part of the calculation of banks’ or financial services institutions’ adequate liable capital.
The trading book will comprise:
* financial instruments (i.e. securities, money market instruments, forex and derivatives) in the own portfolio for generating trading profits from market price or interest rate volatility;
* transactions hedging against trading book risks and connected refinancing transactions;
* give-up trades;
* claims with respect to costs, fees, commissions, interest, dividends and margins directly related to trading book positions;
* repos, lending transactions and similar transactions with respect to trading book positions.
Adequate liable capital
However, the full implementation of the CAD and the Netting Directive provisions into German law also required an amendment to the Federal Banking Supervisory Office’s Credit Risk Determination Ordinance (which occurred on 2 October 1996) and still requires a complete remodelling of the Banking Supervisory Office’s Principles Concerning the Capital and Liquidity of Credit Institutions, particularly of Principle I (which is also included in the statutory drafts being part of the Sixth Amendment to the Banking Act). As a result, trading book risks (general price risks, special price risks, settlement risks, and counterparty risks with respect to OTC transactions) will be included in the calculation of the adequate liable capital, as well as (aggregate) currency risks and commodity risks (market price risks). The existing provisions on counterparty risks remain more or less unchanged. However, it is noteworthy in this context that netting is accepted if certain requirements are fulfilled (master agreement, accepted by the Federal Banking Supervisory Office, due diligence, ongoing review, either netting by novation or close-out netting; “walk-away” clauses will not be recognized).
Appropriate risk-measuring models will be accepted by the supervisory authorities.
Own funds
Moreover, the Sixth Amendment to the Banking Act will have a substantial impact on sec. 10 of the Banking Act regarding own funds of banks and investment services institutions. Own funds will then consist of:
* Core capital (tier 1 capital): inter alia, equity capital, reserves, profits, contribution of silent partners, subject to certain deductions;
* Tier 2 capital: this will be newly divided into (i) lower tier 2 capital (long-term subordinated debt), and (ii) upper tier 2 capital (provision for general banking risks, cumulative preferred shares, subordinated participation capital, unreleased reserves);
* Tier 3 capital: this newly created type of capital is intended to support only certain market risks. It will cover the hypothetical net profit released by close-out of all open trading book positions, minus costs and hypothetical losses from liquidation of the investment book and short-term subordinated debt.
The aggregate of tier 3 capital plus free tier 2 capital must not exceed 200% of the free core capital.
Further amendments to
the Banking Act
Further amendments to the Banking Act include, inter alia, the expansion of the provisions on the consolidation of own funds to investment services institutions. Thereby, these consolidation requirements will become obligatory for groups of credit institutions, groups of investment services institutions, and for financial holding groups (sec. 10a of the Banking Act).
Moreover, the Banking Act’s large exposure provisions will become applicable to investment services institutions, too. With respect to banks or investment services institutions being exempt from the application of the trading book provisions (ie trading book accounts for less than 5% of the total business, the trading book’s single positions are usually below Ecu15 million, the trading book never accounts for more than 6% of the total business, and the total sum of all trading book positions never exceeds Ecu20 million), the current provisions of sec. 13 of the Banking Act are modified. With respect to large exposures by trading book institutions, a new sec. 13a will be added, distinguishing between investment book risk positions and trading book risk positions.
Of course, the large exposure provisions will also be applied on a consolidated basis to groups as defined in sec. 10a of the future version of the Banking Act (own funds).
Other amendments to the Banking Act include the provisions on loans of Dm3 million or more, information requirements regarding deposit protection and investors protection schemes, and certain organisational requirements (for example, sec. 25a para. 2 of the future version of the Banking Act will regulate the outsourcing of certain activities of banks or financial services institutions).
Third financial market
enhancement act
The Sixth Amendment to the Banking Act will by no means be a concluding step in the regulatory changes in the German banking and financial services industry. On April 3 1997, the federal ministry of finance issued a first pre-draft for a so-called Third Financial Market Enhancement Act. This proposed new Act intends to amend the existing stock exchange and securities trading law, the investment fund law, as well as the laws on venture capital companies, mortgage banks and public banks. Since the pre-draft contains more than hundred of different amendments to existing statutes, the following can only be a very broad overview.
Stock exchange and
securities trading law
Among the proposed amendments in the areas of stock exchange and securities trading law (Exchange Act, Exchange Admission Ordinance, Securities Trading Act, Securities Sales Prospectus Act, Securities Sales Prospectus Ordinance) are the following:
* shortening of the period of limitation for prospectus liability with respect to a listing prospectus (official listing), a business report (unofficial listing = regulated market) as well as a sales prospectus (publicly offered securities not admitted to trading on a German exchange) to a maximum of three years;
* shortening of the period of limitation for incorrect investment advice to a maximum of three years;
* abolition of the minimum time of existence of an issuer in order to support young enterprises in applying for inclusion in the regulated market;
* liberalization of statutory provisions to make multiple listings easier;
* introduction of provisions on de-listings in accordance with international standards;
* clarification of the requirements on a prospectus for warrants;
* introduction of provisions on framework prospectuses in order to consider the speciality of medium term note programmes;
* recognition of prospectuses of foreign issuers in a foreign language under certain conditions;
* facilitation of a listing without listing prospectus if the securities of the issuer are already officially listed for at least three years in another EU or EEA member state;
* shortening of the time period between the issue of a listing prospectus and the start of trading from three days to one day;
* the Federal Supervisory Office for Securities Trading will in future check securities sales prospectuses as to their completeness;
* reduction of the number of exemptions from the duty to issue a securities sales prospectus;
* introduction of a duty to issue a sales prospectus for exchange offers relating to non-listed securities;
* increase of the possible administrative fines in connection with a violation of the Securities Sales Prospectus Act to a maximum of Dm 1 million;
* introduction of special provisions reflecting new developments in the area of issuing techniques (e.g., book-building) in admission prospectuses and securities sales prospectuses;
* introduction of a right of the Federal Supervisory Office for Securities Trading to prohibit unfair advertising for securities.
Investment fund law
The core part of the proposed Third Financial Market Enhancement Act consists of provisions amending the German Investment Companies Act. Changes in this area of the law will, according to the pre-draft, include, inter alia, the following:
* New types of funds shall be permitted: funds of funds, mixed securities and real property funds, provision/pension funds (please note that they will still not be comparable to Anglo-Saxon true pension funds), and closed-end funds organised in the legal form of a stock corporation.
* Enlargement of the permitted business activities of securities funds (eg acceptance of stock index funds, acceptance of the bundling of liquid monies of one or more securities funds in money market funds, acceptance of cash deposit accounts of funds with credit institutions other than the respective custodian bank, acceptance of repo transactions, etc), equity funds (eg with respect to silent participations), and real property funds;
* Among the various other provisions proposed by the federal ministry of finance as amendments to the Investment Companies Act is, for example, a clarification regarding the applicable rules on transfer of funds from one investment company to the other.
Further amendments
The pre-draft proposes substantial changes with respect to the Venture Capital Companies Act, including a more favourable tax treatment, the acceptance of venture capital companies in the legal form of limited liability companies, the possibility not to publicly offer the shares of a venture capital company, and a liberalization of the rules on investments and on the re-financing of venture capital companies (eg no longer any limitations on the issuing of debentures).
Among the proposed provisions relating to mortgage banks and public banks are, for example, the acceptance of certain business activities of mortgage banks in so-called central and eastern European reform states belonging to the OECD, and provisions intended to ease the issuing of jumbo-Pfandbriefe (mortgage bonds).
Changes in supervisory practice
Not only the German legislator, but also the regulatory authorities (Federal Banking Supervisory Office and Federal Supervisory Office for Securities Trading) are part of the great regulatory reshuffle currently taking place in Germany.
Netting
It has already been mentioned above that, pursuant to the Credit Risk Determination Ordinance, as amended on 2 October 1996, and the current version of the Principles Concerning the Capital and Liquidity of Credit Institutions, netting arrangements can be recognised and used to lower a bank’s capital burden provided the respective netting agreement has been approved by the Federal Banking Supervisory Office. This requires an application together with a legal opinion confirming the recognition of the netting mechanism by the bankruptcy laws of the relevant jurisdictions.
On 27 December 1996, the Federal Banking Supervisory Office accepted netting agreements based on the German Master Agreement for Derivatives Transactions. The ISDA Master Agreement can be expected to be accepted soon, and other master agreements will follow, although respective applications require not only the above-mentioned legal opinions, but also translations of the master agreements and the accompanying legal opinions into German.
Securitizations
For a long time, the securitization by German banks of their own assets was strongly discouraged by the Federal Banking Supervisory Office. In 1996 the Supervisory Office, however, changed its position and sent out a first draft circular on this subject. After intensive discussions with the banking industry and its advisors the final circular was issued in May 1997. The Federal Banking Supervisory Office now accepts securitization transactions, provided certain regulatory requirements are met. By and large, such transactions are accepted, also for Principle I purposes, if the respective credit institutions are no longer subject to any end-customer default risks in connection with the assigned receivables. Details of the circular are still controversial. The Supervisory Office, on the one hand, insists that the receivables-selling credit institution itself must not bear the placement risk as underwriter of its own asset-backed securities. On the other hand, it indicated in a side letter to its circular its willingness to accept such an bank as an underwriter provided certain conditions are met.
Requirements for trading
As early as October 1995, the Federal Banking Supervisory Office issued a statement concerning minimum requirements for the trading activities of credit institutions, setting forth some general requirements (eg, responsibility of the management, qualification and behaviour of the staff, preservation of documents), some risk controlling and management requirements (eg the use of risk limits, proper documentation, and rules on business risks), requirements on the organization of trading activities (eg separation of trading and back office, monitoring of risk positions), requirements on audits, and some rulings for special types of transactions (eg renewal of forex dealings).
Rules of conduct
In August 1996 the Federal Supervisory Office for Securities Trading issued a draft statement on rules of conduct for investment services providers. Although this draft was heavily discussed in, and often criticised by, the banking industry, the final statement by the Supervisory Office is expected soon.
Increasing market sophistication
Besides the statutory and regulatory changes described above, equally important is the fact that market participants work constantly at increasing market sophistication on various levels.
On a more technical level, it is worth mentioning that in October 1996 the German Central Depository (Deutscher Kassenverein (DKV) shortly to be renamed “Deutsche Börse Clearing”) very successfully started the so-called CARGO system for the collective custody of registered shares transferable only with the issuing company’s consent.
The German Stock Exchange Group (Gruppe Deutsche Börse) is currently developing, and intends to introduce later this year, a new electronic trading system named XETRA (Exchange Electronic Trading), which is intended to supersede the current IBIS trading system.
Furthermore, the associations of the German banking industry developed and published a German Master Agreement for Repo Transactions this spring. A new version of the German Master Agreement for Securities Lending Transactions is expected to follow later this year. The increasingly used German Master Agreement for Derivatives Transactions has already been mentioned above.
In this context, it should be mentioned that, since October 1995, a voluntary so-called Takeover Code (Übernahmekodex) exists in Germany. It intends to help ensure that takeover and other general bids contain all the information that is required if security holders and the administrative or management bodies of the offeree company (target) are to be able to make a careful and objectively informed decision. This is meant to prevent market manipulations and to ensure compliance with the principles of good faith by all parties involved. Due to their voluntary nature, the provisions of the Takeover Code are now accepted by many market participants, but not by all. The latter fact led to an ongoing public debate over whether or not the Takeover Code should become binding law.
All these more technical or legal developments occur at a time when not only the mere size of domestic German capital markets is expanding, but when increasing market sophistication is also becoming visible through the creation of new market segments. On 10 March 1997, the German stock exchange launched, for example, a new initiative for the German stock market: The New Market (Neuer Markt), a new and independent trading segment of the Frankfurt stock exchange, to which the statutory minimum standards of the regulated market apply, but which extends beyond it as far as the preconditions of admission to the market and consequential duties are concerned.
The purpose of the special requirements imposed on the issuers is, above all, a high degree of transparency. This is intended to bring together growth companies and risk-conscious investors.
The target group of the New Market includes, above all, small and medium-sized innovative growth enterprises with an international orientation and a willingness to adopt an active investor-relations policy. The New Market is a “regulated market” as defined in the ISD. Another innovation in German securities trading is the so-called “Betreuer”, enterprises licensed to trade on the Frankfurt Stock Exchange who will provide additional liquidity by quoting prices for the buying and selling of shares for which they are responsible as Betreuer, upon request. They shall also provide additional services in connection with the shares, such as regular analysis of the company for which they are responsible, the publication of research reports, the active marketing of shares, and support in investor relations. In doing so, the Betreuer can become the issuer’s coach on all matters related to the stock market.
At the same time, the forthcoming Emu and the already perceptible increase of competition among banks and other financial institutions in Germany (the dispute among private banks and public banks over the question whether guarantee liability and maintenance liability of the state with respect to public banks violate the EC state aid rules might serve as only one example of this increasing competition),will lead to a further internationalization of the German capital markets.
The successful global IPO of Deutsche Telekom AG in November 1996 as well as the growing interest of German companies in private placements in the US, and the search of DTB, the German futures exchange, for international cooperation partners show, among many other examples, that the domestic German capital markets are preparing to become a vital part of the future European capital markets.
Even the Anglo-Saxon concept of hostile takeovers has made its way to Germany. Despite its failure, the mere attempt of Krupp to take over Thyssen earlier this year, actively supported by major German commercial banks, showed that hostile takeovers are, particularly in less politically influenced industries than the coal and steel sector, no longer inconceivable.
In summary, it is fair to say that capital markets in Germany expand and change, and that market sophistication is constantly increasing. The regulatory framework of capital markets transactions reflects such changes by more and more amendments to existing statutory and regulatory provisions. In this context, liberalization and internationalisation does not automatically also mean deregulation.
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