Electrify the Vickers Ringfence Says Commission

On 21 December 2012, the Parliamentary Commission on Banking Standards published its first report, in which it gives consideration to the draft Financial Services (Banking Reform) Bill and associated proposals which give effect to the conclusions detailed in the Vickers’ report.

Whilst the Commission supports the introduction of ring-fencing, its Chairman Andrew Tyrie MP, stated that the proposals “fall well short of what is required”.  The Commission recommends “electrification” of the ring-fence by given regulators the power to forcibly separate any bank found guilty of trying to circumvent the rules.  In addition, the Commission proposes that the Financial Services and Markets Act 2000 should include a legal duty on boards of directors to preserve the integrity of the ring-fence.

Better news is found in the Commission’s conclusion that there is a case in principle for permitting the sale of simple derivatives to small businesses from within the ring-fence.  However, such permission would need to be subject to conditions and agreement on a satisfactory definition of “simple derivatives”.  Less welcome will be the news that the Commission will investigate further as to whether a ban on proprietary trading – akin to a Volcker Rule – is appropriate.

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European Banking Federation responds to Liikanen

Introduction

On 14 November 2012, the European Banking Federation (EBF) published its response to the final report of the Liikanen Group on proposed structural reforms to the EU banking sector.  Broadly, the Liikanen Group had recommended the mandatory separation, with respect to all banks exceeding a certain threshold, of trading business from more ‘traditional’ banking activities.  The resulting entities would be required to fund themselves separately and meet other prudential regulatory requirements on a stand-alone basis.  The main issues addressed by the EBF are summarised below.

Mandatory Separation

The EBF believes that the case for mandatory separation has not been made in light of the Liikanen Group’s conclusions that:

  • no particular business model was more or less vulnerable in the crisis;
  • the benefits of the universal banking model should be retained;
  • the EU Single Market should remain intact; and
  • the regulatory reform agenda represents a “substantive and robust” response to addressing the deficiencies which become apparent during the financial crisis.

The EBF believes that mandatory separation:

  • does not adequately address the riskiness of assets;
  • does not solve the issue of systemic risk;
  • has distortive effects upon bank functions;
  • will impact negatively on banks’ ability to lend;
  • will reduce diversification benefits of the universal banking model;
  • will reduce the competitiveness of the European financial sector by creating a two-tier system where banks with risky trading positions below the threshold obtain an unfair advantage;
  • will lead to a further fragmentation of the Single Market due to the fact that the reforms proposed by the Liikanen Group represent an add-on to national structural reform proposals such as Vickers and Volcker as well as future proposals being discussed in other Member States, including France, Holland and Belgium; and
  • would result in higher costs for bank customers.

The EBF believes that there is a real risk that an independent trading entity would not be viable and would be downgraded by credit rating agencies, forcing up funding costs.  This, together with the likely increase in administrative costs arising from the proposed requirements for separate reporting and  independent boards and governance, could lead to non-EU banks replacing European banks as providers of ‘trading’ services as well as the concentration of risk in the few market participants large enough to bear the increased cost.

Instead of the proposed mandatory separation, the EBF supports a solution that targets high-risk and speculative trading activities, using proprietary trading activities with no link to clients’ needs as an example.  To this end, it recommends the enhanced use of Recovery and Resolution Plans (RRPs) as a way to address any impediments to resolvability.  However, it maintains that structural separation of certain activities conditional on the RRP should be viewed as a last resort.

Bail-In

The EBF is yet to be convinced that a designated bail-in category, as recommended by the Liikanen Group, is preferable to the proposals in the draft EU Recovery and Resolution Directive (RRD) requiring a broad range of bail-in-able debt instruments.  The EBF also believes that further consideration needs to be given to the exclusion of short-dated instruments, although it acknowledges that a broad range of views exist even within the EBF, from suggestions to remove the short-dated exclusion altogether, to proposals that the one month period be increased to six months on the basis that this is more consistent with other supervisory requirements such as the Net Stable Funding Ratio under Basel III.  The EBF believes strongly that derivative positions should not be included within the scope of bail-in.

Capital Requirements

The EBF believes that the introduction of floors for risk weightings “constitutes a significant threat to risk modelling and to the principle of calibrating capital requirements according to actual risks”.  It also believes that proposals to establish extra non-risk based capital buffers for the trading book as well as LTV caps for real estate related lending (both of which would take effect on top of existing risk-based requirements) should be deferred pending the finalisation of the new Capital Requirements Directive.  Specifically, the EBF states that exposures to funds falling within the scope of the Alternative Investment Fund Managers Directive should not be perceived as risky or speculative activities for which extra measures needs to be undertaken.

 

IMF Speech on Global Financial Sector Reform

On 26 October 2012, the IMF published a speech given in Toronto by its Managing Director, Christine Lagarde, on global financial sector reform.

Ms Lagarde noted that progress had been made on implementing financial sector reform, specifically referring to Basel III and improved standards for the resolution of banks.  In particular, she welcomed the EU’s moves to adopt a legal framework for a single supervisory mechanism by the end of 2012 as well as provisions regarding national resolution and deposit guarantee frameworks.  However, she noted that a globally coordinated discussion and response was still required in a number of areas, including:

  • current efforts to resolve the issue of “too important to fail” through structural reform as proposed by Volcker, Vickers and Liikanen; and
  • international agreement on methodologies to assess compliance of recovery and resolution planning for large cross-border institutions.

Banking Reform Under Fire

The effectiveness of both the proposed Vickers and Liikanen ringfenced were questioned yesterday during evidence given by Paul Volcker to the UK Parliamentary Commission on Banking Standards.

According to this FT article, Mr Volcker described the Vickers ringfence as “difficult to sustain” and full of holes “likely to get bigger over time”.   The article also suggests that the future direction of the legislation designed to enact Vickers may diverge from a wholescale adoption of its proposals.

Elsewhere, the FT also reports that legal advice provided to the EU Council has concluded that plans to create a single eurozone banking supervisor may be illegal unless treaty change is enacted so as to broaden the scope of governance rules at the ECB.  Moreover, non-eurozone countries that wish to opt into the new regime would not legally be entitled to vote, making it less likely that those countries would wish to join and so undermining the effectiveness of the initiative from the outset

Liikanen Report on EU Banking Reform to be published on 2 October 2012

On 28 September 2012, the EU Commission published a press release confirming that the final report of the Liikanen Committee is due to published on 2 October 2012.

The Liikanen Committee is an expert group, formed by the EU Commission in February 2012 and chaired by Erkki Liikanen (former Governor of the Bank of Finland), to investigate the case for structural reform of the EU banking sector in order to strengthen financial stability and improve efficiency and consumer protection.

According to this FT article, it seems that the Liikanen Committee will draw on the proposals of the Vickers Report in the UK and the Volcker Rule in the US and recommend that certain trading activities of banks are ringfenced.  However, it is thought that the committee will not go as far as recommending actual levels of capital that must be applied to ringfenced operations.  Questions also remain as to the maximum permissible volume of trading activities that may take place before a ringfence must be created.

European Banking Federation Publishes Study on Reform of EU Banking Sector

Introduction

On 24 July 2012, the European Banking Federation (“EBF”) published a “Study on the issue of possible reforms to the structure of the EU Banking Sector”.  The report is related to the ongoing work of the High Level Expert Group established by the EU Commission to examine the same issue.

The report distinguishes regulatory reform (such as CRD IV, RRP, EMIR and MiFID) from structural reform – a reference to the Vickers report in the UK and the Volcker rule in the US.

Regulatory Reform

In general, the EBF is supportive of regulatory initiatives.  However, on the subject of RRP, it cautions that “a reasonable balance must be struck between effective, robust supervision and supervisory approaches which are overly intrusive into the normal, day-to-day running of a healthy business”.  The EBF also approves of the concept of “bail-in”, favouring a wide definition of bail-in-able debt so as to reduce the possibility of arbitrage and the need for a statutory minimum quantity of bail-in-able debt to be issued by firms.  However, the EBF believes that the “timing and the implementation of any bail-in mechanism…must…avoid imposing an excessive funding cost that could impair the provision of credit to the real economy and result in an excessive deleveraging”.

Structural Reform

The EBF believes that the objectives of the G20 and the EU are to:

  • increase the stability of the European financial sector by reducing risk;
  • ensure orderly resolution of financial institutions without taxpayer support; and
  • maintain the integrity of the Internal Market and to ensure the ability of banks to serve the real economy.

It claims that all of these objectives can be achieved by the finalisation and implementation of the regulatory reform agenda without the necessity of structural reform.  Citing the ECB’s report on EU Banking Structures, the EBF claims that “there is no convincing evidence that structural reform has a direct influence on systemic risk and would make restructuring or resolution easier in the event of a crisis.”  Quite the opposite, it expresses the view that “the disadvantages deriving from a potential adoption of UK- or US- style structural reforms for the EU would be much larger than the eventual benefits that they would generate” due to the possibility that it will lead to fragmentation of financial markets in the EU and create incentives to circumvent the rules.  As such, it concludes that any structural change should be delayed until the regulatory reform agenda has been completed so that its impact can be properly assessed.

Conclusion

The views of the EBF regarding the definition of bail-in-able debt are interesting.  They accord with opinions expressed by the buyside, such as AIMA,  and are undoubtedly correct.  The more narrow the definition, the greater the risk that the protection afforded by bail-in debt will be rendered toothless at the structuring desks of investment banks around the globe.

The reluctance of the EBF to embrace structural change is understandable.  Whilst the political benefits are clear and opinion both amongst regulators and the industry seems to be swinging behind these initiatives (see, for example, here), the economic case for reforms such as those proposed by Vickers has yet to be made definitively.  Unfortunately for the banks, however, neither the UK nor the US governments seem to have a reverse gear where Vickers and Volcker are concerned.

If you have an hour to spare I would recommend that you read this study for no other reason than it provides an excellent review of the history and developments across the entire regulatory landscape within the EU.