EU Commission to Publish Liikanen Proposal on 29 January 2014

On 24 January 2014, the EU Commission published a press release confirming that, on 29 January 2014, it will publish a legislative proposal on EU bank structural reform designed to implement the findings of the Liikanen High Level Group.

It is thought that political agreement on the legislative proposals will not be reached before the end of 2015, with restrictions on proprietary trading likely to take effect from 2018.

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EU Parliament: We Don’t Actually Expect Liikanen to Work…

…we just want smaller banks.

On 25 June 2013, the EU Parliament’s Economic and Monetary Affairs Committee (ECON) published a report containing a motion for a resolution on reforming the structure of the EU banking sector that it adopted on 18 June 2013.  The report is notable less for the actual wording of the resolution and more for some of the statements made in the recitals which seem to cast light on the underlying motivations driving the structural separation of banks.

Separation doesn’t work

Despite stating the belief that the Glass-Steagall Act “helped to provide a way out of the worst global financial crisis to have occurred [in the US] before the present crisis”, the EU Parliament concedes that “there is no evidence from the past that a separation model could contribute in a positive way to avoiding a future financial crisis or to diminishing the risk of it”.

Banks are too big

Within the motion the Parliament clearly states the position that:

  • individual banks should not be allowed to become so large – even within a single Member State – that their failure causes systemic risks; and
  • the size of a Member State’s banking sector should be limited in terms of:
    • size – the suggestion seems to be that the ratio of private sector loans to GDP should not exceed 100%;
    • complexity; and
    • interconnectedness.

The resolution gives a clue as to the ‘look and feel’ of these smaller banks, urging the EU Commission, inter alia, to:

  • encourage a return to the partnership model for investment banking so as to increase personal responsibility;
  • ensure that remuneration systems prioritise the use of bail-in bonds and shares rather than cash, commissions or value-based items; and
  • rationalise the scale of the activities of banking groups.

EU Commission Publishes Liikanen Consultation

Introduction

On 16 May 2013, the EU Commission published “Reforming the structure of the EU banking sector”, a consultation paper which represents a follow-up to the recommendations made by the Liikanen High-Level Expert Group (the “HLEG”) in its report of October 2012.  The deadline for responses to the consultation is 3 July 2013.

The consultation paper only presents policy options with respect to the structural separation recommendations of the HLEG, noting that the HLEG’s other proposals have been at least partially addressed in other initiatives such as the Bank Resolution and Recovery Directive and the Capital Requirements Directive/Regulation, or will only become actionable after the completion of ongoing exercises such as the Basel Committee’s review of trading book capital requirements.  The Commission also accepts that structural reform will only affect a small subset of the approximately 8,000 EU banks.  In particular, most local and regional banks will be excluded as well as the banks that focus on customer related lending.  Moreover, separation requirements would not necessarily apply automatically to banks exceeding applicable thresholds but may be at the discretion of supervisors.

Policy Options

Against a “no action” baseline, the EU Commission is evaluating options grouped into three basic categories:

  • the scope of banks which should be subject to separation;
  • the scope of activities to be separated; and
  • the strength of separation.

Scope of banks subject to separation

Comments are requested on four options, all of which adopt differing definitions of “trading activity”, the separation criteria suggested by the HLEG:

  • using the original HLEG definition, under which assets ‘held for trading and available for sale’ are to be separated;
  • a narrower definition that excludes ‘available for sale’ assets;
  • a definition focused on gross volume of trading activity, which is likely to focus on proprietary trading and market-making activities; and
  • a definition focused on net volumes, designed to capture only those institutions which concentrate on proprietary trading.

Within each separation option, the Commission asks for responses as to the degree of supervisory discretion which should apply, with specific reference to the following sub-options:

  • ex-post separation determined by EU legislation but with the actual separation decision to be at the discretion of a supervisor;
  • ex-ante separation subject to supervisor discretion to exempt individual institutions or include additional firms in accordance with criteria and limits set out in EU legislation; and
  • ex-ante separation pursuant to which any bank with trading activities above the threshold would automatically be obliged to separate those activities.

The scope of activities to be separated

The Commission are considering three options which can be summarised as follows:

  • “Narrow” trading entity and “broad” deposit bank: under which, broadly, only proprietary trading and exposures to venture capital, private equity and hedge funds would be separated;
  • “Medium” trading entity and “medium” deposit bank: under which both proprietary trading and market making would be separated; or
  • “Broad” trading entity and “narrow” deposit bank: under which all wholesale and investment banking activities would be separated, including proprietary trading, market making, underwriting of securities, derivatives transactions and origination of securities.

Strength of separation

Three broad forms of separation, none of which are mutually exclusive, are considered:

  • accounting separation: the lightest form of separation (and considered unlikely to be sufficient by the Commission) under which a group would be required to make separate reports for each of its different business units but under which there would be no restrictions on intra-group legal and economic risks;
  • functional separation: under which some activities would need to be provided by separate functional subsidiaries with various sub-options available as to the degree of legal, economic, governance and operational separation which should apply; and
  • ownership separation: the strongest form of separation under which the services would have to be provided by different firms with no affiliations.

The three ‘strength of separation’ options proposed by the Commission can be summarised as follows:

Option

Degree of Functional Separation

Degree of Ownership Separation 

Functional   separation with economic and governance links restricted according to current   rules (“Functional Separation 1”)
  • Separate legal entities required
  • Legal entities subject to capital, liquidity, leverage and large   exposure rules on an individual basis
  • Separate governance (unless waived) for each entity
 
Functional   separation with tighter restrictions on economic and governance links (“Functional   Separation 2”)
  • Separate legal entities required
  • Restrictions on ownership links between separated entities   within the group
  • Legal entities subject to capital, liquidity, leverage and large   exposure rules on an individual basis
  • Intra-group dealings to be at arms’ length
  • No waiver of large exposure restrictions in relation to intra-group   trades
  • Limits on intra-group guarantees from deposit taking entity to   trading entity
  • Limits on board directors acting for multiple entities within   the group
 
Ownership   separation  
  • Banks to divest themselves of certain activities

Overview of Options

The Commission provides the following matrix which summaries all of the possible permutations associated with each policy option:

Activities/Strength

Functional Separation 1 (current requirements) 

Functional Separation 2 (stricter requirements)

Ownership   Separation

Narrow Trading Entity/ Broad Deposit Bank

e.g. Proprietary trading +   exposures to venture capital/private equity/hedge funds

Option A

[approximate to   legislation in France and Germany]

Option B

[approximate to US   swaps push-out rule]

Option C

[approximate to US   Volcker rule]

Medium Trading Entity/ Medium Deposit Bank

e.g. proprietary trading +   market making

Option D

[approximate to   legislation in France or Germany if wider separation activated]

Option E

[Approximate to   HLEG recommendations]

Option F

Broad Trading Entity/ Narrow   Deposit Bank

e.g. all investment banking   activities

Option G

Option H

[approximate to US   Bank Holding Company Act and UK Banking Reform Bill]

Option I

 

ECON Draft Report on Structural Reform of EU banking sector

On 13 March 2013, the EU Parliament’s Committee on Economic and Monetary Affairs (ECON) published a draft report on reforming the structure of the EU’s banking sector.

The report welcomed the Liikanen Group’s analysis and recommendations on banking reform, concluding that, while current proposals for reform of the EU banking sector are important, a more fundamental reform of the banking structure is essential.  Accordingly, it urges the EU Commission to draft a proposal for full and mandatory separation of banks’ retail and investment activities via ring-fencing around those activities that are vital for the real economy.  According to ECON, mandatory separation should result in:

  • separate legal entities;
  • separate sources of funding for the bank’s retail and investment entities;
  • the application of adequate, thorough and separate capital, leverage and liquidity rules to each entity (with higher capital requirements for the investment entity); and
  • net and gross large exposure limits for intra-group transactions between ring-fenced and non-ring-fenced activities.

 

The Banking Reform Bill: Secondary Legislation Hints at the Data Challenge Facing Banks

Introduction

On 8 March 2013, three draft statutory instruments to be made under the Financial Services (Banking Reform) Bill 2012-13 (the “Banking Reform Bill”) were published by HM Treasury:

These statutory instruments are starting to put flesh on the bones of the Banking Reform Bill, a piece of framework legislation which was published last month.  For more detail on the Banking Reform Bill in general, please see our previous blog post.

The draft statutory instruments deal with four main issues:

  • The class of institutions which are exempt from the definition of “ring-fenced body” (“Exempt Institutions”);
  • The types of deposit that do not need to be held within a ring-fenced body (“Exempt Deposits”);
  • The types of activities that will not be regarded as “excluded” and therefore can be conducted by a ring-fenced body (“Exempt Activities”); and
  • The amount of exposure a ring-fenced entity is permitted to incur to a “financial institution” (“Permitted Exposure”).

A more detailed summary of the draft statutory instruments is provided in the Schedule below.  As more information becomes known we will provide additional updates.  However, even at this stage of the legislative process, what becomes immediately apparent is the huge data challenge firms will face in monitoring the height and location of the ring-fence, particularly with respect to the process surrounding Exempt Deposits and when incurring exposure to financial institutions.

Schedule

The Ring-fenced Bodies Order

In general, the Ring-fenced Bodies Order defines:

  • The class of Exempt Institutions; and
  • The class of Exempt Deposits.

Exempt Institutions

The following institutions do not qualify as ring-fenced bodies and are therefore not subject to the ring-fencing rules:

  • broadly, any deposit taking institution which has held, on average, GBP 25 billion or less in deposits (calculated by reference to all UK deposit taking institutions in the group);
  • insurance companies; and
  • credit unions or industrial and provident societies.

Exempt Deposits

Deposits are Exempt Deposits if they are held on behalf of:

  • high net worth individuals (“HNWI”) (i.e. individuals who have, on average over the previous year, held free and investible assets worth GBP 250,000 or more); and
  • small and medium sized enterprises (“SME”) which are also financial institutions and have been certified as such within the preceding 18 months.

An SME is:

  • an enterprise which
    • employs fewer than 50 staff; and
    • has a turnover of GBP 6.5 million or less, or an annual balance sheet total of GBP 3.26 million or less; or
  • a charity which has gross income (calculated on a group-wide basis) of GBP 6.5 million or less.

Note, however, that the following do not qualify as “financial institutions” and so deposits held for these institutions cannot qualify as Exempt Deposits irrespective of whether the institutions would qualify as SMEs:

  • ring-fenced bodies;
  • building societies;
  • credit unions; or
  • investment firms authorised to deal in investments as principal or agent.

In addition, if a statement regarding HNW or SME status is not refreshed every 12 months, or if a firm is notified that an account holder no longer benefits from HNW or SME status, and the deposit is held by a firm which is not already:

  • a ring-fenced body;
  • an Exempt Institution; or
  • a building society

then the firm in question must notify the account holder that the deposit will become a “core deposit” (and therefore subject to the ring-fencing requirements) if the HNW or SME status is not refreshed within 18 months of its original date.  The notification must also request that the account holder respond to the firm within six months:

  • providing an updated HNW or SME certificate;
  • nominating a ring-fenced body to which the deposit can be transferred if it becomes a “core deposit”; or
  • acknowledging that the account holder will accept repayment of the deposit, together with details necessary to effect such repayment.

The account holder must also be warned that a failure to respond will result in the transfer of the deposit to an identified ring-fenced body.  If the firm has a group member which is also a ring-fenced body, then the transfer of the deposit should be made to that group member.

The Excluded Activities Order

Exempt Activities

Under the Banking Reform Bill, ring-fenced bodies are not allowed to partake in “excluded activities” (i.e. dealing in investments as principal).  However, under the Excluded Activities Order, a ring-fenced body will not be regarded as carrying on an excluded activity by:

  • entering into a transaction if the sole or main reason for doing so is to hedge interest rate, currency, default or liquidity risk;
  • buying, selling or acquiring investments for the purposes of maintaining liquid resources as required by BIPRU 12 (provided that this does not result in a breach of the “Financial Institutions Exposure Limits” detailed below); or
  • entering into derivatives transactions with its accounts holders, provided that such transactions comply with the “Derivative Transactions” requirements detailed below.

Derivative Transactions

A ring-fenced body may enter into derivatives transactions with its account holders provided that those transactions:

  • have a linear pay-off (i.e. no options); and
  • the sole or main purpose of the transaction is to hedge:
    • interest rate risk;
    • currency risk; or
    • commodity price risk; and
  • there is evidence available to assess the “fair value” of the investment; and
  • the “position risk requirement” (i.e. the capital requirement applied to market risk positions under BIPRU 7) attributable to all such transactions remains less than TBD% of the ring-fenced body’s own funds; and
  • the sum of the position risk requirements attributable to each individual transaction is less than TBD% of the “credit risk capital requirement” of the ring-fenced body calculated in accordance with GENPRU 2.1.51.

Financial Institution Exposure Limits

Ring-fenced bodies are prohibited from entering into any transaction under which it will incur exposure to a financial institution unless:

  • the sole or main reason for entering into the transaction is to hedge:
    • interest rate risk;
    • currency risk; or
    • default risk; and
  • where the transaction is concluded with a member of the ring-fenced body’s group, it is done so on arms’ length terms; and
  • where the financial institution in question is a “small credit institution” (judged by reference to the size of its balance sheet), the transaction does not increase the ring-fenced body’s exposure:
    • in aggregate to small credit institutions above TBD% of the ring-fenced body’s own funds; or
    • to its counterparty (i.e. to the small credit institution) above TBD% of the ring-fenced body’s own funds; and
  • the transaction does not:
    • increase the aggregate payment exposure of the ring-fenced body to an amount equal to or greater than:
      • TBD% of the ring-fenced body’s own funds in relation to overnight payment exposure[1], or
      • TBD% of the ring-fenced body’s own funds in relation to intra-day payment exposure; and
      • increase the ring-fenced body’s exposure to the financial institution to an amount which is TBD% or more of the ring-fenced body’s own funds; and
  • the transaction does not:
    • increase the aggregate settlement exposure of the ring-fenced body to an amount equal to or greater than:
      • TBD% of the ring-fenced body’s own funds in relation to settlement exposure with a maximum tenor of t+2, or
      • TBD% of the ring-fenced body’s own funds in relation to settlement exposure with a maximum tenor of t+5[2]; and
      • increase the ring-fenced body’s exposure to the financial institution to an amount which is TBD% or more of the ring-fenced body’s own funds; and
  • in relation to letters of credit issued to a financial institution on behalf of a customer of the ring-fenced body:
    • the customer is not a financial institution; and
    • the letter of credit:
      • is issued in connection with the supply of goods or services; and
      • specifies the transactions to which it relates; and
      • specifies the total credit available under it; and
      • is subject to the uniform customs and practices for documentary credits 2007 version[3]; and
      • the total exposure of the ring-fenced body in relation to letters of credit is less than TBD% of the ring-fenced body’s own funds.

Ring-fenced bodies will be required to disclose payments exposure, settlements exposure and exposure to letters of credit.

Other Developments

Inter-bank Clearing and Settlement Services

Ring-fenced bodies will be required to access inter-bank clearing and settlement systems either directly, or indirectly via another ring-fenced body.

Non-EEA Branches and Subsidiaries

Without the approval of the Prudential Regulation Authority (“PRA”), a ring-fenced body may not:

  • maintain or establish a branch in any country or territory which is not an EEA member state; or
  • have a participating interest in any undertaking which is incorporated in or formed under the law of country which is not an EEA member state.

Moreover, although a ring-fenced body will be deemed to have provisional approval for its application, ultimately the PRA will only be able to approve an application if, at a minimum:

  • information sharing arrangements exist which will enable the PRA to obtain any required information;
  • any stabilisation powers exercised by the Bank of England or the Treasury would be recognised in the jurisdiction in question; and
  • approval of the application would not increase the risk that the failure of the ring-fenced body would have an adverse effect on the continuity of the provision within the UK of “core services”

The Fees Order

These regulations enable HM Treasury to charge certain expenses associated with the UK’s participation in the Financial Stability Board, to a defined class of market participants.


[1] The implication appears to be that incurring payment exposure which is greater than overnight is not permitted.

[2] The implication appears to be that incurring settlement exposure in excess of t+5 is not permitted

[3] As published by the International Chamber of Commerce

Liikanen, Non-bank RRP and SRM Rules Expected in H2

On 27 February 2013, the European Commission published an updated summary of the legislative and non-legislative proposals it expects to adopt between 21 February and 31 December 2013.

Among the legislative acts expected to be adopted are a:

  • Directive/Regulation on the reform of the structure of EU banks (i.e. Liikanen), expected in Q3 2013;
  • Framework for crisis management and resolution for financial institutions other than banks, expected in Q4 2013; and
  • Regulation on a single resolution authority and a single resolution fund within a Single Resolution Mechanism (SRM), expected in Q4 2013.

“2013 is the year when we re-set our banking system…”

…said George Osborne in a speech to staff at JP Morgan in Bournemouth yesterday.  According to the Chancellor, the reset button comprises four main elements:

  • The transfer of responsibility for banking supervision from the FSA back to the Bank of England, which will have the “power to call time before the party gets out of control”;
  • The ringfencing of retail banking from investment banking;
  • Changing the culture and ethics of the banking industry; and
  • Giving customers more choice in their receipt of banking services.

Ringfencing

On the subject of ringfencing of retail banking, Mr Osborne confirmed that the Banking Reform Bill was published yesterday.  The bill is based on the recommendations of the Vickers Report and will require the creation of a ringfence around the retail arms of banks, enabling essential operations to continue in the event that the whole bank fails.  If a bank flouts the rules, the Bank of England and the Treasury will have the power to break it up altogether.  Mr Osborne expects the bill to be passed into law this time next year.  In addition, the Chancellor announced that:

  • A high street bank will be required to have different bosses from its investment bank;
  • A high street bank will manage its own risks, but not the risks of its investment bank; and
  • Investment banks will not be allowed to use retail savings in order to fund “risky investments”.

Increased Choice

On the subject of increased choice, the Chancellor announced that the Government would bring forward detailed proposals to open up payment systems, ensuring that new players in the market can access these systems in a “fair and transparent way”.  The implication is that responsibility for supervision of payment systems will be taken away from the Payments Council, a bank-led body.