The European parliament has updated its BRRD procedure file, postponing the plenary consideration of the proposal to its 14-17th April session. The regulatory framework has been agreed, however the plenary vote is a very necessary formality. Any further delay would place this cornerstone of EU banking reform perilously close to the 22nd May EU election.
On 17 January 2014, the EU Commission published a press release confirming that it will make a proposal “in coming weeks” for the reform of the structure of banking in the EU. The proposal will be based on the findings of Liikanen Report, published in October 2012, and will apparently will be “the final piece of the puzzle to address “too big to fail” banks”.
On Monday, Bundesbank Vice President Sabine Lautenschläger spoke out in favour of a single resolution authority at a conference in Berlin, according to this article. She said an EU wide mechanism would be able to take a “bird’s eye view” of financial institutions allowing for an easier and quicker solution in crisis situations. Lautenschläger added that it does not make sense to oversee banks at the European level while leaving their resolution to national authorities, although accepted that this would require amendment to EU treaties.
Her comments are at odds with the German government which ideally seeks a network of national resolution authorities (although recently agreed to a “resolution board” made up of national authorities) and is resistant to any scheme that could empower an external agency to independently decide when to close a bank. German Deputy Finance Minister Thomas Steffen, speaking at the same conference, said that the EU Commission would have a centralised resolution authority proposal soon.
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.
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:
Degree of Functional Separation
Degree of Ownership Separation
|Functional separation with economic and governance links restricted according to current rules (“Functional Separation 1”)||
|Functional separation with tighter restrictions on economic and governance links (“Functional Separation 2”)||
Overview of Options
The Commission provides the following matrix which summaries all of the possible permutations associated with each policy option:
Functional Separation 1 (current requirements)
Functional Separation 2 (stricter requirements)
|Narrow Trading Entity/ Broad Deposit Bank
e.g. Proprietary trading + exposures to venture capital/private equity/hedge funds
[approximate to legislation in France and Germany]
[approximate to US swaps push-out rule]
[approximate to US Volcker rule]
|Medium Trading Entity/ Medium Deposit Bank
e.g. proprietary trading + market making
[approximate to legislation in France or Germany if wider separation activated]
[Approximate to HLEG recommendations]
|Broad Trading Entity/ Narrow Deposit Bank
e.g. all investment banking activities
[approximate to US Bank Holding Company Act and UK Banking Reform Bill]
On 6 May 2013, the EU Commission published a roadmap regarding a proposal for a structural reform of EU banks (i.e. the Liikanen reforms). This followed the publication, on 2 October 2012, of the final report of the High-level Group on reforming the structure of the EU banking sector, chaired by Erkki Liikanen, a summary of which can be found here.
The main issues being considered by the Commission are:
- The definition of relevant activities to be separated from deposit-taking entities. This could include:
- proprietary trading;
- market-making; and
- securities underwriting.
- The nature and extent of separation and governance of separated entities. Available options include:
- functional separation (also referred to as “ring-fencing” or “subsidiarisation”);
- accounting separation; or
- full ownership separation.
- Thresholds and de minimis exemptions. These are likely to be based on:
- bank balance sheet size; or
- share of trading activities.
Consideration will also be given to:
- the treatment of derivatives business (as principal or as agent);
- the treatment of non-EU assets; and
- exposures to hedge funds and private equity funds.
A further public consultation will be launched in early May 2013 and a meeting of stakeholders is due to be held on 17 May 2013. Thereafter, as per its recent update, the Commission intends to adopt a legislative proposal in Q3 2013, although it is not yet certain whether that proposal will take the form of a Directive, a Regulation, or a combination of the two.
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.
On 21 January 2013, the European Commission published a timetable for certain legislative proposals that it expects to adopt between 1 January 2013 and 31 December 2013, including the following:
- Directive/Regulation on the reform of the structure of EU banks (i.e. the Liikanen reforms)
- Framework for crisis management and resolution for financial institutions other than banks
- Regulation on a single resolution authority and a single resolution fund within a Single Resolution Mechanism.
This is a link to an article in today’s Financial Times regarding a European Commission draft proposal which will force euro zone countries to share the cost burden of future bailouts in return for aid from the zone’s €500bn rescue fund.
The plan, circulated among euro zone finance minister officials late last year, calls for struggling countries to either invest in the rescue fund, European Stability Mechanism (ESM), or guarantee the fund against any losses. The proposal calls into question EU leaders’ commitment to “break the vicious circle” between failed banks and their sovereign leaders.
In June, the ESM agreed to directly recapitalise banks in countries such as Ireland and Spain in order to move large amounts of debt resulting from bank bailouts on to the ESM. However, the plan states that the ESM will only pay out once countries that could afford it place their own funds into failing banks first. A country facing insolvency after a bank bailout would also need to guarantee that the ESM would get its money back. Finance ministers have until June to make a final decision while in the interim period, the draft is likely to change
On 21 December 2012, the European Commission published a summary of the replies received to its October 2012 consultation on the recommendations of the high-level expert group on reforming the structure of the EU banking sector (the “Liikanen Group”). It also published links to individual responses.
In total, the Commission services received 89 responses and broke its summary down by reference to the five main recommendations of the Liikanen Group, as set out below.
Mandatory Separation of Proprietary Trading Activities and Other Significant Trading Activities
In general, banks believe that a compelling case for mandatory separation has not been made and contend that the current reform agenda is sufficient to tackle identified problems in the banking sector. Structural separation was criticised on the following grounds:
- Costs are high: the proposals are regarded as being inconsistent with universal banking and the associated costs will ultimately be borne by users of banking services;
- Claimed benefits may not materialise: bank structure is not regarded as a main driver of the financial crisis and structural change may actually create incentives for regulatory arbitrage;
- EU banking competitiveness will be harmed: Non-EU banks may not be subject to similar rules and only the largest trading houses will remain viable, leading to increased market concentration;
- Lack of consistency with other structural reform initiatives: such as those proposed in the USA and the UK; and
- Lack of clarity and detail: what is to constitute ‘significant’ trading activity that would mandate separation; which activities are to be separated; and what will be nature of the resultant relationship between a separated trading entity, a deposit bank and their holding company?
Even public authorities, including central banks and national finance ministries do not universally hold the view that the Liikanen reforms are necessary, although other types of financial institution, as well as consumer groups and think-tanks, were generally in favour of the proposals.
Additional Separation of Activities Conditional on Recovery and Resolution Plans (RRPs)
Respondents were generally in support of strengthened RRPs, with banks arguing that an effective RRP obviated the need for mandatory separation. However, some respondents argued that conditional separation based on RRPs would be arbitrary and that supervisors lack the capacity to adequately evaluate RRPs. Accordingly, mandatory separation would not only simplify banks but make the RRP framework more effective and credible.
Amendments to the Use of Bail-In Instruments as a Resolution Tool
There were respondents both for and against a more targeted bail-in approach involving clearly designated bail-in instruments (as opposed to bail-in of almost all unsecured liabilities). However, the majority of respondents did not support the proposal that bail-in instruments should not be held by other banks, on the basis that this would limit the investor base, raise bank funding costs and be ineffective at limiting interconnectedness in the financial system.
Review of Capital Requirements on Trading Assets and Real Estate Related Loans
Most respondents opposed the proposal to revise capital charges for the trading book, by setting an extra capital buffer or introducing a minimum floor to risk-based requirements, believing that these risks are being addressed via CRDIII and CRR/CRDIV.
Strengthening the Governance and Control of Banks
Respondents pointed out that significant progress has been made in banks’ corporate governance practices in recent years, and that further improvements are in the pipeline. There was general support for enhanced shareholders’ say on pay. Whilst the need for diversity of skills and experience of Board members was recognised, there was less support for introducing the proposed “fit & proper” tests. The general support for strong risk management contrasted against the lack of support for the proposed parallel risk reporting by Risk and Control Management to the Chief Executive Officer and the Risk and Audit Committee. There was also a lack of support (among banks) for the proposal to set a maximum ratio between variable and fixed pay or for the proposal to fix remuneration to dividends. Views were split on the use of bail-in bonds as part of remuneration.