PCBS Itching to Ban Proprietary Trading

On 15 March 2013, the Parliamentary Commission on Banking Standards (PCBS) published its Third Report on proprietary trading within banks.

The PCBS considers that there is no commonly-accepted definition of proprietary trading and recognises that most activity undertaken by banks results in some form of proprietary position.   However, it is primarily concerned with trading in which a bank uses its own funds to speculate on markets, without any connection to customer activity.  It accepts that proprietary trading results in risks which are not necessarily any different from those associated with other banking activities, many of which actually made a greater contribution to the financial crisis.  Nonetheless, it considers that the argument that proprietary trading can have harmful cultural effects within a bank has been “convincingly made”, creating a conflict of interest between a bank’s attempts to serve its customers and the trading of its own positions and, as such, being “incompatible with maintaining the required integrity of customer-facing banking”.

Despite its in-principle opposition to proprietary trading, even outside of a ring-fenced bank, the PCBS recognises the practical difficulty in establishing a definition of “proprietary trading” which is capable of being effectively enforced, given its similarity to other activities such as market-making.  Even alternative metric-based approaches, such as those being considered in the US, which track patterns of trading activity remain unproven, relatively complex and resource-intensive.  Consequently, the PCBS believes that it would not be appropriate to attempt immediate prohibition of proprietary trading through the Banking Reform Bill (BRB).  However, it does recommend that the current legislation require the regulators to carry out, within three years of the BRB being enacted, a report to include, inter alia, a full assessment of the case for and against a ban on proprietary trading.  This report would be presented to the Treasury and to Parliament and serve as the basis of a full and independent review of the case for action in relation to proprietary trading by banks.  In the meantime, the PCBS recommends that the Prudential Regulation Authority (PRA) monitor the main UK-headquartered banks’ assertion that they no longer engage in proprietary trading, and should use its existing tools such as capital add-ons or variations of permission to “bear down on such activity and incentivise the firm to exercise tighter control”.

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

Bank Ring-fencing in the UK: The Financial Services (Banking Reform) Bill 2013

Introduction

On 4 February 2013, the Financial Services (Banking Reform) Bill 2013 (the “BRB”) was published on the UK Parliament website.  The BRB had its first reading in the House of Commons on 4 February, and its second reading on 5 February.  Its purpose is to implement the recommendations of the Independent Commission on Banking (ICB) and deals with the following issues:

  • ring-fencing requirements for the banking sector;
  • depositor preference; and
  • Financial Services Compensation Scheme.

This article focuses on ring-fencing requirements, an initiative which the UK government estimates will cost the banking industry between GBP 1.5 and 2.5 billion to implement and between GBP 1.7 and 4.4 billion per annum thereafter in terms of increased capital, funding and operational costs.

Ring-fencing

The BRB will implement ring-fencing in the UK via amendments to the Financial Services and Markets Act 2000 (“FSMA”).  As currently drafted, the Prudential Regulation Authority (“PRA”) will be charged with ensuring that the business of “ring-fenced bodies” is carried on in a way that avoids any adverse effect on the continuity of the provision in the UK of “core services”.

A “ring-fenced body” is a UK institution which carries out one or more “core activities”.  Currently, the only “core activity” is the accepting of deposits.  It is widely assumed that a de minimis exemption will apply for UK institutions with less than GBP 25 billion in deposits from individuals and small and medium sized entities (“SMEs”).  In addition, building societies are not regarded as “ring-fenced bodies” or otherwise subject to the BRB, although the Treasury is empowered to pass similar rules for these institutions.

 “Core Services” include the provision of:

  • facilities for the accepting of deposits or other payments into an account which is provided in the course of accepting deposits;
  • facilities for withdrawing money or making payments from such an account; and
  • overdraft facilities in connection with such an account.

Additions to the lists of “core activities” and “core services” are possible but, broadly, require the Treasury to form the view that an interruption of the provision of the activity or service in question could adversely affect the stability of all or a part of the UK financial system.

The Location and Height of the Ring-Fence

The location and height of a ring-fence at any time should be considered within the context of the general powers of prohibition granted to the Treasury.  These powers allow it, inter alia, to prohibit a ring-fenced body from entering into transactions of a specified kind or with persons falling within a specified class if it considers that it would be more likely that the failure of a ring-fenced body would have an adverse effect on the continuity of the provision in the UK of core services.  With that in mind, some clarity has been provided as to the type of services that can, and cannot, reside inside a ring-fence.

Outside of the Ring-fence

Ring-fenced bodies are not permitted to carry out “excluded activities”.  Presently, only the regulated activity of dealing in investments as principal constitutes an “excluded activity”.  However, the Treasury has powers to define other “excluded activities” if it considers that the carrying on of that activity by a ring-fenced body would make it more likely that its failure would have an adverse effect on the continuity of the provision in the UK of core services.  In addition, the Treasury has power to allow a ring-fenced body to deal in investments as a principal if this would not be likely to result in any significant adverse effect on the continuity of the provision in the UK of core services.

Inside the Ring-Fence

Simple Derivatives

Secondary legislation will define the conditions under which ring-fenced banks may enter into derivatives contracts.  The government has confirmed that this will reflect the recommendations of the Parliamentary Commission on Banking Standards (“PCBS”), which require:

  • the implementation of adequate safeguards to prevent mis-selling;
  • agreement on a “limited and durable” definition of “simple” derivatives; and
  • the imposition of limits on the proportion of a bank’s balance sheet which can be allocated to derivatives.

Non-Core Deposits

“Non-Core Deposits” are deposits made by high-net-worth private banking customers and larger organisations.  They may be taken by a bank which is either inside or outside of a ring-fence.  However, outside of a ring-fence, safeguards will be enacted via secondary legislation to ensure that depositors are able to make an informed choice prior to placement of the deposit.  These safeguards are likely to include monetary thresholds and a requirement that eligible individuals and organisations must actively seek the exemption if they wish to use it.

Retail and SME Lending

Banking groups will not be required to carry out retail and SME lending exclusively from within the ring-fence.

Electrifying the Ring-fence

In order to ensure its robustness and effectiveness over time, the PRA will be required to report annually on the operation of the ring-fence.  Specifically, it will be required to address:

  • the extent to which ring-fenced bodies have complied with ring-fencing provisions,
  • steps taken by ring-fenced bodies to comply;
  • enforcement measures taken by the PRA; and
  • the extent to which ring-fenced bodies have acted in accordance with guidance regarding the operation of the ring-fence.

In addition, the government has confirmed[1] that it will amend the BRB in order to give the PRA the power, if required, to enforce full separation between retail and wholesale banking with respect to an individual banking group.  However, it has chosen not to act on the recommendation of the PCBS to grant the PRA the power to enforce industry-wide separation, considering that decisions over the fundamental structure of banking in the UK should be left to Parliament rather than to a regulator.

Independence of the Ring-Fenced Body

Ring-fenced bodies will be required to ensure that, as far as reasonably practicable:

  • the carrying on of core activities is not adversely affected by the acts or omissions of other members of its group;
  • it is able to take decisions independently of other members of its group;
  • it does not depend on resources from group members which would cease to be available in the event of the insolvency of the group member; and
  • it would be able to continue to carry on core activities in the event of the insolvency of one or more other group members.

In order to give teeth to these provisions, ring-fenced bodies will be required to:

  • enter into contracts with group members on arm’s length terms;
  • restrict the payments (e.g. dividends) that it makes to other group members;
  • disclose to its regulator information relating to transactions between it and other group members;
  • include on its board of directors members who are independent both of the ring-fenced body and the wider group as well as non-executive members;
  • act in accordance with a remuneration policy and a human resources policy meeting specified requirements;
  • make arrangements for the identification, monitoring and management of risk in accordance with specified requirements; and
  • implement such other provisions as its regulator considers necessary or expedient.

In addition, the government has confirmed that:

  • directors of ring-fenced banks should be personally responsible for ensuring that their banks comply with ring-fencing provisions; and
  • a director of a ring-fenced body must be an approved person so that the full range of PRA disciplinary powers may be applied to any director who is knowingly concerned in a contravention of any ring-fencing obligation.

The Treasury may also require banking groups to split pension schemes between ring-fenced and non ring-fenced entities as the former cannot become liable to meet, or contribute to the meeting of, liabilities in respect of pensions or other benefits payable to or in respect of persons employed by non ring-fenced bodies.  However, this requirement will not enter into force until 1 January 2026 at the earliest.

Conclusion

The BRB inevitably leaves many question unanswered, including:

  • the exact scope of the ring-fence i.e. the activities and assets which can (or cannot) be within the ring-fenced body: whilst some guidance has been provided at the edges the majority in the middle remains unknown;
  • the exact nature of exemptions (including the de minimis exemption) from ring-fencing;
  • specific prohibitions on the activities of ring-fenced banks; and
  • the definition of a “simple” derivative: despite the recent mis-selling scandal it would appear that interest rate swaps used for the purposes of hedging can be sold from within the ring-fence.  Presumably the same will be the case for vanilla currency swaps.

Much of the detail of the BRB remains to be fleshed out via statutory instrument.  However, despite this, fundamental questions already exist about the enforceability of ring-fencing as current drafted.  For example, the prohibition on non ring-fenced group companies benefiting from funding providing by a ring-fenced entity does not appear to be entirely consistent with Article 16(1) of the draft EU Recovery and Resolution Directive (“RRD”), which requires Member States to “ensure” that group companies can enter into an agreement to provide financial support to one another in the event of financial difficulties.

The UK government remains lukewarm at best to the idea of implementing further reform along the lines of the Volcker Rule, as advocated by the PCBS.  Neither is it minded to increase the Basel III Leverage Ratio from its current 3% to 4%; another PCBS suggestion. Further afield, attempts to implement structural reform of banks at a national level within Germany and France may yet halt the momentum behind the Liikanen reforms.  Ultimately, time will tell, but perhaps UK banks should be thankful for small mercies in that they may only face the prospect of having to split themselves in two, rather than three or even four, parts.

Whatever the final form of the BRB and other structural reform initiatives, one thing is certain: the process of separating a retail bank from a wholesale bank will be a monumental undertaking.  It will require a detailed analysis of assets and liabilities for the purposes of allocation inside or outside of the ring-fence, fundamental legal and operational re-structuring, wholesale re-papering of contractual relationships and robust policies and procedures for the purposes of monitoring the location and height of the ring-fence on an ongoing basis.  Despite the 2019 deadline and the many blanks in the legislation yet to be completed, any bank likely to be subject to the BRB should already be planning how it will implement organisational change on this scale.


Osborne Promises to Electrify the Ringfence

The FT reports that George Osborne will today make clear that any bank which attempts to circumvent the ringfencing rules, proposed as part of the Vickers Report and published today in the form of the Banking Reform Bill, faces the prospect of separation in full by the Bank of England.

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.

Commission on Banking Standards Threatens Forced Bank Break-Ups

The FT reports this morning that the Parliamentary Commission on Banking Standards may recommend that UK banks which fail to comply with the Vickers proposals are subject to a complete separation of retail and investment banking activities.  It also seems increasingly likely that banks will be subject to frequent checks as to their compliance with the ringfencing requirements of Vickers.

Make All Existing Debt “Bail-inable” Say Banks

This is a link to an FT article reporting on evidence given yesterday to the Parliamentary Commission on Banking Standards by Stephen Hester, Chief Executive of Royal Bank of Scotland and Peter Sands, his opposite number at Standard Chartered.

Both men support proposals to make all existing unsecured bank debt “bail-inable”, irrespective of maturity.  This, the FT reports, would create a buffer of more than £200 billion before bank failure would result in taxpayer liability.  Mr Hester is reported to have recognised that such a move was “essential for society”, even if it led to increases in the cost of bank debt.

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

Tough Times for UK Banks: The Liikanen Group Publishes its Final Report

Introduction

On 2 October 2012 the High-level Group on reforming the structure of the EU banking sector, chaired by Erkki Liikanen, published its final report.  The Group had been charged with the task of assessing whether reforms, additional to those already being implemented or proposed at an EU level and targeted directly at the structure of individual banks, would further reduce the probability and impact of bank failure, help ensure the continuation of vital economic functions and better protect retail banking clients.

At a high level, the Group considered two possible options:

  • make the decision on whether to require the separation of a bank’s activities conditional on an assessment of the adequacy of the bank’s recovery and resolution plan and the ultimate resolvability of the bank in question (“Discretionary Separation”); or
  • require the mandatory legal separation of banks’ proprietary trading and other risky activities (“Mandatory Separation”).

In broad terms, the Group concluded that Mandatory Separation, rather than Discretionary Separation,  is necessary.  Specifically, it recommended five measures which it believed augmented and complemented the existing regulatory reform programme.

Mandatory separation of certain trading activities

Separation requirement

The Group recommended that certain trading activities should be assigned to a legally separate investment firm or bank (the “Trading Entity”) if the scale of those activities exceeds a specified threshold.  Specifically, the activities which would have to be separated would include:

  • proprietary trading of securities and derivatives;
  • all assets or derivative positions incurred in the process of market-making;
  • any loans, loan commitments or unsecured credit exposures to hedge funds (including prime brokerage for hedge funds), SIVs and other such entities of comparable nature; and
  • private equity investments.

Exclusions

The following non-exhaustive list of activities would be exempt from the Mandatory Separation requirement:

  • lending to large, small and medium-sized companies;
  • trade finance;
  • consumer lending;
  • mortgage lending;
  • interbank lending;
  • participation in loan syndications;
  • plain vanilla securitisation for funding purposes;
  • private wealth management and asset management;
  • exposures to UCITS funds;
  • the use of derivatives for own asset and liability management purposes;
  • sales and purchases of assets to manage liquidity portfolios;
  • provision of hedging services to non-banking clients (e.g. FX and interest rate options and swaps) which fall within narrow position risk limits in relation to own funds; and
  • securities underwriting.

The Trading Entity would also be permitted to engage in all other banking activities, apart from the ones which must be conducted via the Deposit Bank.  Specifically, this means that the Trading Entity would not be able to fund itself with insured deposits and would not be allowed to supply retail payment services.

Threshold

The Group proposed a two-stage test for determining whether Mandatory Separation is required:

Stage 1:

A bank being assessed would pass Stage 1 and proceed to Stage 2 if its assets held for trading and available for sale exceed the lower of:

  • 15-25% of its total assets, or
  • EUR 100 billion.

Stage 2:

The aim of the Stage 2 test is to ensure that Mandatory Separation applies to all banks for which the activities to be separated can be regarded as “significant”, judged by reference to a threshold to be set by the EU Commission.  Supervisors would be required to assess the share of assets to which the separation requirement would apply, as a proportion of the bank’s total balance sheet.  If the results of this assessment exceeded the specified threshold, all of the activity which would be subject to Mandatory Separation would have to be transferred to the Trading Entity.

Ongoing relationship between the Trading Entity and the Deposit Bank

Under the proposals, both the entity from which the ‘risky’ activities were removed (the “Deposit Bank”) and the Trading Entity could remain part of the same banking group.  However, in order to ensure full separability and protection against intra-group contagion, the Trading Entity could neither own nor be owned by an entity which itself carries out other banking activities.  As such, a holding company would have to own both the Trading Entity and the Deposit Bank.

Both the Trading Entity and the Deposit Bank must be separately capitalised and both will be regulated on an individual basis.  Furthermore, the Deposit Bank must be “insulated” from the risks associated with the Trading Entity.  At the very least, this will mean that any transfer of risks or funds between the Deposit Bank and the Trading Entity must be on market-based terms and subject to normal large exposure rules.

Additional separation of activities conditional on the recovery and resolution plan

The Group considered that, in practice, the production of an effective and credible RRP may require the scope of separable activities to be even wider than that implied by Mandatory Separation.  Particular emphasis was placed on the need to:

  • segregate retail banking activities from trading activities;
  • wind down derivatives positions in a manner that does not jeopardise the bank’s financial condition and/or significantly contribute to systemic risk; and
  • ensure the operational continuity of a bank’s IT/payment system infrastructures.

Possible amendments to the use of bail-in instruments as a resolution tool

The Group supported the application of bail-in requirements to certain categories of debt over an extended transitional period.  However, it was felt that banks should be allowed to satisfy any requirement to issue bail-in debt with common equity if they prefer to do so.

Beyond this, the Group believed that a clearer definition of bail-in debt was required.  Not only would this provide clarity to investors regarding the position of bail-in debt within the insolvency/resolution hierarchy, but it would also increase the general marketability and facilitate valuation and pricing of such instruments.

In order to limit interconnectedness within the banking system and increase the practical effectiveness of bail-in as a remedy in a resolution scenario, the Group recommended that bail-in debt should not be held within the banking sector. Instead, it proposed that the holding of bail-in debt should be restricted to non-bank institutional investors such as investment funds and life insurance companies.

Finally, in order to align decision-making within banks with long-term performance, the Group proposed that bail-in debt be used in remuneration schemes for top management.

A review of capital requirements on trading assets and real estate related loans

The Group proposed to apply more robust risk weights in the determination of minimum capital requirements and more consistent treatment of risk in internal risk models. Specifically, two approaches were identified:

  • setting an extra, non-risk based capital requirement on trading activities in addition to the Basel risk-weighted requirements, for banks with “significant” trading activity (measured by reference to trading assets); and
  • introducing a “robust” floor for risk weighted assets.

Strengthening the governance and control of banks

The Group felt that corporate governance reforms currently being implemented were beneficial but that it was necessary to further strengthen controls in the following areas:

Governance and control mechanisms

It was recommended that more attention be given to the ability of management and boards to run and monitor large and complex banks.  Specifically, fit-and-proper tests should be applied when evaluating the suitability of management and board candidates.

Risk management

The Group recommended that legislators and supervisors fully implement the Credit Requirements Directive (“CRD”) proposals, specifically CRD III and CRD IV.  In addition, level 2 guidance should provide much greater detail on the CRD requirements as they apply to individual banks so as to minimise the possibility of circumvention of the rules.

Incentive schemes

The Group proposed that bank remuneration schemes be aligned with long-term sustainable performance.  In addition to the CRD III requirement that 50% of variable remuneration be in the form of bank shares or other instruments and subject to appropriate retention policies, the Group recommended that a share of variable remuneration should be in the form of bail-in bonds.  Furthermore, consideration should be given to specifying an absolute level of overall compensation (for example that overall bonuses cannot exceed paid-out dividends).

Risk disclosure

The Group recommended that public disclosure requirements for banks should be enhanced.  Specifically, risk disclosure should:

  • include detailed financial reporting for each legal entity and main business lines;
  • include indications of which activities are profitable and which are loss-making; and
  • be presented in “easily-understandable, accessible, meaningful and fully comparable” format.

Sanctioning

In order to ensure effective enforcement, the Group recommended that supervisors must have effective sanctioning powers to enforce risk management responsibilities, including lifetime professional ban and claw-back on deferred compensation.

Conclusion

The EU Commission is seeking views on the final report of the Liikanen Group via its website.  The deadline for receipt of comments is 13 November 2012.  The Group’s conclusions have also been passed to Michel Barnier, the EU Commissioner with responsibility for financial services.  Mssr Barnier will ultimately decided whether the proposals should be taken forward at an EU level.  Whilst publicly stating his independence, it is thought that, in reality, he is supportive of the Group’s findings, bringing the likelihood of a legislative proposal in this area that much nearer.

The Liikanen Group regards its recommendations as “fully compatible” with the proposals of the UK Independent Commission on Banking (“ICB”).  Whilst it may be the case that they are ‘compatible’, it is difficult to see how these proposals are ‘aligned’ with those of the ICB given that Liikanen requires the ringfencing of Trading Entity activities, whereas the ICB requires the ringfencing of retail banking activities of large UK banks.  As always, the devil will be in the detail but this initiative raises the prospect of the largest UK banks being required to establish two separate ringfences, further threatening the future of the universal banking model in the UK.