EU to Adopt Liikanen Proposals and Non-Bank RRP in 2013

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:

Q3 2013:

  • Directive/Regulation on the reform of the structure of EU banks (i.e. the Liikanen reforms)

Q4 2013:

  • 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.

EU Publishes Responses to Liikanen Consultation

Introduction

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.

EBA Provides Opinion on Liikanen

Introduction

On 14 December 2012, the European Banking Authority (“EBA”) published its opinion on the recommendations of the High-level Expert Liikanen Group on reforming the structure of the EU banking sector.

The final report of the Liikanen Group was published on 2 October 2012 and made the following recommendations:

  •  mandatory separation of proprietary trading and other high-risk trading activities to the extent exceeding a threshold;
  • possible additional separation of activities conditional on an institution’s resolvability;
  • possible amendments to the use of bail-in as a resolution tool;
  • review of the capital requirements on trading assets and real estate loans; and
  • strengthening banks’ governance and controls.

General Comments

In general, the EBA considers that the Liikanen proposals strike an appropriate balance between protecting the core features of the universal banking model and strengthening the resilience of the financial sector.  However, it believes that an impact assessment is required in order to properly be able to evaluate the potential benefits and cost of the proposals.

Aware that several Member States are considering structural change to national banking industries, the EBA emphasises the need to ensure consistency across the EU so as to protect the operation of the Single Market.  To this end, it states that clear criteria must be established in relation to such issues as:

  • the situations where separation is mandatory;
  • parameters that apply to exceptions such as the provision of “hedging services to non-banking clients”; and
  • the provision of financial support between deposit banks and trading entities pursuant to the proposed bank recovery and resolution directive (the “RRD”).

Banks’ compliance with the proposals should also be subject to periodic review and macro-prudential monitoring to avoid structural arbitrage.  In addition, any structural changes must be consistent with existing legislation, such as the RRD and the large exposures regulation, but should not be viewed as a substitute for adequate supervision.

Bail-in

The EBA considers that there is a need to further develop the bail-in framework in the RRD in order to improve its legal and operational certainty and so avoid possible destabilising effects.  The EBA repeats its preference for a two-tier bail-in regime.  Under such a regime, bail-in would initially be applied to a targeted category of debt instruments.  This targeted approach would, it is hoped, avoid the risk that a wide ex ante bail-in regime turns out to be of limited value once resolution actually occurs.  Only if the targeted approach proved insufficient, would remaining creditors be bailed-in within a proper administrative resolution procedure.

In addition, banks would be required to issue and hold a minimum percentage of their liabilities as “bail-inable” debt.  It is anticipated that this would create a market in bail-in debt, encourage the standardisation of contracts and incentivise rating agencies to focus on the rating of bail-in instruments.  However, the EBA supports the proposal that such debt should be held outside of the banking system, suggesting that penal risk-weightings could be introduced in order to discourage acquisition of such securities by the banking sector.  It also welcomes the suggestion to use bail-in instruments in remuneration schemes for top management and as part of bonus schemes.

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.

 

Financial Markets Law Committee responds to Liikanen Report

On 13 November 2012, the Financial Markets Law Committee (“FMLC”) published a response to the Liikanen Report on structural reform of the EU banking sector (see blogpost dated 4 October 2012 for more detail on the report itself).  The response focuses on two aspects of the Liikanen Report:

  • Bail-in, and
  • Ring-fencing.

On the subject of bail-in, the FMLC supports the Liikanen group’s recommendation that the set of instruments to which the bail-in tool would apply needs to be more clearly defined.  It also reiterated its previous concern that over-reliance on exemptions from the scope of the bail-in tool risks undermining one of the key principles of insolvency law, being the pari passu distribution of assets to creditors of the same class.

On the subject of ring-fencing, the FMLC made clear its belief that any structural reforms implemented at an EU level must take account of existing and proposed Member State ring-fencing regimes, or risk a situation where certain institutions would, in effect, have to be split into three parts.

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.

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.

EU Banks to face Vickers Style Ringfence?

This is a link to an article in today’s Financial Times (subscription required) regarding the progress of an on-going review into the structure of EU banking.

The Liikanen Review was established in November 2011 by Michel Barnier, the EU single market commissioner.  It ‘s remit was to examine the need for structural reform of the banking sector within the EU and it is due to report in October 2012.  Early indications are that it may recommend that any bank which exceeds a specified threshold of trading assets, calculated as a proportion of total assets, should be obliged to establish a separately capitalised subsidiary to house those assets, along this lines recommended by the Vickers Report in the UK.  It is thought that this percentage could be as low as 5%.

However, the members of the committee conducting the review do not appear to be unanimous in their support of this recommendation and it is thought that a compromise proposal may yet emerge.  Under this compromise, a bank may be required to create a ringfenced entity only if it came close to failure.  The trigger for ringfencing would be documented within the bank’s Living Will.  Quite how this compromise would work in practice is difficult to see.