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.

European Banking Federation Publishes Study on Reform of EU Banking Sector

Introduction

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

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

Regulatory Reform

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

Structural Reform

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

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

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

Conclusion

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

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

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