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EU banking reform proposals promise consulting windfall

Banking reform
Erkki Liikanen
Michel Barnier

Brussels: EU banking reform proposals unveiled yesterday promise a bonanza for financial services consultancies as their clients — governments, regulators and not least European banks themselves — grapple with the implications.

  • Liikanen recommends ring-fencing high risk banking
  • Report maintains universal banking model
  • Commissioner Barnier puts report out to six weeks' consultation
  • Mixed reaction from advisory community
  • In UK, Labour opposition threatens to "break up" banks
  • French government to keep universal banking

The EU Commission yesterday received the report prepared by the High-level Expert Group on reforming the structure of the EU banking sector by Erkki Liikanen, Governor of the Bank of Finland, who presented the main findings to Michel Barnier, Commissioner for internal market and services.

Liikanen's proposals would force banks to separate their risky trading activities from their high street operations in the latest effort to prevent a rerun of the 2008 banking crisis — in effect they are a mirror image of the Vickers' Report in the UK, which would ring-fence retail banking.

The EU report, commissioned by Michel Barnier in February, also proposes that senior bankers should have part of their bonuses paid in bonds, which could ultimately be used to prop up ailing banks and a lid be put on the total amounts that can be handed out to staff.

Governor Erkki Liikanen said, "The report contains the Group's recommendations for further reforms of the banking sector, including structural reform. Building on the substantial measures already under way, I believe that the Group's recommendations would if implemented provide for a safer, more stable and efficient banking system serving the needs of citizens, the EU economy and the internal market."

Internal Market and Services Commissioner Michel Barnier said "This is an important report that will inform our policy on regulating the financial sector. The report underlines the excessive risks taken by banks in the past, and makes important recommendations to make sure that banks work in the interest of their customers.

"This report will feed our reflections on the need for further action. I will now consider the next steps, in which the Commission will look at the impact of these recommendations both on growth and on the safety and integrity of financial services. We need to look at these questions also in light of the financial reforms that I have already put on the table of the European Parliament and the Council".

In brief, the Group recommends actions in the five following areas:

  • Mandatory separation of proprietary trading and other high-risk trading activities,
  • Possible additional separation of activities conditional on the recovery and resolution plan,
  • Possible amendments to the use of bail-in instruments as a resolution tool,
  • A review of capital requirements on trading assets and real estate related loans, and
  • A strengthening of the governance and control of banks.
Shoomon Perry

Shoomon Perry, Managing Principal at Capco, the specialist financial services consultancy commented, "Today's announcement is the latest in a series of regulatory interventions imposing constraints on the activities of large universal banks.

"These proposals are separate but complementary to the Vickers proposal for ring fencing of deposit taking institutions.

"Banks must start thinking now about key strategic questions that will shape the future of the global banking industry."

Perry said these included:

  • How do banks withstand this regulatory storm cloud which consists of Vickers in the UK, Dodd-Franks' Volcker in the US and now these proposals from the EU?
  • How will both sets of ring-fencing impact capital requirements and funding costs for different parts of a universal bank? Will some universal banks scale back their trading activity further?
  • How will banks knit together a coherent offering for their clients using expertise sitting either side of the ring-fence(s)?
  • How will banks operationalize both sets of ring-fences? Which systems and services can be shared between trading arms and deposit taking arms?

"Banks are already engaged in deep cost cutting, these new regulatory proposals may be the trigger for a more fundamental reassessment of business strategy", Perry added.

Clifford Smout, co-head of the Deloitte Centre for Regulatory Strategy, said the Liikanen report raised serious questions for regulators and firms.

Trading ring-fence

"The Liikanen report covers a wide range of issues, not least in its call for a review of the treatment of real estate lending within the capital framework. How this feeds into action by the Commission remains to be seen.

"Of all its recommendations, the trading ring-fence is of most interest, especially to universal banks. Although on the surface such a ring-fence seems easy to implement, experience elsewhere suggests it is a huge task to determine exactly how it would work. Even with detailed rules it may still be difficult for regulators to distinguish what should lie on which side of the fence — for instance what constitutes a hedging service; or asset and liability management.

"Banks need to look at these recommendations carefully to assess which businesses and initiatives the Liikanen report affects and how these interact. EU banks that operate in the UK and US will need to be particularly careful to understand the interactions of initiatives there — such as those from the Independent Commission on Banking and the Volcker Rule — with the Liikanen proposals. The challenge is managing these interactions in a way that minimises the potential for unintended non-compliance with different sets of requirements in different jurisdictions."

Ambitious plan

Kevin Burrowes, UK banking leader, PwC, said, "The proposals today from the High-level Expert Group set out an ambitious plan for structural reform in the EU financial system. While ring-fencing on its own does not change the risks inherent in banking, it avoids disruptions to vital deposit and lending functions in the event of bank trading desks getting into trouble.

"Adopting a one-size-fits all approach to structural reform will be difficult to achieve due to the inherent differences in the Member States' legal systems and the diversity of their financial sectors.

"Policy makers need to consider how these proposals align with the current regulatory reform agenda, particularly proposals to create a banking union in the Eurozone, and ongoing structural reforms in other Member States. The trade-off between improved financial stability and facilitating economic growth remains a key issue.

"The Group's decision to keep the universal banking model in Europe intact will ensure that customers continue to have access to a wide variety of financial services."

Mirror image of Vickers

Thomas Huertas, partner in financial services at Ernst & Young, commented, "The Liikanen Group has taken what appears to be the mirror-image of the Vickers approach to the nettled issue of how to separate investment banking from retail and commercial banking. Vickers recommends ring fencing the retail and commercial bank; Liikanen would ring fence trading and market-making activity. As the Liikanen Group recommends that the final Commission proposal should have "harmonised implementation across Member States" questions will naturally arise as to whether Liikanen is compatible with Vickers, and, if not, which will take precedence.

"The Liikanen report takes a belt and braces approach to the question of regulatory reform. It recommends various means to tighten the belt of existing capital and liquidity, resolution and remuneration reforms, including notably an endorsement of bail-in bonds a means to enhance banks' loss-bearing capacity and facilitate resolution of failing banks.

"The braces are the Liikanen Group's proposal to ring fence a bank's trading and market-making activity in a separate subsidiary that does not take insured deposits. The braces are as much about aesthetics as about risk. The Group did not like the idea or public perception of insured deposits supporting trading activities. However, the Group also acknowledged that lending, in particular real estate lending, was also risky and has recommended introducing caps on loan to value ratios as a means to control this risk. It now falls to the Commission to consider the report and make legislative proposals."

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