The Liikanen Group published its final report (PDF 2.43 MB) on reforming the structure of the EU banking sector on 2 October. The EU Commission will have to decide which, if any, of the report's recommendations should be carried forward as EU legislative proposals.
The report makes five main recommendations; the first of which is new and only the first two relate to bank structure:
- Banks' proprietary trading and other significant trading activities should be ring-fenced in a separate legal entity (but this entity can remain as part of a banking group);
- Resolution authorities should request further separation if necessary to enhance the operational continuity of critical functions;
- Bail-in liabilities should be more clearly defined, both to increase overall loss absorbency and to provide greater certainty to creditors;
- Risk weights should be more robust - in the sense of potentially higher risk weights for trading activities and real estate lending, and more consistent risk weights generated using internal models - and both micro and macro-prudential supervisors should be able to set maximum loan to value (and/or loan to income) ratios; and
- Various corporate governance reforms.
Implications for banks
- Banks will need to assess whether the ring-fencing of trading activities might apply to them, and if so what the implications may be for the legal entity and operational structure of their groups, both within and outside the EU.
- Ring-fencing is likely to increase the overall capital that a banking group needs to hold - and is likely to increase the cost of funding (especially if different parts of the group receive different external credit ratings).
- The Liikanen proposals require fewer risk taking activities to be separated from insured deposits than under similar proposals from the UK Independent Commission on Banking. Its definition is instead similar to those under the US Volcker proposals (with the addition of market making and credit exposures to a wide range of financial institutions). Unlike Volcker, however, it stops short of banning these activities outright, instead adopting the ICB approach of allowing a separate legal entity within the same group.
- As a result, banks operating in the UK will need to assess the combined impact of these separate ring-fencing proposals to determine what this means in terms of operating structure, and what happens to business activities (in particular services for corporate customers) which could fit into either of the ring-fenced entities set out in current proposals.
- Although not new, the report's other recommendations reinforce initiatives that are already under way on bail-in liabilities, risk weightings and corporate governance. These recommendations are relevant to the EU's Recovery and Resolution Directive (RRD), the Basel Committee's reviews of trading book capital requirements and of the use of internal models to generate risk weightings, and the corporate governance amendments that the European Parliament is seeking to add to the Capital Requirements Directive (CRD 4).
In the detail
The main ring-fencing recommendation is that a banking group must undertake certain activities within a separate legal trading entity. These activities include:
- Proprietary trading
- All assets and derivative positions incurred in the process of market-making
- Credit exposures to hedge funds, prime brokers, Structured Investment Vehicles (SIV) and similar entities
- Private equity investments
These trading entities would not be funded by insured deposits and could not supply retail payment services.
Meanwhile, deposit banks (banks that use insured deposits as a source funding) could however continue to use derivatives for own asset and liability management purposes, sales and purchases of assets in the liquidity portfolio, basic hedging services for non-banking clients, and securities underwriting. They could also undertake corporate and household lending, trade finance, interbank lending, loan syndication, simple securitizations, and private wealth management and asset management.
Transactions between the trading entity and a deposit bank would have to be on market terms and be subject to large exposure rules on interbank exposures. Both the trading entity and the deposit bank would have to meet independently all the capital requirements under CRR/CRD 4. This will lead to higher capital requirements for the banking group as a whole, and higher overall funding costs.
This separation of activities would only be mandatory if trading activities are a significant proportion of a bank's total assets or if they amount to a large enough volume to be of importance to financial stability. The report suggests metrics of (i) assets held for trading or available for sale of at least 15-25% of a bank's total assets, and (ii) an absolute threshold of €100 billion of trading assets. The first metric would capture around 20 to 25 large EU banks and some smaller specialist trading banks, while the second metric would capture a similar set of large EU banks. If a bank met either of these metrics, then it would be subject to further (unspecified) tests of trading activity significance, to be developed by the EU Commission.
The report argues that such separation and ring-fencing would limit the ability of banking groups to take excessive risks with insured deposits; limit the coverage of trading losses by the funds of a deposit bank; and reduce interconnectedness between banks and the shadow banking system. But by allowing banking groups to continue to undertake hedging and other risk management activities, they could continue to provide a wide range of services to their customers.
Recovery and resolution planning
The report recommends that resolution authorities should require banks to go further than the separation of trading activities if this is necessary to enhance resolvability. It is not clear what this recommendation adds to the RRD, which already requires resolution authorities to intervene in advance to change a bank's structure if this is necessary to enhance resolvability. But it may well mean that the negotiation of how to execute recovery and resolution plans may lead to more ex-ante requirements to restructure banking groups.
The report recommends that the RRD should be refined to provide greater clarity on which instruments would be bailed-in – and in which order – so as to provide predictability for a bank's investors and other creditors. However, the report does not make any specific recommendations on which instruments should be bailed-in, or what the order of preference should be.
The report also recommends that bail-in instruments should not be held by other banks, which appears to preclude the possibility (as is currently the case under the RRD) that wholesale deposits raised from other banks could be bailed-in. The report appears to envisage that both would issue a new type of 'bail-in' instrument that would not count as regulatory capital but would add to lose absorbency. But it is not clear who would invest in such instruments, or at what price.
Review of capital requirements
In addition to supporting the Basel Committee reviews of trading book capital requirements and of differences across in the risk weightings generated from internal models, the report recommends the possibility of higher (but unspecified) capital requirements on trading book assets and real estate lending.
The report also recommends that both micro-level supervisors and macro-prudential authorities should be able to impose maximum loan to value (and/or loan to income) ratios, although no specific limits are suggested.
The report also recommends that consideration should be given to whether the Basel 3 minimum leverage ratio of 3% is sufficiently tough, although no specific alternative figure is suggested.
Perhaps surprisingly for a report on structure, a series of recommendations are put forward on corporate governance and remuneration, including:
- Applying fit and proper tests when evaluating the suitability of management and board candidates;
- An independent reporting line for risk management to Risk and Audit Committees;
- A share of variable remuneration should be in the form of bail-in bonds;
- An assessment should be undertaken of limiting variable remuneration to no more than 100% of fixed remuneration;
- Banks should not pay out more in bonuses than in dividends;
- Risk disclosure should be improved; and
- Supervisors should have effective sanctioning powers against bank executives.