Two main elements of proposed regulation:
- The prohibition of proprietary trading, including commodities. The original Liikanen report did not include any recommendation to prohibit proprietary trading; and
- A structural separation power, under which national authorities could prohibit a bank that takes insured deposits from undertaking trading activities. Essentially, a banking group would have to undertake its trading activities in a separate legal entity from its retail deposit-taking.
These restrictions would apply only to major banks operating in the EU. The Commission estimates this would apply to around 30 European banks, together with some branches of third country banks. They refer to US and Japanese banks being affected – we can imagine some Swiss and Canadian banks will need to assess the proposals also.
A member state can request a derogation (ie. an exemption) from the Commission from the structural separation requirement on a bank (but not from the prohibition of proprietary trading) if national legislation was in force on 29 January 2014 that already requires at least an equivalent degree of separation. This may apply to France, Germany and the UK.
The prohibition on proprietary trading would take effect from 1 January 2017; and the structural separation provisions from 1 July 2018.
Separately, the Commission has issued proposals for the detailed reporting of securities financing transactions.
Importance for financial institutions:
These proposals would have major implications for banks' business models. Large banks subject to these proposals will therefore need to assess the commercial viability of their current business activities.
Large banks would have to stop proprietary trading throughout their groups (albeit the level of proprietary trading is considerably down from pre Global Financial Crisis levels), and put in place internal control processes to ensure that trading activities do not ‘cross the boundary’ between allowable and non-allowable activities. The extremely complex and lengthy regulations introduced in the US to implement the Volcker rule show how difficult this can be in practice.
Similarly, the structural separation of core deposit-taking and trading activities is both complicated and costly. This involves not only the creation of entities that are legally, economically and operationally separate, but also the continuous internal policing of the boundary between these entities.
- Strategic challenge – these proposals represent a major constraint on how large banks can operate, in addition to all the other national, EU and international regulatory reforms. They reinforce moves towards imposing structural separation on EU universal banks. Banks therefore face a strategic challenge to determine their optimal business model in response to these constraints.
- Lost business – many banks have already reduced their proprietary trading, so the impact of the prohibition of this activity may be relatively small. However, some banks may find that a combination of structural separation and the difficulties in policing the boundaries makes it uneconomic to continue to provide some trading and risk management services to their clients.
- Operational costs – banks will find it expensive to introduce the systems and controls required to collect and monitor the data and information required to operate the structural separation and the ban on proprietary trading; and will find it challenging to establish and maintain the necessary governance and risk management arrangements.
- Funding costs – a separate trading entity (investment bank) within a banking group may be subject to a separate external rating and may find it more difficult and expensive to raise funding. It may also find that some counterparties are no longer willing to trade with it. This could reinforce the pressures on investment banks to pull out of some markets, and place EU investment banks at a competitive disadvantage.
Ban on proprietary trading
The proposed regulation defines proprietary trading as trading for the sole purpose of making profits for a bank’s own account, without any link to actual or anticipated client activity or to the hedging the bank’s risks arising from client-related positions. It remains to be seen whether the Commission’s one paragraph definition of proprietary trading is more or less effective than the voluminous 1,000 page implementation of the Volcker rule in the US.
Banks would also be prohibited from owning, holding shares in, or sponsoring alternative investment funds.
However, the prohibition does not apply to trading in financial instruments issued by member state governments and the Commission may extend this by delegated acts to some third country sovereign debt.
For a more information on scope and timelines or to discuss the implications further, please contact Giles Williams or Clive Briault.