Why EU banks need limited liability

Author: | Published: 16 Sep 2012
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European policymakers should now introduce limited liability for EU banks not more regulation, UK lawyers have warned.

Ahead of the anticipated Liikanen Report, speculation is growing that the Liikanen Committee will advocate the introduction of a hybrid model combining the US and UK approaches to bank reform.

The US Volcker approach bans proprietary trading. In contrast, the UK’s Vickers will require major European banks to build a firewall between consumer and investment banks. In an IFLR poll last week, 75% of participants opposed a combined approach to reform.

Shearman & Sterling’s Barney Reynolds said Europe’s regulators were applying too many safety belts. It was now time to look from the other end and consider the application of limited liability for banks, he said.

“There is currently a very small number of significant banks in Europe, none of which has sprung up overnight and all of which are of huge value and key to the regional economies,” he said.

“But by applying yet more restrictions - partly out of a desire to be safe and partly out of an understandable desire for retribution - policymakers are in danger of killing parts of the banking system and being left with very little,” he added

It is time for banks to have the option of shedding their skin by placing riskier assets in a bad bank with residual liability, while instigating a possible charge over the equity of the ongoing bank remaining.

“Financial institutions facing liquidation should not be killed off entirely,” said Reynolds. “Experience shows such businesses do not get replaced. We’re in danger of going too far.”

The Liikanen Review, together with US and UK banking reforms, simply add another seat belt by further reducing market participants’ permitted activities. “How much safer does it actually make the market, if regulators keep adding more rules, and is that safety worth the price?” he asked.

The creation of a sustainable European-wide resolution framework, including the establishment of bridge banks to partially takeover the undertaking of failed banks, has been proposed by Europe’s policymakers.

The European Commission’s Recovery and Resolution Directive might also require that retail depositors be given preference over ordinary, and even some senior, creditors in the event of a bail-in of liabilties.

But Reynolds suggests taking the concept further and wiping the slate clean for a small core of the bank, which can continue in business. This protection would mirror that given to ship-owners worldwide.

Ashurst’s James Perry said the Directive, as proposed, would significantly reduce the cost of deposit guarantee schemes, but at the expense of higher funding costs.

Vickers vs Volcker

Perry was hopeful the Liikanen Report would suggest, at worst, a Vickers-style separation of banks’ businesses over and above the more radical Volcker Rule.

“There are so many balls in the air in Europe at the moment, I just don’t think the Commission and politicians will have the stomach to fight for full Volcker-style separation,” he said. “Ultimately Vickers is Volcker-light. It clearly would cause some degree of upheaval for Europe’s banks but nowhere near as much as Volcker’s heavy alternative.”

Reynolds agreed. “The Volcker Rule has proved very unpopular in the US,” he said. “Once you drill down into the details, and particularly how key terms, such as proprietary and portfolio hedging, are defined under Volcker, it becomes too imprecise and controversial to be easily applicable.”

Vickers' more sophisticated, less blunt approach would likely prove more successful for Europe’s banks, he said.

“The beauty of ring-fencing is it can be implemented with minimum distortion to Europe’s current market structure,” said Reynolds.

UK banks

Although undesirable and arguably unnecessary, UK banks would still be able to operate under a combined UK/EU Vickers ring-fencing, Reynolds said. “In theory UK financial institutions could just function as three separate business,” he said. “The cost of this would depend on as-yet undisclosed regulatory capital requirements for any EU ring-fence,” he said.

But one UK-based compliance officer argued the increased regulatory burden would leave UK banks operating with two broken legs – one broken by Vickers and the other by European reform. “I don’t understand why UK regulators didn’t foresee that,” he said.

Market participants are hopeful that if a ring-fencing mechanism is incorporated within EU reforms, it would only be activated in an emergency - for example, if a bank is approaching failure. This model could be included in a bank’s so-called living will - the plan to help dismantle a bank during a crisis.

Even so, the compliance officer believed the days of big banks were numbered. “There’s too much political capital been invested; the introduction of further ring-fencing or limits on trading is highly likely,” he said.

Perry said European reforms would add to further costs for both European and UK banks, with the latter potentially worse off if the Liikanen Committee opts against a Vickers equivalent. “If that were to happen UK banks would complain and rightly so,” he said.

Liikanen – part of the jigsaw

Perry stressed, however, that any reforms suggested by the Liikanen Committee should not be seen in isolation.

“The Liikanen Review is just another piece of the jigsaw,” he said. “It’s one further thing to add to a long list of costs that are going to hit the EU banking industry over the next six to seven years along with liquidity, capital, trading book reforms and the rest.”

“They will have a fundamental impact when you put them together,” he said. “But Liikanen is only a part of it.”

The Liikanen Review was established in November 2011 by EU commissioner, Michel Barnier. Its purpose is to conduct a full-scale analysis of Europe’s lending sector and recommend banking reforms for the region. The Committee’s findings are not expected to be published until next month.

See also

‘Liikanen poll: 75% Volcker/Vickers hybrid wrong for Europe’s banks’


‘EU split over banking union decentralisation’