European bank reform: the Liikanen Report revealed

Author: | Published: 2 Oct 2012
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The Liikanen Committee has today revealed its recommendations for how Europe's banking structure should reform.

The High-level Expert Group, chaired by Bank of Finland governor Erkki Liikanen, was set up by European Commissioner Michel Barnier in November 2011 to assess the need for bank structural reforms.

In a statement released this morning, a European Commission (EC) spokesperson said the analysis revealed excessive risk taking – often in trading highly complex instruments or real estate-related lending – and excessive reliance on short-term funding in the run-up to the financial crisis.

"The risk taking was not matched with adequate capital protection and high level of systemic risk was caused by strong linkages between financial institutions," the statement read.

To counteract this, the suggested changes include a mandatory separation of proprietary trading and other high-risk trading activities, and a possible additional separation of activities conditional on the recovery and resolution plan.

A review of capital requirements on trading assets and real estate related loans, and a strengthening of the governance and control of banks have also been proposed. There is also potential for amendments to the use of bail-in instruments as a resolution tool.

It is understood that the mandatory separation of proprietary trading aims to improve the risk sensitivity of trading operations’ funding costs. At the same time, the recommendations would maintain banks’ ability to efficiently provide a wide range of financial services to their customers.

"Banking groups would have fewer reasons to take excessive risk with insured deposits," the Group said in today's statement. "It would also make them simpler and more transparent, which would facilitate market discipline, supervision, and resolution."

"It would make deposit banks less exposed to trading activities, notably preventing deposit banks from covering losses in the trading entity," he said. "It would reduce interconnectedness between banks and shadow banking system."

The structural reform proposed by the High-level Expert Group is a complement, not a substitute, to the other areas of bank regulation and does not represent and end to the universal banking model.

The changes in detail

It is understood the scope of activities to be included within the mandatory separation of proprietary trading will be: proprietary trading; market-making; loans and unsecured credit exposures to hedge funds; structured investment vehicles; and private equity investments.

Client-driven transactions that fall within narrow risk position limits and securities underwriting would not have to be separated.

Separation would only be mandatory if the relevant activities amount to a significant share of a bank’s business. The legally separate deposit bank and trading entity could operate within a bank holding structure. While the trading entity could do more activities than the ones outlined above, it would not be able to be funded by insured deposits.

The deposit bank and the trading entity would need to be funded and capitalised separately. Accordingly, transfer of risks or funds between the deposit bank and trading entity within the same group should be done on market-based terms. At the same time, transfers of risks or funds from the deposit bank to the trading entity – either directly or indirectly – would not be allowed if its capital adequacy (including additional capital buffer requirements on top of the minimum capital requirements) would be endangered.

In terms of the possible additional separation of activities conditional on the recovery and resolution plan, the recovery and resolution planning foreseen in the Commission's proposals on Bank Recovery and Resolution is important.

Producing an effective and credible resolution plan may require the scope of separated activities to be wider. That judgement is left to supervisors, but the EC statement said the Europeans Banking Authority (EBA) would play an important role in harmonising recovery and resolution plans and their assessment.

It went on to say that the EBA could develop standards for triggering additional separation based on the complexity of the trading instrument, the complexity of the organisation and the absolute and relative size of risk positions.

Moreover, given the potential funding and liquidity implications, transaction service continuity should be subject to particular attention in the recovery and resolution planning process.

Possible amendments to the use of bail-in instruments as a resolution tool would include building on the bail-in regime contained in the bank recovery and resolution proposal. The Liikanen Group recommends certain amendments that, in its view, would make it more practical.

In particular, it recommends that the bail-in requirement be used explicitly in relation to a certain category of clearly defined debt instruments, and that those instruments should not be held within the banking sector. This is to limit interconnectedness and increase the likelihood that the authorities are eventually able to apply the bail-in requirements in the event of a systemic crisis.

In relation to the review of capital requirements on trading assets and real estate related loans, at a general level the Group calls for strong and coordinated actions to improve the consistency of internal models across banks.

As regards the trading entity, the Group recommends that the Commission assesses whether the future result of the Basel Committee on Banking Supervision's trading book review is sufficient to cover risks of every type of EU bank. With as regards the deposit bank, the Group recommends that supervisors make sure that capital requirements include sufficient safeguards against substantial property market stress and that strict loan-to-value and/or loan-to-income caps are part of the macro-prudential toolbox in all member states.

Finally, the Group recommends a number of measures to strengthen the governance and control of banks. These include 'fit and proper' tests to ensure management's ability to run large and complex banks, risk and control management should report both to the chairman and to the CEO, tighter measures related to remuneration of bank management and staff. And as regards risk disclosure, more detailed financial reporting by banks for each legal entity and main business lines in an easily understandable, accessible, meaningful and comparable format.

In a press release circulated today, governor Erkki Liikanen said he believed 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.

The Group's report contains recommendations to the EC. On this basis, the Commission will now undertake further analysis and consultations so as to determine the appropriate course of action. Any legislative proposals would be accompanied by an impact assessment by the Commission.

For more of IFLR's Liikanen coverage see:

' Why EU banks need limited liability'

'Liikenan poll: Volcker/Vickers hybrid wrong for Europe's banks'