DRS’ Michael Beaton explains the main components of the recently published Liikanen Group report and explores what the possible impact may be on UK banks in terms of ringfencing activities and other changes.
Introduction
On 2 October 2012 the High-level Group on reforming the structure of the EU banking sector, chaired by Erkki Liikanen, published its final report. The Group had been charged with the task of assessing whether reforms, additional to those already being implemented or proposed at an EU level and targeted directly at the structure of individual banks, would further reduce the probability and impact of bank failure, help ensure the continuation of vital economic functions and better protect retail banking clients.
At a high level, the Group considered two possible options:
• make the decision on whether to require the separation of a bank’s activities conditional on an assessment of the adequacy of the bank’s recovery and resolution plan and the ultimate resolvability of the bank in question (“Discretionary Separation”); or
• require the mandatory legal separation of banks’ proprietary trading and other risky activities (“Mandatory Separation”).
In broad terms, the Group concluded that Mandatory Separation, rather than Discretionary Separation, is necessary. Specifically, it recommended five measures which it believed augmented and complemented the existing regulatory reform programme.
Mandatory separation of certain trading activities
Separation requirement
The Group recommended that certain trading activities should be assigned to a legally separate investment firm or bank (the “Trading Entity”) if the scale of those activities exceeds a specified threshold. Specifically, the activities which would have to be separated would include:
• proprietary trading of securities and derivatives;
• all assets or derivative positions incurred in the process of market-making;
• any loans, loan commitments or unsecured credit exposures to hedge funds (including prime brokerage for hedge funds), SIVs and other such entities of comparable nature; and
• private equity investments.
Exclusions
The following non-exhaustive list of activities would be exempt from the Mandatory Separation requirement:
• lending to large, small and medium-sized companies;
• trade finance;
• consumer lending;
• mortgage lending;
• interbank lending;
• participation in loan syndications;
• plain vanilla securitisation for funding purposes;
• private wealth management and asset management;
• exposures to UCITS funds;
• the use of derivatives for own asset and liability management purposes;
• sales and purchases of assets to manage liquidity portfolios;
• provision of hedging services to non-banking clients (e.g. FX and interest rate options and swaps) which fall within narrow position risk limits in relation to own funds; and
• securities underwriting.
The Trading Entity would also be permitted to engage in all other banking activities, apart from the ones which must be conducted via the Deposit Bank. Specifically, this means that the Trading Entity would not be able to fund itself with insured deposits and would not be allowed to supply retail payment services.
Threshold
The Group proposed a two-stage test for determining whether Mandatory Separation is required:
Stage 1:
A bank being assessed would pass Stage 1 and proceed to Stage 2 if its assets held for trading and available for sale exceed the lower of:
• 15-25% of its total assets, or
• EUR 100 billion.
Stage 2:
The aim of the Stage 2 test is to ensure that Mandatory Separation applies to all banks for which the activities to be separated can be regarded as “significant”, judged by reference to a threshold to be set by the EU Commission. Supervisors would be required to assess the share of assets to which the separation requirement would apply, as a proportion of the bank’s total balance sheet. If the results of this assessment exceeded the specified threshold, all of the activity which would be subject to Mandatory Separation would have to be transferred to the Trading Entity.
Ongoing relationship between the Trading Entity and the Deposit Bank
Under the proposals, both the entity from which the ‘risky’ activities were removed (the “Deposit Bank”) and the Trading Entity could remain part of the same banking group. However, in order to ensure full separability and protection against intra-group contagion, the Trading Entity could neither own nor be owned by an entity which itself carries out other banking activities. As such, a holding company would have to own both the Trading Entity and the Deposit Bank.
Both the Trading Entity and the Deposit Bank must be separately capitalised and both will be regulated on an individual basis. Furthermore, the Deposit Bank must be “insulated” from the risks associated with the Trading Entity. At the very least, this will mean that any transfer of risks or funds between the Deposit Bank and the Trading Entity must be on market-based terms and subject to normal large exposure rules.
Additional separation of activities conditional on the recovery and resolution plan
The Group considered that, in practice, the production of an effective and credible RRP may require the scope of separable activities to be even wider than that implied by Mandatory Separation. Particular emphasis was placed on the need to:
• segregate retail banking activities from trading activities;
• wind down derivatives positions in a manner that does not jeopardise the bank’s financial condition and/or significantly contribute to systemic risk; and
• ensure the operational continuity of a bank’s IT/payment system infrastructures.
Possible amendments to the use of bail-in instruments as a resolution tool
The Group supported the application of bail-in requirements to certain categories of debt over an extended transitional period. However, it was felt that banks should be allowed to satisfy any requirement to issue bail-in debt with common equity if they prefer to do so.
Beyond this, the Group believed that a clearer definition of bail-in debt was required. Not only would this provide clarity to investors regarding the position of bail-in debt within the insolvency/resolution hierarchy, but it would also increase the general marketability and facilitate valuation and pricing of such instruments.
In order to limit interconnectedness within the banking system and increase the practical effectiveness of bail-in as a remedy in a resolution scenario, the Group recommended that bail-in debt should not be held within the banking sector. Instead, it proposed that the holding of bail-in debt should be restricted to non-bank institutional investors such as investment funds and life insurance companies.
Finally, in order to align decision-making within banks with long-term performance, the Group proposed that bail-in debt be used in remuneration schemes for top management.
A review of capital requirements on trading assets and real estate related loans
The Group proposed to apply more robust risk weights in the determination of minimum capital requirements and more consistent treatment of risk in internal risk models. Specifically, two approaches were identified:
• setting an extra, non-risk based capital requirement on trading activities in addition to the Basel risk-weighted requirements, for banks with “significant” trading activity (measured by reference to trading assets); and
• introducing a “robust” floor for risk weighted assets.
Strengthening the governance and control of banks
The Group felt that corporate governance reforms currently being implemented were beneficial but that it was necessary to further strengthen controls in the following areas:
Governance and control mechanisms
It was recommended that more attention be given to the ability of management and boards to run and monitor large and complex banks. Specifically, fit-and-proper tests should be applied when evaluating the suitability of management and board candidates.
Risk management
The Group recommended that legislators and supervisors fully implement the Credit Requirements Directive (“CRD”) proposals, specifically CRD III and CRD IV. In addition, level 2 guidance should provide much greater detail on the CRD requirements as they apply to individual banks so as to minimise the possibility of circumvention of the rules.
Incentive schemes
The Group proposed that bank remuneration schemes be aligned with long-term sustainable performance. In addition to the CRD III requirement that 50% of variable remuneration be in the form of bank shares or other instruments and subject to appropriate retention policies, the Group recommended that a share of variable remuneration should be in the form of bail-in bonds. Furthermore, consideration should be given to specifying an absolute level of overall compensation (for example that overall bonuses cannot exceed paid-out dividends).
Risk disclosure
The Group recommended that public disclosure requirements for banks should be enhanced. Specifically, risk disclosure should:
• include detailed financial reporting for each legal entity and main business lines;
• include indications of which activities are profitable and which are loss-making; and
• be presented in “easily-understandable, accessible, meaningful and fully comparable” format.
Sanctioning
In order to ensure effective enforcement, the Group recommended that supervisors must have effective sanctioning powers to enforce risk management responsibilities, including lifetime professional ban and claw-back on deferred compensation.
Conclusion
The EU Commission is seeking views on the final report of the Liikanen Group via its website. The deadline for receipt of comments is 13 November 2012. The Group’s conclusions have also been passed to Michel Barnier, the EU Commissioner with responsibility for financial services. Mssr Barnier will ultimately decided whether the proposals should be taken forward at an EU level. Whilst publicly stating his independence, it is thought that, in reality, he is supportive of the Group’s findings, bringing the likelihood of a legislative proposal in this area that much nearer.
The Liikanen Group regards its recommendations as “fully compatible” with the proposals of the UK Independent Commission on Banking (“ICB”). Whilst it may be the case that they are ‘compatible’, it is difficult to see how these proposals are ‘aligned’ with those of the ICB given that Liikanen requires the ringfencing of Trading Entity activities, whereas the ICB requires the ringfencing of retail banking activities of large UK banks. As always, the devil will be in the detail but this initiative raises the prospect of the largest UK banks being required to establish two separate ringfences, further threatening the future of the universal banking model in the UK.
