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Structural measures to improve the resilience of EU credit institutions – frequently asked questions

Commission Européenne - MEMO/14/63   29/01/2014

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European Commission

MEMO

Brussels, 29 January 2014

Structural measures to improve the resilience of EU credit institutions – frequently asked questions

See also IP/14/85 and MEMO/14/64

What is the proposal about?

The proposed Regulation on structural measures to improve the resilience of EU credit institutions aims at further strengthening the stability and resilience of the EU banking system. The proposal completes the financial regulatory reforms undertaken over the last few years by setting out rules on structural changes for "too-big-to-fail banks" (TBTF). A bank is considered TBTF when the consequences of its failure are believed to be detrimental for the financial system as a whole. In order to prevent this risk from materialising, the proposal would impose a ban on speculative activities (proprietary trading, i.e. trading using own money as opposed to on behalf of customers) and caters for the potential separation of other risky trading activities carried out by these banks. The proposal builds on the recommendations made by the High Level Expert Group chaired by the Governor of the Bank of Finland, Mr Erkki Liikanen ("Liikanen Group" - see IP/12/1048 and background section of this MEMO).

Why do we need structural reform?

In the last five years the EU has undertaken a large number of reforms to establish a safer, sounder, more transparent and responsible financial system serving the economy and society as a whole.

However, the size and complexity of a number of banks remain an issue of concern. The balance sheet of some of these banks is larger than the GDP of their home countries. These banks still remain too-big-to-fail, too-big-to-save and too-complex-to-resolve. These considerations make TBTF banks "special" as they enjoy a privilege that other banks do not. They benefit from the presumption that the state will step in to bail them out with taxpayers' money rather than letting them fail. Such implicit public support has a direct impact on the bank's funding costs, thus creating a market distortion vis-à-vis other, smaller banks. This implicit support leads to moral hazard, excessive risk-taking and weaker market discipline.

In a region where the banking sector as a whole is so significant, both in absolute (€45 trillion) and relative terms (nearly 350% of EU GDP), addressing these concerns is paramount and urgent.

Why is action needed at EU level now?

Several EU Member States (Belgium, France, Germany and the United Kingdom) as well as other countries, including the United States, have already enacted, or are in the process of enacting, structural reforms for their respective banking sectors to address concerns related to the largest and most complex financial institutions. As national reforms proliferate, without necessarily being coordinated, an EU-wide initiative is needed to preserve the smooth functioning of the single market. Specifically, an EU-wide initiative is needed to preserve the provision of banking services and capital movements across borders, the completion of a single rulebook applicable throughout the EU, and the effectiveness of the Banking Union.

What are the expected benefits?

Significant tangible and non-tangible benefits are expected from this reform, however difficult their quantification might be. These include but are not limited to: reduced risk of bank failure, thus a more resilient banking system, the facilitation of bank resolution and recovery which in times of stress will translate into lower costs of possible bank failures, easier monitoring and supervision of banks, reduced moral hazard and conflict of interest, improved capital and resource allocation for the benefit of the real economy and enhanced competition among market participants.

The separation of trading activities from a deposit-taking entity within a banking group would considerably facilitate bank resolution. Better structured groups make it easier to isolate the problem than when the group structure is opaque. It would not be necessary for governments to intervene to save expensive speculative activities with questionable benefits for financing the real economy. Structural reform will make the public safety net more limited in scope and therefore more credible and effective in preventing bank runs. Overall, the proposed structural reform measures will bring significant net social benefits, as demonstrated in the accompanying impact assessment.

What are the expected costs for banks?

The proposal would reduce the implicit subsidies that the EU TBTF banks enjoy today for some of their risky trading activities. The proposed measures may lead to higher funding costs for these trading activities within the banks concerned. There may also be operational costs related to the separation of some trading activities in a specific legal entity. However, banks would have time to deal with this transfer of existing trading activities as the proposal would be phased in over time.

This reform would focus on EU TBTF banks. It would not affect the vast majority of EU banks providing traditional financing activities to retail customers, SMEs or larger companies. Overall, the public benefits expected from this reform far outweigh the private costs by increasing the financial stability and resilience of the EU banking and financial system as a whole (see the impact assessment).

What impact would the proposal have on competition?

Competition distortions in favour of the too-big-to fail banking groups would be reduced. The reduction of implicit public subsidies would contribute to enhancing the level-playing field in the banking sector because the gap in the funding costs between the TBTF and smaller banks would narrow.

In addition a number of key provisions in the proposal (i.e. proprietary trading ban) would apply to all entities of a banking group subject to this proposed regulation. It means that the TBTF banking groups would not be able to circumvent the new requirements by shifting activities within the group.

Medium-sized competitors or new entrants that are not subject to mandatory separation may gain market share in some trading activities as the TBTF will face corresponding restrictions imposed by the proposed Regulation. However, should the activities of such medium-sized banks become too important and risky, they would in turn be submitted to a supervisory assessment and possibly to the measures of the proposed Regulation, as would be the case for the TBTF banks.

What is the scope of the proposal?

The proposal focuses on TBTF banks, in particular those with significant trading activities, whose failure could have a detrimental impact on the rest of the financial system and the whole economy. These are European banks deemed to be of global systemic importance or those exceeding certain thresholds (€30 billion in total assets, and trading activities either exceeding €70 billion or 10 per cent of the bank's total assets).

Imposing structural measures across the board would have disproportionate and unnecessary costs for smaller banks. Out of the 8,000 banks operating in the EU, only a handful (probably around 30) would be affected by the proposal, representing however over 65 percent of the total banking assets in the EU. This approach is consistent with the recommendations made by the "Liikanen Group".

Are we targeting European banks only?

This proposal aims first and foremost at enhancing the resilience of the European banking sector, thus it would apply to EU banks and their Union parents, including their subsidiaries and branches wherever they are located. However, foreign branches operating in the EU would also be covered.

Such a broad territorial scope is justified to ensure a level playing field and avoid circumvention by transferring potentially affected businesses outside the EU. The proposal provides, however, for a third country equivalence regime to mitigate possible costly overlaps and redundant obligations for internationally active banks. Subject to certain conditions supervisors would also have the power to exempt from the separation requirements, foreign subsidiaries of groups with geographically decentralised structures that are based on a network of legally, operationally and economic independent entities that can more easily be resolved.

Does this mean the end of the universal banking model for large EU banks?

Universal banks are an important feature of the European banking landscape. Many large banks offer a wide range of products and services such as deposit-taking, consumer and corporate lending, asset management, investment in securities markets, insurance underwriting, etc. This model of universal banking has proven its advantages in Europe.

The proposal is not calling for a break-up of European universal banking groups. Universal banks would continue to serve clients with a broad set of services and financial products. The reform measures proposed would simplify the way the TBTF banks operate and would facilitate their resolvability. Trading activities, undertaken on own account through dedicated business structures (proprietary trading activities), would have to be divested but today, these represent only a marginal portion of the European universal banking groups' activities. This makes a ban on such activities less costly at this point in time, while bringing considerable benefits for the society as a whole.

The Commission is mindful of the important diversity of the EU banking landscape which is not called into question in any way by this proposal.

What are the main elements of the proposal?

Proprietary trading ban

The proposed Regulation would prohibit a bank, and any entity belonging to its group, from engaging, through dedicated desks and personnel using the bank's own funds or borrowed capital, in proprietary trading in financial instruments, trading of physical commodities and investing in hedge funds (with few explicitly spelled-out exceptions). These are generally highly risky speculative activities, alien to the traditional role of banks as intermediaries between borrowers and capital suppliers. Proprietary trading today represents only a limited part of banks’ activities/revenues but it was significant prior to the crisis. This proposal would prevent a reversal of this process in the future, when market conditions improve.

Potential separation of certain trading activities

Banks engage in a number of other trading and investment banking activities including market making, investment and sponsorship of complex securitised products and over-the-counter derivatives trading. These activities might however expose credit institutions to excessive risks if they represent a significant part of the bank's business. In such cases, where large risky trading activities trigger a number of risk alerts (because of their size, complexity, opaqueness etc.), a separation of these activities from group entities that take eligible deposits might be warranted. Where the trading activities of banks and the related risks are found to exceed certain thresholds, the supervisor would have to require the bank in question to separate these activities from the deposit-taking entity, unless the bank demonstrates to the satisfaction of the supervisors that these activities do not compromise the objectives set out by the proposed Regulation. The proposed Regulation also grants the supervisor powers to require separation of certain trading activities when it deems that the activity in question threatens the financial stability of the bank in question or of the EU.

- Scope of activities subject to separation

The proposal provides for a broad interpretation of what constitutes trading activities, potentially subject to separation from deposit taking entities. Other than traditional banking operations such as deposit-taking, lending, money broking and payment services, trading in EU sovereign debt instruments are excluded from the scope of activities subject to separation. The Commission may extend the scope of this exemption to other sovereign debt instruments if they conform to certain conditions.

- Duty to review activities

When looking into the trading activities of a bank, particular attention is required from supervisors on businesses related to market making, complex securitisation and risky derivatives trading. These activities would have to be assessed against a number of risk parameters (size, leverage, complexity, profitability, market and counterparty risk, interconnectedness) that would ultimately determine the supervisor's decision whether or not to instruct the bank to separate.

- Cooperation between the supervisory and resolution authorities

There is an obligation for the supervisory authorities to cooperate with the respective resolution authorities, in particular to ensure compatibility between separation measures imposed under this draft Regulation and those imposed according to Article 13 of the Bank Recovery and Resolution Directive (MEMO/13/1140).

- Rules on separation of trading activities

A supervisor's decision to separate certain trading activities implies a number of business restrictions both for the deposit-taking and the trading entities. The former would be barred from carrying out the business operation subject to the separation decision. The latter would not be able to take up eligible deposits and carry out related payments.

In addition, both entities would need to be part of distinct separate sub-groups within the company. A number of strict rules would be imposed on both so as to make sure that the separation is real and effective and the entities in question remain legally, economically and operationally separate. These rules would include cross directorship and cross ownership restrictions (with limited exceptions for some banks having specific corporate structures), separate funding arrangements for both entities, contracts and transactions among these must be on terms similar to those with third parties, an obligation to have a distinct name easily identifiable for the public, and stricter large exposure limits.

- Separation plan

The proposal provides for an obligation for relevant banks to submit a "separation plan". This plan would have to be approved by the supervisor, with the latter having the possibility to require changes to the plan as appropriate, or setting out its own plan for separation in case of inaction by the relevant bank. The plan must be detailed and take into account any pre-existing resolvability assessment of the bank.

- Prohibited activities for the trading entity

Trading entities that have been subject to a separation obligation may neither take deposits eligible for protection under deposit guarantee schemes nor provide associated retail payment services. These activities are considered "core" to the banking business and a disruption of these services may be particularly disturbing for the functioning of the financial system and economy as a whole, thus the need for special protection.

- Derogation

A derogation may be granted from separation of trading activities to individual banks that are already subject to equivalent measures in another Member State. To ensure that the impact of the national legislation does not jeopardise the aim or good functioning of the single market, the goals of the national legislation must be the same as those set out in this draft Regulation.

Supervision

Most banks likely to fall within the scope of the proposed Regulation operate in several countries via branches and subsidiaries and are supervised by several different supervisors. In order to ensure an effective and efficient group-level application of structural reform, the final say over structural separation decisions would be given to the lead supervisor with responsibility over the consolidated group. The consolidating supervisor would however need to consult the other supervisors when one of the entities affected is deemed "significant".

Relationships with third countries

The proposal provides the possibility for the Commission to adopt delegated acts to recognise third countries’ structural reforms as being equivalent when they meet certain conditions. This recognition, when materialised, would make it possible for third country banks operating in the EU or EU banks operating overseas to be exempted from the obligations of this Regulation.

What is the role of the European Banking Authority?

This proposal takes due account of the rapidly evolving financial markets and financial innovation as well the evolution of the EU regulatory and supervisory frameworks. In order to ensure the effective and consistent supervision and the development of the single rule book in banking, this proposal envisages an important role for the European Banking Authority (EBA). The EBA would be consulted by competent authorities when taking certain decisions as set out in this proposal and would be required to assess the potential impact of such decisions on the financial stability of the EU and the functioning of the internal market. In addition, the EBA would be required to prepare draft regulatory and implementing technical standards, and submit reports to the Commission.

Are we in line with what other jurisdictions are doing?

In the EU, a number of Member States (Belgium, France, Germany and the United Kingdom) have engaged in bank structural reform efforts and others (the Netherlands and Denmark) are considering such reforms.

At international level, the Federal Agencies in the United States have recently issued the final so-called “Volcker” rule prohibiting proprietary trading by banks.

In addition, even if structural reforms have not so far been an explicit part of the international reform agenda agreed by the G20, many international bodies such as the Financial Stability Board, the Bank for International Settlements (BIS) or the Organisation for Economic Cooperation and Development (OECD) have all highlighted the significance of such reforms and have called for a broad and global debate on bank business models.

How similar/different is this EU approach from existing reforms implemented by some Member States?

When designing the measures envisaged by the proposed Regulation, the Commission has considered all existing discussions/initiatives on banking structural reform at the Member States level.

All these reforms share the common objective of addressing the remaining risks associated with the TBTF banks by ensuring that all of them can be resolvable and no longer require taxpayer bailouts. Most of these initiatives also intend to ban or set aside risky trading activities that are of limited added-value for the real economy.

The proposed Regulation has taken these elements into account and goes further where it considers necessary, for example as regards the separation of proprietary trading from a specific legal entity, the proposal envisages to prohibit these activities within the TBTF banking groups.

How similar/different is this approach from the U.S. Volcker rule?

The Commission proposal and the U.S. Volcker rule share the same objectives: to protect core deposit-taking and lending from ‘casino activities’. There are a number of other similarities, the most important one being the prohibition on banks engaging in trading activities with their own funds for speculative purposes.

The U.S. bank structural reform measures are, however, not identical to the measures proposed by the Commission. The final provisions of the Volcker rule issued by the U.S. Federal agencies on 10 December 2013 affect not only TBTF banks but also smaller banks. They also provide for a broader definition of what constitutes proprietary trading, subject to certain exemptions.

In contrast, the Commission's proposal provides for a number of measures related to the potential separation of other trading activities from the deposit-taking entity. Such provisions are not included in the U.S. rule, although other provisions in the U.S financial regulatory framework may have a similar impact.

The Commission’s proposal also provides for the possibility to recognise third country regimes that meet certain criteria and pursue objectives similar to the EU reform.

When would the Regulation start to apply?

In order to allow banks to adapt their structures in a smooth, non-disruptive and timely fashion, the proposal foresees an appropriate transition period before some of the most significant provisions would take effect.

The proprietary trading ban would apply as of 1 January 2017 and the effective separation of other trading activities would apply as of 1 July 2018.

Background

Liikanen Group: The High-level Expert Group on reforming the structure of the EU banking sector, chaired by Erkki Liikanen, delivered its report in October 2012 (see IP/12/1048). It notably recommended the mandatory separation of certain high-risk trading activities (proprietary trading, market-making, and loans and unsecured exposures to hedge funds, SIVs and private equity investments) into a separately capitalised and ring-fenced legal entity.

The Liikanen report recommendations were:

  1. Mandatory separation of proprietary trading and significant other trading activities;

  2. Possible additional separation of activities conditional on the recovery and resolution plan;

  3. Possible amendments to the use of bail-in instruments as a resolution tool;

  4. A review of capital requirements on trading assets and real estate related loans;

  5. Measures to strengthen the governance and control of banks.

Following the publication of the report, the Commission carried out a public consultation on the recommendations of the report. The responses have been taken into account in the follow-up work.

Public Consultation

Two public consultations and a stakeholders’ meeting on all problems and solutions identified have been conducted:

  1. Consultation (03.05.2012 – 01.06.2012) on the Liikanen Report;

  2. Consultation (16.05.2013- 11.07.2013) on the structural reform of the banking sector;

  3. A stakeholders’ meeting on bank structural reform (17 May 2013) gave an opportunity to a range of stakeholders to air their views on the key issues relating to this subject.

Annex: Facts and Figures

  • Currently the Regulation would cover approximately 30 banking groups totalling approximately €23.4 trillion in total assets. This is an assessment based on historical data. It is not a final list but is subject to change as the final list will reflect future thresholds and future EU G-SIBs. Therefore the number of banks included can go both up and down (Annex A8 of the Impact Assessment, SNL Financial data).

  • The 10 largest banking groups each have total assets between €1 000 billion and €2 000 billion (end 2012, Chart 1 of the Impact Assessment, SNL Financial data).

  • The European Commission’s Joint Research Centre estimates that implicit subsidies (i.e. artificially reduced funding costs due to a perceived TBTF status) enjoyed by the largest European banks (that jointly represent 60-70 % of EU assets) amounted to approximately €72-95 billion in 2011 and €59-82 billion in 2012 (Annex A4.2 of the Impact Assessment).

  • The notional value of derivatives has increased from 3.5 times world GDP in 1988 to 12 times world GDP today. The volume of primary securities (consisting of all issued domestic and international securities, bank intermediated credit and equity market capitalisation), in contrast, has remained stable at approximately 3 times GDP (Annex A6 of the Impact Assessment, Blundell-Wignall, A., P. Atkinson, and C. Roulet (2012), “The business models of large interconnected banks and the lessons of the financial crisis”, National Institute Economic Review, 221: R31.).

  • Medium-sized and small banks use a greater proportion of their balance sheet to make loans and advances, compared to large banks. Total loans and advances over total assets amount to 50 % for the large EU banks, whereas this ratio is 70 % for medium-sized and small banks (end 2011, Chart 6 of the Impact Assessment, ECB consolidated banking data).

  • Assets held for trading amount to 25% on average for large banks, less than 5% for medium-sized banks and almost 0% for small banks (end 2011, Chart 7 of the Impact Assessment, ECB consolidated banking data).

  • Price-to-book ratios of large euro area banks are approximately 0.6 on average in Q3 2013, whereas they have recovered to above 1 on average for large US banking groups (ECB Banking Structures Report, November 2013, Special feature: Structural characteristics of the euro area and US banking sectors: Key distinguishing features).

  • Taxpayer support (bank recapitalisation, guarantees on newly issued bank debt and asset relief measures) to date represent approximately €1.6 trillion or 13 % of EU GDP (European Commission, DG Competition, State aid scoreboard). In addition, the large European banking groups still rely on more than EUR 600 billion of long-term refinancing operation (LTRO) funding from the European Central Bank (ECB).

  • On average, public debt in the EU went up by 28 percentage points of EU GDP between end 2007 and 2013 (European Commission).


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