Banking Reform Updater 6

In February 2012, the EU Commissioner for the internal market and services, Michael Barnier, established a high-level expert group on structural bank reforms. The group was chaired by Erkki Liikanen, the Governor of the Bank of Finland. The group presented its final report in October 2012 and concluded that despite the various regulatory reforms that had been adopted since the financial crisis in 2008 further reform was needed to require the legal separation of particularly risky financial activities from deposit-taking banks within a banking group.

Following the Liikanen report the European Commission issued a brief consultation document which asked fundamental questions including whether bank structural reform was needed in the EU. The consultation closed on 11 July 2013. Shortly before the consultation closed the European Parliament adopted on 18 June 2013 a motion for a resolution on reforming the structure of the EU banking sector. Following this the European Parliament adopted on 3 July 2013 a report called Reforming the structure of the banking sector in which it welcomed structural reform measures to tackle too-big-to-fail banks in the EU.

On 29 January 2014, the Commission published a draft Regulation on structural measures improving the resilience of EU credit institutions (the draft Regulation).

Article 3 of the draft Regulation sets out those banks that are within scope.

These are EU banks that have been identified as being of global systemic importance or those that have had for three consecutive years total assets of at least €30 billion, and trading activities amounting to at least €70 billion or 10 per cent of its total assets.

The draft Regulation applies to EU banks and their EU parents, their subsidiaries and branches, including in third countries. It also applies to branches and subsidiaries in the EU of banks established in third countries.

Article 22 sets out rules governing the calculation of the threshold mentioning that for financial conglomerates, the activities of insurance and non-financial undertakings are not to be included. Article 23 establishes a formula for the calculation of trading activities which will be supplemented by a methodology that will be described in implementing technical standards produced by the European Banking Authority (EBA).

The Commission believes that out of the 8,000 banks operating in the EU, only a handful (probably around 30) would come within the scope of the draft Regulation. However, it estimates that such banks represent over 65 per cent. of the total banking assets in the EU. Therefore in line with the earlier European Parliament report the Commission has designed the draft Regulation for those banks that are still considered to be too-big-to-fail.

It is also worth noting that banks falling below the threshold in article 3 would not be subject to the requirements of the draft Regulation. Their home Member State jurisdiction would be free to impose its own structural requirements on them.

Article 27 of the draft Regulation provides that third country subsidiaries of EU banks and EU branches of third country banks can be exempted if the Commission determines that they are subject to equivalent separation rules. The Commission will adopt delegated acts to set out the criteria for assessing whether or not a third country framework is equivalent to the draft Regulation.

A number of Member States (the UK, France and Germany for instance) have produced their own domestic bank structural separation legislation.

Article 21 of the draft Regulation provides for the possible derogation from the separation measures for banks that are already covered by equivalent national legislation. To qualify for the derogation, the Member State’s primary legislation must have been adopted before 29 January 2014 and meet certain conditions set out in article 21(1).

It is perhaps more than co-incidental that those EU countries that are potentially able to benefit from the derogation in article 21 are those that have adopted their primary legislation before 29 January 2014. By enacting the Banking Reform Act  in December 2013, the UK has at least put itself in a position where it can make an application to the Commission.

The draft Regulation provides for a ban on proprietary trading for those EU banks that are within scope.

However, given the challenges derived from the difficult distinction between proprietary trading and other similar trading activities (for example market making) the Commission has adopted a narrow definition in article 5(4). The definition is as follows: “using own capital or borrowed money to take positions in any type of transaction to purchase, sell or otherwise acquire or dispose of any financial instrument or commodities for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity’s risk as a result of actual or anticipated client activity, through the use of desks, units, divisions or individual traders specifically dedicated to such position taking and profit making, including through dedicated web-based proprietary trading platforms.”

Article 6(2) provides that where an EU bank within scope operates dedicated structures for buying and selling money market instruments for the purposes of cash management, they will not be captured by the prohibition. Trading in EU government bonds is also exempt from the prohibition.

It is important to note that to prevent EU banks that are within the scope of the draft Regulation from circumventing the prohibition by, for example, owning or investing in hedge funds, article 6(1)(b) also prohibits them from investing in or holding shares in hedge funds (or certificates/derivatives linked to these), or entities that engage in proprietary trading or sponsor hedge funds. Unleveraged and closed ended funds are exempted from this prohibition.

Also, article 7 provides that EU banks within scope must ensure that their remuneration policies do not, directly or indirectly, encourage or reward the carrying out by any staff member of proprietary trading.

The draft Regulation obliges Member State authorities to undertake a systemic review of the trading activities of those EU banks that are within scope.

Article 8 provides a broad interpretation of what constitutes “trading activities”. Generally these are activities other than traditional banking operations (taking deposits eligible for deposit insurance, lending, money broking and retail payment services). Article 8(2) exempts EU sovereign bonds from the obligation to review and the power to separate. Article 8(3) provides that the Commission may by delegated acts extend the scope of this exemption to non-EU sovereign bonds if they conform to certain conditions.

Member State authorities will be required to pay particular attention in their review to market making, investing in and sponsoring securitisation and trading in derivatives (other than those that are specifically allowed for the purpose of prudent risk management).

Member State authorities will assess trading activities using certain metrics set out in article 9(2)  which will indicate relative size, leverage, complexity, profitability, associated market risk, as well as interconnectedness. To ensure that the metrics are consistently applied article 9(4) states that the EBA will develop regulatory technical standards that will provide Member State authorities with a methodology for their consistent measurement and application.

Importantly the decision to require structural separation is left to Member State authorities but before taking any decision it must first consult with the EBA.

A Member State authority will require structural separation under article 10(2) if the trading activities of an EU bank within scope exceeds the thresholds and conditions linked to the metrics in article 9. However, if the bank demonstrates to the satisfaction of the Member State authority that its activities do not endanger EU financial stability then separation may not be required. Conversely where the thresholds and conditions are not exceeded a Member State authority may still require separation where it considers the bank’s activities threaten the financial stability of the EU or the bank itself.

The draft Regulation foresees that the actual separation of trading activities will be preceded by an obligation for the bank or, where appropriate, its EU parent to submit a separation plan.

The separation plan will explain in detail how the structural separation will be carried out. Article 18 provides that it shall contain at least the following:

• specification of assets and activities that will be separated from the retail bank (the draft Regulation defines this as the “core credit institution”);
• details on how legal, economic, governance and operational separation will be applied; and
• a timeline for the separation.

Within six months of submission the Member State authority must adopt a decision approving the separation plan or require changes to it. Where changes are required the core credit institution or, where appropriate, the EU parent has three months to submit a revised separation plan. The Member State authority then has one month in which to adopt a decision and make any necessary changes. Therefore the separation plan itself may effect structural changes to the bank.

If a Member State authority requires separation of trading activities and these activities remain within a banking group the draft Regulation requires these to be transferred to a distinct legal entity referred to as the “trading entity”.

Article 13(3) provides that if separation occurs, the group must be organised into homogeneous functional subgroups constituted on the one side by “core credit institutions” (those that take deposits and provide retail payment services) and on the other side trading entities. Articles 13(5) to (13) set out the conditions that apply to ensure separation in legal, economic, governance and operational terms. Such conditions include:

• the core credit institution shall not hold capital instruments or voting rights in a trading entity;
• a majority of the members of the management body of the core credit institution and of the trading entity respectively shall consist of persons who are not members of the management body of the other entity; and
• all contracts and other transactions entered into between the core credit institution and the trading entity shall be as favourable to the core credit institution as are comparable contracts and transactions with or involving entities not belonging to the same sub-group.

Trading entities that are subject to the separation obligation must not take deposits eligible for deposit insurance nor provide retail payment services as defined in the Payment Services Directive.

Article 12 provides that a core credit institution may sell certain risk management products (i.e. derivatives) to non-financial clients.

Interest rate, foreign exchange, credit, emission allowance and commodity derivatives eligible for central counterparty clearing can be sold by a core credit institution to its non-financial clients, insurance undertakings and institutions for occupational retirement provision where the following conditions are satisfied:

• the sole purpose of the sale is to hedge interest rate risk, foreign exchange risk, credit risk, commodity risk or emissions allowance risk; and
• the core credit institution’s own funds requirements for position risk arising from the derivatives and emission allowances does not exceed a proportion of its total risk capital requirement which will be specified in a Commission delegated act.

The draft Regulation complements the draft Recovery and Resolution Directive.

Article 19 of the draft Regulation provides that if a Member State authority decides to require separation, it must notify the appropriate resolution authority and take into account any on-going or pre-existing resolvability assessment. Likewise, the resolution authority has to take into account the notification of a separation decision by a Member State authority when assessing the resolvability of bank.

The draft Regulation is now being reviewed by the European Parliament and the Council of the European Union and it is difficult to say when agreement will be reached particularly in light of the European Parliament elections this year. This point was picked up by Sharon Bowles MEP when the proposals were published. She said that she was “bitterly disappointed” that the Commission had issued the proposal at a time “when there is no possibility for there to be any serious work done.”

The explanatory memorandum to the draft Regulation gives an indication as to timing on the basis that it is adopted by the European Parliament and the Council of the European Union by June 2015:

• a list of covered and derogated banks is published 1 July 2016 and on a yearly basis thereafter;
• the prohibition on proprietary trading becomes effective on 1 January 2017; and
• the draft Regulation’s provisions on the separation of trading activities become effective on 1 July 2018.

However, some commentators believe that the best case scenario would see serious negotiations on the draft Regulation begin in 2015 with a deal potentially by the end of the year.

It is worth noting that the draft Regulation was not published in isolation. At the same time the Commission published a draft Regulation on reporting and transparency of securities financing transactions (the draft SF Regulation).

Like the draft Regulation this proposed measure has been on the Commission’s radar for some time. On 19 March 2012, the Commission published a Green Paper on shadow banking which recognised that any reinforced banking regulation could drive a substantial part of banking activities beyond the boundaries of traditional banking and towards the less-regulated shadow banking system. Following the Green Paper the European Parliament adopted a resolution on shadow banking that called for greater transparency. The Commission responded on 4 September 2013, with a communication highlighting the need to strengthen securities financing transactions.

Unsurprisingly the draft SF Regulation seeks to prevent banks from attempting to circumvent the proposed rules in the draft Regulation by shifting their activities to the shadow banking sector. It does this by increasing the transparency of certain transactions outside the regulated banking sector. In particular it provides for a set of measures that are designed to enhance regulators’ and investors’ understanding of securities financing transactions.