Since the financial crisis wrought havoc upon financial institutions, businesses and nations alike, there has been a concerted and controversial effort, in both the US and Europe, to reform the global banking sector.
To that end, in late January the European Commission (EC) released its latest blueprint to wholly reform the EU banking sector. The unveiling of the banking reforms by the EC is a watershed moment in many respects; following the Volcker Rule in the US, the European proposals mark the end of the first stage of the global reform process.
Under the EC’s proposed rules, the banking structures of the EU will be recast, which will see complexity greatly reduced across the sector. The new regulations will also look to curb market speculation supported by state-backed deposits. In many respects the new EU banking reforms take their lead from the controversial and wide-ranging US Volcker Rule, which also curbs proprietary trading. Furthermore, the new EU blueprint calls on the EU to embrace some of the structural reforms pursued in numerous European states, most notably in the UK, France and Germany. However, despite drawing inspiration from a number of domestic European policies, the proposed EU reforms, with their ban on proprietary trading, actually go beyond the various pieces of domestic legislation that inspired them.
Accordingly, many European states have expressed their concern regarding the new regulations. The French, German and British authorities are all unhappy that the proposed regulations have expanded beyond their own domestic reforms. The UK, for example, will have to add the ban on proprietary trading to its Vickers Report, which outlines measures to ringfence investment banking operations. The measures proposed by the EC are distinct from the ringfence between UK banks’ retail and investment activities, due to be implemented by 2019 as part of the Banking Reform Act. These changes will mean that companies need to consider their compliance efforts extremely carefully. Under the proposals many UK banks will face a double compliance burden. When the EU reforms are considered alongside the Vickers proposals, banks will face multiple ringfencing requirements – the EU will demand the separation of certain trading activities from deposit-taking and the Vickers report will require banks to ringfence what is essentially retail banking activities from those of the wider bank.
The French finance minister Pierre Moscovici has also expressed his dissatisfaction with the new regulations. Mr Mosccovi declared his belief that EU banking reforms should more closely reflect regulations already in place in France and Germany. In their current form, Mr Moscovic believes that the EU reforms unfairly favour banks operating in London.
Despite sharing some ancestry with domestic European reforms, the new banking reforms have more in common with reforms initially instigated in the US. The DNA of both the Volcker Rule and Dodd-Frank legislation can be clearly identified in the new banking legislation. Indeed, in some quarters the new regulations have been referred to as a Volcker Rule for Europe.
The fresh memory of the financial crisis and its many scandals has emotions around banking reform running high. To that end, the new EU proposals have only served to heighten tensions. Although the plans fall short of the radical overhaul that many within the European banking industry feared, they have still encountered strong opposition in some quarters. There is a belief within the banking sector that the measures go too far and that the EC’s plans will ultimately hurt the wider EU economy, causing risky activity to be pushed into markedly less regulated parts of the financial system.
The EU first began the process of reforming its banking sector in February 2012, when the EC established a high level expert group to examine what possible arrangement a reform of the banking sector could take. The EC appointed a group to explore the potential reforms with the mandate of determining whether, in addition to ongoing regulatory reforms, structural reforms of EU banks would strengthen financial stability and improve efficiency and consumer protection.
However, some legislators within the European Parliament believe that the proposals do not go far enough. There is a belief that the separation of a bank’s investment activities should be automatic and mandatory for all financial institutions.
With the introduction of the reforms, the EC is hoping to strengthen the resilience of the continent’s banking sector to future financial crises while simultaneously ensuring that banks and financial institutions continue to finance economic activity and growth. By adopting these reforms, the EC believes that in future the EU can avoid the prolonged periods of economic stagnation witnessed across the continent since the onset of the financial crisis.
The proposal on the structural reform of EU banks will apply only to the largest and most complex institutions which undertake the most significant trading activities. The EC has noted that it intends to target the very small number of large banks which, without the reforms, would remain “too-big-to-fail, too-big-to-save and too-complex-to-resolve”. Therefore, the largest credit institutions operating in the EU, including branches of a number of non-EU firms, will be affected by the proposals. Consequently, those banks that are EU-based, but globally important, or those institutions with both assets of at least €30bn and trading activities exceeding €70bn, or 10 percent of the bank’s assets, will be affected. According to the EC’s data, the new reforms would affect approximately 30 banks.
The proposed ban on proprietary trading would cover all groups operating within the EU, including any EU credit institution and branches of credit institutions which are headquartered outside the EU but which meet the criteria based on the EU activities of the branch. Additional ringfencing would then apply to a subset of these banks following an assessment of their trading activities.
The EU’s process of bank restructuring takes the form of three major policies.
First, the EC has proposed a ban of proprietary trading in financial instruments and commodities. This activity entails many risks but no tangible benefits for the bank’s clients or the wider economy.
Second, the reforms will provide supervisors with the power and the obligation to require the transfer of other high-risk trading activities, such as market-making, complex derivatives and securitisation operations, to separate legal trading entities within the group. The reasoning behind this reform is that it will help avoid the risk that some banks might manoeuvre their way around the ban on the prohibition of certain trading activities by engaging in hidden proprietary trading activities. These hidden activities can often become too significant or highly leveraged; once this has occurred, it can potentially put the whole bank, if not the wider financial system, at risk. Under the auspices of the new reforms, banks will have the possibility of not separating activities if they can satisfactorily demonstrate that the risks generated are mitigated by other means.
The third goal of the banking reforms is to provide banks with rules on the economic, legal, governance and operational links between the separated trading entity and the rest of the banking group.
There are some in the international community who feel that these measures will push banks’ riskier activities to significantly less regulated areas, although the EC is confident that that this will not occur. According to the EC’s proposal, in order to prevent banks from circumventing its new regulations and shifting parts of their activities to the ‘shadow banking sector’, the wider structural separation measures employed by the EC should also be accompanied by provisions improving the transparency of the shadow banking sector itself. “Structural separation measures must be accompanied by provisions improving the transparency of shadow banking. The accompanying transparency proposal will therefore provide a set of measures aiming to enhance regulators’ and investors’ understanding of securities financing transactions,” said an EC statement. “A better monitoring of these transactions is necessary to prevent the systemic risk inherent to their use.”
According to the EC, transactions in the recesses of the financial sector served as a source of corruption, leverage and procyclicality during the prolonged financial crisis. Better monitoring of these transactions is necessary to prevent the systemic risk inherent to their use.
Reaction to these new reforms has been somewhat mixed. The wider banking sector believes that the new proposals in their current form would only serve to negatively affect the competitiveness of the financial sector, as it will have to capitalise the subsidiaries responsible for conducting risky investment activities, though the EC did not provide figures on how much it could cost the financial sector to do so.
Furthermore, some legislators in the European Parliament believe that the new rules do not go far enough. For many legislators, there is a belief that the separation of a bank’s investment activities should be automatic and mandatory for all financial institutions. Responding to the criticisms of the new proposals, the EU’s Internal Market Commissioner Michel Barnier noted that the disapproval with which the proposals were met in some circles was by no means a surprise. “The parliament which says the rules don’t go far enough; the bankers who say the rules are too strict; the British who want general exemptions – when I work out the balance between all these reactions I think we have found a balanced solution. In the name of what exactly do we allow banks to conduct pure and simple speculative trades?” he asked.
The EC estimates the proposed regulations will be adopted by June 2015, with the required additional delegated acts to be adopted by the following January. Within this timeline, an initial list of covered and exempt banks would be published by July 2016. The ban on proprietary trading would become effective from January 2017 onwards, and separation of trading activities mandatory by July 2018.
In order for the EC’s plans to come into law, the proposals must first pass through the EU legislature, a process which could be problematic. Much like the Volcker Rule in the US, which took a number of years to finally come into force, the EU recommendations may face a lengthy and bitter struggle. The EC may find it difficult to get its proposals through the European parliament for some time to come. The last session of this parliament is due to be held in April before the parliamentary elections in May.
The European parliament has already expressed disappointment that the proposals have emerged at such a late stage in this parliamentary session. Sharon Bowles, chair of the economics and finance committee, called the timing of the announcement “insulting”.
Europe has waited a long time for its transformative banking reforms and, based on the reactions to the new proposals, it would appear that the wait is far from over.
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