Too big to fail - EU banking structural reform

Given the ongoing uncertainties in the global economic environment, such as the slide in oil prices, credit expansion in the US and weakness in the Eurozone, some economists are predicting another market crash is likely. Therefore, the appetite for regulation and mitigation of risk amongst politicians looks unlikely to diminish and a major step in the protection of economies will be the proposed EU structural reform of financial institutions.

Banks from countries with equivalent laws in place may be exempted from the legislation, but a number of recent financial crises have fuelled an argument for EU wide legislation on the lines of Glass-Steagall, the US provision for bank separation repealed in 1999.

It would therefore be prudent for banks to assume that this regulation will go ahead and plan accordingly, as being ‘too big to fail’ may no longer be an option, and the bail-out money may no longer be available for firms at risk.

Background

By 2008 large parts of the global economy had become dependent on the interconnected investment and retail banking institutions. When the crash occurred governments realised that systemic failure would affect large swathes of the electorate through pension funds and individual deposits and consequently that the protection of the real economy required huge injections of public money.

The public subsidies which the financial system required resulted in the distortion of competition and the accusation, however undeserved, that profits were being privatised whilst debt was being socialised.

As a result the EU, and various individual governments, set up commissions to assess the reforms that would be necessary to protect both economies and the financial system in the future, and this has resulted in the proposals for structural reform in the banking system.

It is proposed that Europe's largest banks will be regulated in such a way that risky trading activities will be separated from retail activities to protect customer’s deposits. The proposed EU legislation could be viewed as something of a composite, including aspects of the US Volcker Rule (restricting proprietary trading, investing in hedge funds) and also elements of EU national government proposals being enacted in the UK (Vickers Report), Germany, France and Belgium.

The EU proposals, the US restrictions and the individual country legislation are not exactly the same in implementation, but the overarching spirit of the changes is to protect depositors and taxpayers from the perceived casino banking model of the crash. Although, for instance, the Volcker Rule does not suggest separation, the rule is part of wider US legislation which is driving towards greater transparency and accountability.

What has been done? Who is affected?

In 2012, the EU Commission established a High Level Expert Group, headed by Erkki Liikanen - Governor of the Bank of Finland, to examine possible reforms to the structure of the EU’s banking sector. The group published their report in October 2012 with five main recommendations:

1. Mandatory separation - of proprietary trading and other high-risk trading to protect retail deposits.
2. Disaster Management - the possibility of additional separation of activities, conditional on the recovery and resolution plan which should cover preparedness in the event of the institutions’ failure.
3. Amendments to the use of bail-in instruments - as a resolution tool to include specific categories of debt. The result of which would be to recoup more losses from bondholders before dipping into the public purse.
4. Toughening of capital requirements - on trading assets and real estate related loans to ensure systemic risk is covered.
5. Augment bank governance and control of banks - including measures to rein in compensation for bank management and staff.

In January 2014 the EU Commission clarified and built on the Liikanen report with a proposed regulation to strengthen the safeguards in the banking sector.

An impact assessment found that the greater the size of the institution, and the greater the interconnectedness (e.g. though interbank credit exposures) the greater the likelihood was of stress spreading rapidly through the system (the feared “domino affect”). This resulted in a recommendation for separation, either by the legal separation of the ownership of entities for proprietary trading from those for deposit taking, or by the use of subsidiaries with tighter restrictions on intra group connection.

In June 2015 the Council of the EU agreed its negotiating stance, stating that banks of global systemic importance or banks which exceed certain thresholds would be subject to mandatory separation, and that other trading activities would be reviewed for risk assessment.

The proposed structural reform will apply to EU credit institutions and their EU parents, subsidiaries and branches, including those in third countries. It will also apply to EU branches and subsidiaries of banks established in third countries. The main recommendations are as follows:

• By 1st January 2017

A ban on proprietary trading in financial instruments and commodities (including hedging of the entity’s risks) by a credit institution and entities within the same group is advised. This will include proscribing the ownership of, or investment in, hedge funds and derivatives linked to entities engaged in proprietary trading. 

As an example, where the ring fenced institution exceeds the given threshold, they will not be able to trade for profit on their own behalf or own or invest in hedge funds, because this could mean trading for profit in risky derivatives, albeit at arm’s length. The deposit taking, or retail, entity may be able to trade in certain derivatives but only for risk mitigation purposes.

The definition of proprietary trading is quite narrow, confined to areas which carry out this specific activity, but how far other trading activities (which could affect clients), will be impacted is still unclear, as these would be subject to a risk assessment.

• By 1st July 2018

National regulators will be able to enforce the legal separation of high risk trading activities from core lending and deposit taking activity, if there is perceived to be a risk to the stability of the financial system. 

Banks may be able to avoid this separation if they can show to the regulator that the risks have been mitigated by other means and do not put financial stability at risk. Regular reviews of activities will be performed where it is suspected that possible proprietary trading may continue to be carried out despite the prohibition. 

Whilst the EU Commission estimates that these new rules will apply to only 29 European banks, the affected firms hold a total of 65% of EU banking assets. The rules will cover the Global Systemically Important Banks (G-SIBs) and those which are engaged in significant trading activities. To fall within the rules, banks would have to exceed, for three consecutive years, the threshold of €30 billion in total assets, and their total trading assets and liabilities would have to constitute more than €70 billion, or more than 10% of their total assets.

In June 2015, the Council agreed its negotiating stance on structural measures to improve the resilience of EU credit institutions and on the basis of this mandate, the incoming Luxembourg presidency will start negotiations with the European Parliament as soon as the latter has adopted its position. 

Costs and benefits

Whilst the Volcker Rule has been implemented in the US it is still too soon to assess the impact on the banking industry, so the real costs and benefits are still speculative, driven very much by an individual preference for more, or for less, regulation.

Concerns have been raised about the negative impact on the cost of financing and the higher operational cost of separation, although the counter argument has been that it will no longer be possible to hide risks, and the true cost of such financing will become apparent. It is also possible that a simpler and more transparent structure will allow for more efficient, and thus cost-effective, regulation of financial markets.

A further concern is that the separation will prevent the diversification of risk across group entities which could make failure more likely, and that the size of the separated entities will be so large that the impact of failure, if a further crisis occurs, would still be unacceptable. The proposals may also negatively impact economies of scale and the possibility of shared business processes across the entire bank.

For risk mitigation purposes the deposit taking entity's exposure to other entities in the group, and to individual external institutions, would be limited to 25% of its capital. A further restriction would be the cap on aggregate exposure of 200% of capital. This clearly has funding implications for the deposit taking entity and will potentially restrict growth and flexibility, but until a detailed analysis is carried out for the individual bank (to model different potential structures and the asset / liability mix) it is difficult to know what the financial and operational costs may be, for both deposit taking and trading entities. 

It is possible that market based activities could rise by a significant amount due to a lack of shared funding resource, e.g. PwC has estimated costs could rise by 70 bps. It may also restrict a bank's ability to meet the capital requirements regulations if capital cannot be optimised across the entire institution and if risk remediation cannot be shared across processes.

One area which may benefit from the proposed structural reform is private equity. It is not beyond the bounds of possibility that private equity firms could move in, as hedge fund owners and the larger banks withdraw. In addition to providing a consistent return, this would widen the customer base of these firms.

There is also a case to be made that the less regulated ‘shadow banking’ sector will cream off the riskier activities denied to the banking sector and will therefore profit from the regulatory changes.

Next steps

Within the proposal is an obligation for affected banks to submit a detailed separation plan for approval by the supervisor. Banks who believe they will be affected may well want to consider this for inclusion in their project portfolio.

Any banks likely to be affected by future regulation still have sufficient time to reorganise their activities, but there are obvious advantages in scoping out the costs and timelines early in order to assess the current position.

During the planning period affected banks should also consider potential overlaps in regulation, including areas such as capital requirements and regulatory reporting, and, for banks with a US presence, other regulatory requirements such as Volcker.

Conclusion

Banks should model a number of restructuring scenarios based on the regulations that will affect them, whether these are country specific or EU wide. Scenario modelling needs to consider what the finalised impact of the regulation might be, e.g. banning rather than separating some activities.

Creating alternative future state operating models requires careful analysis; it can be a lengthy (and costly!) business, but time and money can be saved by the use of specialist modelling tools which can easily replicate the business processes and legal in different scenarios, creating comprehensive business architectures that can be viewed across multiple dimensions. The target models can then be used to create cost / benefit analyses and proposed project portfolios.

Using the target operating models in conjunction with an institution-wide analysis of the regulations relevant to the bank will expose potential regulatory overlaps for each legal entity. Again, there are specialist tools which can accelerate the analysis process and present user-friendly dashboards of the resulting conclusions.

An analysis of current risk mitigation and any gaps would also be advantageous as, if a bank could prove to the authority that the risks it takes are mitigated by other means, it would be exempt from the separation requirement.

A structured approach to these challenges is essential if banks are to be in a position of strength to weather either full restructuring or any new regulatory requirements in this area which may be announced by individual EU countries.

Understanding how the new regulations affect the current operating model and how a change in the operating model will affect compliance is some of the most useful knowledge available in navigating the turbulent waters of regulatory change that lie ahead for the foreseeable future.