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EU Report Recommends Split in Retail and Riskier Banking

An EU-commissioned report on the European banking industry recommends that banks separate deposit taking from trading and other high-risk investment banking activities, to protect taxpayers against further bailouts and protect savers. The report mirrors the UK’s earlier post-crash Vickers Report to some extent, although that ultimately only lead to the planned ‘ring-fencing’ of retail and invest bank operations, not the full separation that happened under the Glass-Steagall Act in the US following the 1929 crash, which itself was repealed in the 1990s and has been much discussed since the baking crisis of 2008.

The EU report is the product of a review set up in November 2011 and headed by Erkki Liikanen, governor of the central bank of Finland. His team was mandated to investigate whether European banks and bank structures would benefit from structural reform to strengthen their financial stability, improve efficiency and provide greater consumer protection.

"Proprietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amount to a significant share of a bank’s business,” the report recommends. “As a consequence, deposits, and the explicit and implicit guarantee they carry, would no longer directly support risky trading activities.” The Volker Rule concerning prop trading in the US examined a similar area.

Liikanen and his European advisors, however, also single out the risks of property lending, which they recommend should be underpinned with larger capital reserves.

The EU Liikanen report’s similarities to those of the UK report produced by a panel of experts headed up by John Vickers, a former chief economist at the Bank of England (BoE), are striking. Vickers recommended that the retail arms of banks be ‘ring-fenced’ by a cushion of extra capital beyond the international norm, effectively establishing ‘chinese walls’ within universal banks and necessitating extra capital reserves as ‘cross-subsidisation’ would be banned.

Liikanen and his team also support the concept of bail-in debt, a mechanism to impose losses on bondholders in the case of a bank’s bailout or collapse. Their report suggests that bankers should accept this type of bond as part of their bonus.

Industry reaction and analysis
“The Liikanen report covers a wide range of issues, not least in its call for a review of the treatment of real estate lending within the capital framework,” said Clifford Smout, co-head of the Deloitte centre for regulatory strategy. “How this feeds into action by the European Commission [EC] remains to be seen.

“Of all its recommendations, the trading ring-fence is of most interest, especially to universal banks. Although on the surface such a ring-fence seems easy to implement, experience elsewhere suggests it is a huge task to determine exactly how it would work. Even with detailed rules it may still be difficult for regulators to distinguish what should lie on which side of the fence – for instance what constitutes a hedging service, or asset and liability management.

“Banks need to look at these recommendations carefully to assess which businesses and initiatives the Liikanen report affects and how these interact,” added Smout. “EU banks that operate in the UK and US will need to be particularly careful to understand the interactions of initiatives there – such as those from the Independent Commission on Banking [ICB] Vickers Report and the US Volcker Rule – with the Liikanen proposals. The challenge is managing these interactions in a way that minimises the potential for unintended non-compliance with different sets of requirements in different jurisdictions.”

Commenting on the report’s proposal that banks should pay bonuses in debt, Dr Peter Hahn of the Cass Business School in London, said: “Remuneration in banks has not been an easy situation to solve and many of the simple solutions create complex unintended consequences, demonstrating why flexibility and institution-specific solutions remain important.

“Imagine the management team at a bank with a lot of remuneration-debt piled up responding to the government’s call to lend more into an uncertain economic recovery: ‘Sorry, we’re not up for any new risks - until after we retire’ [is likely to be the response].”