11 December 2012

EBA opinion on the recommendations of the High-level Expert Group on reforming the structure of the EU banking sector

The introduction of structural measures to complement the existing and forthcoming regulatory reform is being considered in several Members States. The EBA emphasises the need to ensure consistency across the Single Market in order to foster level playing field and to avoid regulatory arbitrage. Otherwise, there is a risk that the development of structural measures at the national level ends up supporting a ring fencing of national establishments and contributes to a segmentation of the Single Market. The EBA stands ready to contribute to the design of an EU framework and to monitor possible flexibility left to national authorities.

The EBA emphasises the need to strike an appropriate balance in the trade off between preserving the core features of the traditional European model of universal banking and strengthening the resilience of the financial sector by segregating riskier capital market business into a separate legal entity. The proposals put forward by the High Level Group are mindful of balancing these two objectives by preserving the benefits of universal banking thanks to a separate legal entities approach within a single banking group rather than by adopting a complete separation of activities. However, only a thorough impact assessment could provide an evaluation of the potential benefits of such measures on the European banking sector and on the real economy and to compare them with their costs. In conducting this impact assessment, the EBA suggests that particular attention should be devoted to the impact of the increase in the cost of capital and funding for trading firms to assess whether this would be commensurate to the objectives of the reform and would not create unintended adverse consequences. The possible consequences on the structure of the market for investment banking services in the EU should also be assessed.

The EBA would also like to stress the need to maintain full consistency between the legislation on bank recovery and resolution and any additional structural measures. As the draft Directive on Bank Recovery and Resolution already provides strong incentives to modify business models away from complex firm structures, which would not allow for a smooth management of a crisis, the assessment of additional structural measures should focus on the incremental net benefit of a legal obligation to segregate trading activities. Within this framework, it will be appropriate to consider that in the absence of a legal segregation, as proposed by the High Level Group, it might be extremely difficult for a supervisory authority to exercise its discretionary judgment and impose a break up of a universal bank, especially if other competent authorities are not responding with similarly harsh measures in comparable cases. Some common, EU-wide legal constraints could be helpful in supporting the supervisory work on bank resolvability. This consideration, however, also points to the need to maintain an appropriate sequencing and coordination of the different legislative measures.

Implementation of any structural measures, such as a legal separation of risky financial activities from deposit-taking within a group, would need to be reasonably enforceable by competent authorities. Clear and fair criteria must be established in order to determine situations where this separation is mandatory, bearing in mind that the purpose of this breakdown is to protect the socially most vital parts of the banking group and to limit the taxpayers’ stake in the trading parts of the group.

Any structural measure should not be viewed as a substitute for adequate supervision. The crisis showed that any form of banking business carries a high potential for systemic risk. This is true for liquidity and maturity transformation in traditional banking as well as for complex derivatives transactions conducted on banks’ accounts in the trading book. All types of activities generating systemic concerns should be subject to intensive supervision. The fact that certain business is done on wholesale markets, between parties who should be able to properly assess the risks stemming from the transactions, and does not entail an immediate impact on retail business and payment activities is not a sufficient reason to reduce supervisory coverage. During the past 20 years, major operational losses faced by individual institutions occurred from activities considered non-risky, where risk management was inadequate.

These measures should be accompanied by review clauses and macro-prudential monitoring. Since structural measures are easily eroded via financial innovations, they should be accompanied by arrangements for swift review, while macro-prudential authorities should be requested to closely monitor the migration of risks to non regulated financial intermediaries and the overall effect on the build up of risks in the financial system as a whole. One should avoid that such structural breakdown unintentionally feeds the development of the shadow banking system.

Beyond such structural measures, the Report also “strongly supports the use of designated bail-in instruments within the scope of the BRR Directive, as it improves the loss-absorbency of the bank”. It calls for a clear definition of the position of bail-in instruments in the hierarchy of commitments, which would facilitate the pricing and trading of such instruments and the resulting market discipline and monitoring.

The EBA also considers that there is a need to further develop the bail-in framework in the BRR Directive in order to improve its predictability. As already expressed in the 3 March 2011 Opinion on “Technical Details of a Possible EU Framework for Bank Recovery and Resolution”, the EBA would rather support a two tier regime where bail-in requirements would be applied explicitly first to a certain category of debt instruments (targeted approach) and, if this proved insufficient, only in a second stage and within a proper administrative procedure for resolution to the remaining classes of debtors (comprehensive approach). Bail-in needs to be carefully designed in order to ensure legal and operational certainty and prevent the risk that its implementation impair the pricing mechanism of banks’ liabilities and cause unintended consequences, triggering destabilising effects on other financial institutions and the financial stability as a whole. In the absence of a targeted approach, there is a risk that a wide ex ante scope of bail-in instruments turns out to be limited once the resolution occurs.

As noted in the abovementioned EBA Opinion, requiring credit institutions to issue and hold a minimum percentage of their liabilities as “bail-inable” debt instruments, besides ensuring a minimum loss-absorbing capacity, has also the advantage to create large market volumes, which in turn will provide market participants with an incentive to standardise contracts, and rating agencies to focus properly on rating such debt instruments.

The EBA believes that clear requirements for a minimum amount of loss-absorbing liabilities, calibrated according to a thorough impact assessment and combined with a comprehensive statutory approach to bail-in would ensure strict adherence to creditors’ hierarchy and would be appropriately targeted, while preserving the essential features of a comprehensive statutory approach.

Full opinion

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