17 January 2013

EPFSF Briefing "Liikanen High-level expert group on structural reform"

What is put into question?

At this stage, given the different national initiatives in UK, Belgium, France, Netherlands and US and/or considerations around structural reform of the banking system, the European Commission’s attempt to coordinate approaches within Europe is acknowledged. The distinction between the different views behind the structural proposals appear to be dependent on what are the economic activities that are deemed socially useful/vital (Vickers deems retail and SME banking services crucial to the functioning of the economy, Liikanen proposal adds on corporate banking and primary markets and the French proposal adds on market-making) rather than the perceived riskiness of the business lines. However, stakeholder views are currently divided on how to take forward the Liikanen proposals on structural reform:

• Some agree with the HLEG’s conclusions that structural reform would make banks both more resilient in the face of external shocks and more resolvable should they still become vulnerable;
• There is a concern that the proposal is too lenient, the ring-fence would capture only a small subset of universal banks within the EU and that thus the financial stability and resolution benefits may be reduced despite high costs imposed on banks;
• Some are not yet convinced that structural reform is necessary or a priority, instead arguing that the ‘live’ legislative banking measures need to be fully implemented and their effectiveness assessed prior to taking any further regulatory action; and
• There is also support for the conditional structural reform, a minority view in the HLEG, subject to banks’ resolvability under its Recovery and Resolution Plans (RRP). With certain reservations, this view is particularly favoured by the industry as it;
  • protects the financial systems from particularly risky operations;
  • allows for a natural evolution of the European banking system to take place;
  • complements other regulatory reforms that address the same systemic issues as the HLEG’s structural reform; and
  • does not increase pro-cyclicality in the system: Any measures that restrict funding flows and capital allocation for a bank should depend on the bank specific operating model rather than businesses it is engaged in, according to the proposed RRD procedures.

Economic impact

Considering that European banking is already undergoing profound change as a result of regulatory reform and of shifts in market fundamentals, it is not clear at this stage what the additional impact of the mandatory structural restrictions would be on the capacity of European capital markets and European growth at a time of subdued bank lending. According to the IMF3 many European banks are reviewing their business strategies and making cuts to their market-making and other financing capacities, as well as retreating from non-core markets. Deloitte’s recent Bank Survey (2012) reveals that the ongoing voluntary structural reform will be a lengthy process and re-sizing the industry will be achieved through a combination of natural run off, divestment and balance sheet constraint. Consequently, the industry and some Member States call for a reduction in regulatory uncertainty and are asking authorities to provide for a well sequenced and harmonised regulatory framework that allows for the ongoing adjustment process to take place, thus questioning the need for structural reform at this stage.

According to the estimates of Standard and Poor’s (S&P) European institutions (sovereigns, corporates and banks) have new financing needs of $US1.9-$2.3 trillion and $8.6 trillion in refinancing needs for existing debt by the end of 2016, equivalent to around 75 per cent of EU GDP. S&P also estimates that European institutions have a projected annual funding gap of $US210-260 billion. With bank lending in Europe having collapsed over the last five years from €685 billion to a net repayment of €33 billion in September 2012 according to the ECB, partly as a result of regulatory pressures forcing the industry in aggregate to shrink balance sheets, this financing gap will have to be met very largely from the capital markets.

The debt and equity issuers typically expect, as a condition of being able to underwrite or bid for securities at auction, that the dealer bank provides some type of ongoing secondary liquidity in their new issue. Therefore, some of the Member States (e.g. France allows market-making in the deposit bank under the proposed national restrictions) believe that market-making, considered to be economically useful activity, should be allowed within the “deposit bank”. Splitting up of market activities in different legal entities could substantially reduce the market-making capacity of European banks and the consequent narrow-scoped trading entities may not be viable businesses against competition from institutions that do not have to comply with similar structural limitations.

Concluding remarks

• European banks are already going through profound structural changes, as a result of the regulatory reform and changes in the market;
• A coordinated approach from the Commission on the Liikanen recommendations could help avert the risk that European banking sectors and the Single Market in financial services will be further fragmented due to national level structural reform initiatives;
• Stakeholder views are divergent on whether mandatory separation of banks’ trading activities at a European level is necessary. The key areas where stakeholders disagree are:
  • whether structural reform is a key priority and whether it should be mandatory or based on the recovery and resolution plans;
  • timing of the potential structural reform and sequencing with other regulatory initiatives; and
  • whether there will be financial stability benefits when market capacity is reduced and costs to banks are increased.
• An impact assessment is required to analyse the economic impact of the proposed structural restrictions at a time of increased real economy borrowing requirements and reduced bank lending; and
• The other Liikanen recommendations are directly linked to other regulatory agendas that are currently debated.

Full Briefing

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