Debate over how best to prevent a recurrence of the bank failures of the financial crisis has dragged on since 2008. The prospects for achieving former UK prime minister Gordon Brown’s dream of a single global prudential framework with shared standards and cross border supervision are a distant memory. Instead the focus has shifted almost exclusively to a populist effort to ensure taxpayers are never again forced to underwrite losses from banks’ investment banking and trading operations.
Separate regulatory reforms aimed at reducing the systemic risks from banks’ proprietary and third-party trading activities are being pursued in the UK, the US and the EU. And to further muddy the waters, France and Germany are pushing ahead with their own schemes.
All the European proposals involve ring-fencing: restructuring banks’ retail and investment banking operations under distinct subsidiaries to prevent trading losses from impacting depositors.
One of the subsidiaries would be ring-fenced with its own capital and subject to stricter controls. The subsidiary sitting inside the fence would also have a higher capital requirement as an additional buffer against failure. However, there the similarities end.
The US, which already has a form of light-touch ring-fencing, is considering ring-fencing foreign banks’ US operations from the global parent, applicable to banks with global assets of $50 billion or more.
Rules are also being drafted banning all banks from proprietary trading – hedging, market making and underwriting excepted – and restricting their hedge fund and private equity activity: the Volcker rule in the Dodd-Frank Act.
“It’s all a bit of a mess that will only add to doubts over the efficacy of ring-fencing,” says Simon Gleeson, partner at Clifford Chance.
In Europe, the assets that will be placed inside the protective fence and the activities the retail arm will be permitted to engage in differ in each of the proposals.
In the UK it will be the retail business, as recommended by Sir John Vickers’ Independent Commission on Banking, which will not be allowed to engage in proprietary trading.
Under the EU’s Liikanen report recommendations, a mixture of Dodd-Frank and Vickers, the trading arm would be ring-fenced and required to hold its own capital.
The retail arm will also hold its own capital, yet unlike Vickers it would still be permitted to underwrite securities but not engage in market making or derivatives trading. Liikanen would apply to banks with trading arms holding assets of more than €100 billion, or 15% to 25% of total assets.
Germany has tabled Liikanen-light legislation, giving banks until July 2015 to fence off their proprietary trading, high-frequency trading and lending to hedge funds, into separate fully capitalized units with no guarantee from the parent.
It applies to all banks whose trading plus for-sale assets exceed €100 billion, or 20% of total assets. Savings banks are exempt provided these assets do not exceed €90 billion.
Broadly similar proposals in France are due to come into force in mid-2015.
The French and German rules both permit the retail arm to hedge against exposures to clients and engage in market making.
The raft of different proposals in different jurisdictions is causing uncertainty and confusion. Critics of banking fear complex, ambiguous rules might encourage banks to innovate their way around them or engage in “regulatory arbitrage”.
For the industry, attempting to plan ahead when there could be any number of different possible final outcomes is proving a headache.
“In the UK’s case, the problem is that banks may be faced with the difficult and costly prospect of setting up two ring-fences if the EU implements Liikanen on a normal directive basis, because that would make them subject to the EU rules and Vickers,” says Gleeson.
If Liikanen were implemented on a maximum harmonization basis, Vickers would have to be abandoned altogether, he explains, noting that Liikanen is by no means guaranteed to become law.
“The EU and UK proposals don’t have much to say that’s new,” says Gleeson. “They’re an ill-defined effort to expand on rules the US has had for years to protect federally insured deposit-taking banks from losses arising from dealings with affiliates.”
He is particularly sceptical about Vickers’ plan, which he describes as “the UK version of sections 23A and 23B of Federal Reserve Act on steroids”.
Sections 23A and 23B create a firewall between commercial and investment banks by restricting the transactions of a bank, or its subsidiaries, with any affiliate to 10% of the bank’s capital, and total transactions with all affiliates to 20% of capital. Transactions must also be on market terms.
Dodd-Frank substantially widens and strengthens these provisions. Regulations in the Glass-Steagall Act, which was partially repealed in 1999, already restrict deposit-taking banks’ underwriting and securities dealing activities.