Liikanen Out of the Blocks

Introduction

On 29 January 2014, the EU Commission published a legislative proposal and accompanying press release regarding a regulation on structural reform of the EU banking sector.  Recognising that the Bank Recovery and Resolution Directive will be unable to address the issue of “too-big-to-fail” in its entirety, and in furtherance of the political agenda to “refocus…banks on their core relationship-oriented role of serving the real economy”, the regulation was hailed by Michel Barnier, Commissioner for internal market and services, as “the final cogs in the wheel to complete the regulatory overhaul of the European banking system”.

Application and Scope

Broadly, the proposed regulation imposes a ban on proprietary trading and potential separation of certain trading activities of “too-big-to-fail” banks[1].  Specifically, it applies to any:

  • EU bank or its parent (including all branches and subsidiaries irrespective of where they are located) identified as a global systemically important institution (G-SII); and
  • any of the following entities that for three consecutive years has total assets amounting at least to EUR 30 billion and trading activities amounting at least to EUR 70 billion or 10% of its total assets:
    • EU credit institutions, their EU parents, their subsidiaries and branches (including those in third countries); and
    • EU branches and subsidiaries of banks established in third countries.

However, exemptions will be available for foreign subsidiaries of EU banks and EU branches of foreign banks which are subject to equivalent non-EU rules.  In addition, non-EU subsidiaries of EU parent companies may be exempt if a robust “Multiple Point of Entry” resolution strategy is in place[2].

Prohibited Activities

Proprietary Trading

“Proprietary trading” is defined as “using own capital or borrowed money to…purchase, sell or otherwise acquire or dispose of any financial instrument or commodities for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity’s risk…through the use of desks, units, divisions or individual traders specifically dedicated to such position taking and profit making”.[3]  Notably, the concept does not include trading in EU government bonds or instruments of other institutions which benefit from a 0% RWA rating under CRD IV (“Permitted Investments”) or investments in certain highly liquid investments for the purposes of internal cash management[4].

Investing in Funds

The definition of “proprietary trading” is deliberately narrow.  Therefore, to prevent banks from circumventing the prohibition, in-scope entities must not, with their own capital or borrowed money and for the sole purpose of making a profit for own account:

  • acquire or retain units/shares of Alternative Investment Funds (AIFs);
  • invest in any financial instrument the performance of which is linked to units/shares of AIFs; or
  • hold any units/shares in an entity that engages in proprietary trading or acquires units or shares in AIFs.

However, this restriction does not apply to the following (“Permitted Funds”):

  • closed-ended and unleveraged AIFs established or marketed in the EU;
  • qualifying venture capital funds;
  • qualifying social entrepreneurship funds, and
  • AIFs authorized as European long term investment funds.[5]

Separation of Trading Activities

By implication,[6] “trading activities” includes market making, investments in and acting as a sponsor for a securitisation, trading in derivatives,[7] and all other activities other than:

  • taking deposit guarantee scheme eligible deposits
    • lending;
    • financial leasing;
      • payment services;
      • issuing and administering other means of payment such as travellers’ cheques and bankers’ drafts;
        • money broking, safekeeping and administration of securities;
        • credit reference services;
          • safe custody services;
          • issuing electronic money;[8]
            • the buying or selling of Permitted Investments.

The scale of “trading activities” is measured by reference to the following formula[9]:

(TSA+TSL+DA+DL) / 2,   where:

“TSA” are “Trading Securities Assets” – assets that are part of a portfolio managed as a whole and for which there is evidence of a recent actual pattern of short-term profit taking, excluding derivative assets;

“TSL” are “Trading Securities Liabilities” – liabilities taken with the intent of repurchasing in the near term, part of a portfolio managed as a whole, and for which there is evidence of a recent actual pattern of short-term profit-taking, excluding derivative liabilities;

“DA” are “Derivative Assets” – derivatives with positive replacement values not identified as hedging or embedded derivatives; and

“DL” are “Derivative Liabilities” – are derivatives with negative replacement values not identified as hedging instruments.[10]

An EU Member State that has adopted “super-equivalent” legislation prior to 29 January 2014 and which meets certain other criteria[11] may make a request to the EU Commission to grant a derogation from the regulation’s requirements regarding the separation of trading activities.  The competent authority may also exempt subsidiaries of EU parents established in third countries where there are no equivalent rules if satisfied that:

  • there is a resolution strategy agreed upon between the EU group level resolution authority and the third country host authority; and
  • the resolution strategy has no adverse effect on the financial stability of the Member State(s) where the EU parent and other group entities are established.

Once separated, those entities engaged in “trading activities” may not:

  • take deposit guarantee scheme eligible deposits, except where they relate to the exchange of collateral relating to trading activities; or
  • provide retail payment services, except where they are ancillary and strictly necessary for the exchange of collateral relating to trading activities[12].

For its part, the entity not involved in “trading activity” (the “Core Credit Institution”) must have strong, independent governance, separate management and must be capable of carrying on its activities in the event of the insolvency of the trading entity.[13]  Both it and the trading entity will be subject to their own capital and liquidity requirements.  In addition, all contracts entered into by the Core Credit Institution must be on an ‘arms-length’ basis[14] and will be subject to exposure limits as set out below:

Description

Maximum Exposure

Exposure to an entity that does not belong to the same sub-group (intra-group or extra-group) 25% of eligible capital[15]
Aggregate exposure to financial entities 200% of eligible capital[16]

Competent Authority Review

The proposed regulation requires the “competent authority” to undertake an ex-post review of certain other activities which are not currently subject to a prohibition but which have been identified as carrying the greatest risk of involving proprietary trading by the back door: market-making, investment in/sponsoring of securitization and trading of certain derivatives.  The purpose of the review is to determine whether these activities should also be subject to separation.  In performing this assessment, the competent authority is to use certain metrics[17].  It must (if the metrics are satisfied) and may (if they are not), separate an offending activity provided that, in both cases, it has concluded that the activity in question constitutes a threat to financial stability.

Permitted Activities

A Core Credit Institution may continue to sell interest rate derivatives, foreign exchange derivatives, credit derivatives, emission allowances derivatives and commodity derivatives capable of being centrally cleared as well as emission allowances to non-financial clients, Permitted Funds, UCITS, insurance undertakings and pension funds provided that:

  • the sole purpose of the sale is to hedge interest rate risk, foreign exchange risk, credit risk, commodity risk or emissions allowance risk; and
  • the Core Credit Institution’s own funds requirements for position risk arising from these transactions does not exceed a proportion of its total risk capital requirement to be specified in a Commission delegated act.[18]

Timeline

The EU Commission is targeting the following implementation timetable:

Regulation adopted by EU Parliament and EU Council June 2015
EU Commission adopts delegated acts required for implementation 1 January 2016
First annual list of covered and derogated banks published 1 July 2016
Ban on proprietary trading takes effect 1 January 2017
Separation of trading activities from deposit-taking entity 1 July 2018
First review of the operation of the regulation 1 January 2020

 

The Challenge to Banks

Any requirement to separate the trading activity of a bank from its core credit business will be a major undertaking, involving an extensive initial data trawl, mass novation and assignment of contractual relations and a fundamental restructuring of back and middle office functions.  However, in reality, the greatest challenge to Banks will be in generating the data necessary to monitor and evidence compliance with the Liikanen regulation.  Bank structural reform may not prove to be the ‘final cog in the wheel of the overhaul of the EU banking system’, but it may prove to be the final nail in the coffin of some bank’s ailing IT systems.

The Liikanen regulation is likely to trigger a fundamental review of the way banks generate and manipulate data.  At a macro level, all banks which are subject to the regulation must have appropriate measures in place, and provide all information necessary, to enable the competent authorities to obtain information needed to assess compliance.  In addition, they must ensure that their internal control mechanisms and administrative and accounting procedures permit the monitoring of their compliance at all times.[19]  More specifically, they must register all their transactions and document systems and processes used for purposes of the regulation in such a manner that the competent authority is able to monitor compliance at all times.[20]  At a micro level, banks will be required to generate and monitor wholly new views of data.  Monitoring the scale of trading activities will prove challenging enough, but understanding the motivation of clients seeking to trade or determining whether the bank has direct or indirect holdings in entities that engage in proprietary trading or themselves hold units or shares in AIFs seems little more than a distant pipe dream for many.

Liikanen is out of the blocks.  The next two years will see the ability of banks to manage data put firmly in the docks.

 

January 2014

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Email: drs@drsllp.com
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[1] Article 2

[2] Article 4(2)

[3] Article 5

[4] Article 6(2)

[5] Article 6

[6] See Article 9(1)

[7] Other than for own risk management or the provision of risk management services to clients

[8] Article 8

[9] In all cases, the activities of insurance and non-financial undertakings are to be excluded (see Article 23(2))

[10] Article 23(1)

[11] See Article 21(1)

[12] Article 20

[13] Article 13(4)

[14] Article 13(7)

[15] Article 14(2)

[16] Article 15(1)

[17] See Article 9(2)

[18] Article 12

[19] Article 25

[20] Article 25