Brussels, 02/10/2012 (Agence Europe) - The expert group chaired by Erkki Liikanen that is studying how European banks are organised has suggested legally hiving off the riskiest trading in order to ensure the stability of the financial system and avoid retail banking having to automatically and without any upper limit pay the price for any crisis in order to bail out dodgy investment. The submission on Tuesday 2 October of the Liikanen Group's report to the European Commission opens a public consultation process that may lead to new legislation before the summer of 2013.
The implicit state guarantee (that the state will always bail out banks) was key in the 2008 financial crisis because it led to greater risks being taken in investments, explains the Governor of the Finnish Central Bank, Erkki Liikanen, who chaired the group of experts. Combined with weak capital requirements, the growth of financial bubbles fuelled by cheap lending and over-confidence in constant growth of share prices, a major crisis erupted that saw countries using public funds to bail out the collapsing banking system, with profits being privatised and losses being nationalised. It was in response to this that the Liikanen Group was set up to find answers to the bank problem while bearing in mind that the banks finance up to 80% of the real economy in Europe.
Erkki Liikanen divides the five main recommendations of the expert group into three categories. Firstly, innovative ideas like setting up a separate legal body, separate from retail banking but part of the same bank holding, for the riskiest trading (over-the-counter, market-making, speculation, SIV securities and private equity fund investment).
Two thresholds need to be set to decide when exactly bank supervisory bodies should examine the question of hiving off trading and when to make it compulsory. The Liikanen Report leaves it to the Commission to decide on the other threshold, but suggests making bank separation compulsory when risky trading accounts for between 15% and 25% of a bank's assets or over €100 billion. Savings banks would be able to continue providing services like credit default swaps, portfolio management, currency exchange and hedging).
The subsidiary game. The third route suggested for Europe, the legal separation of trading, is not like the Volcker rule in the US that slashes back banks' ability to invest its own funding in speculation, (see EUROPE 10561), nor like the ideas set out in the Vickers Report in the UK that recommends separating off retail banking into separate, high capital, legal entities which would be banned from speculating on their own account (see EUROPE 10500).
This “subsidiary game” for some investment would improve the prospects for rescuing a failing bank because it would lead to better risk assessment and would restrict reliance on risk by the rest of the bank, explain Commission sources. In the event the new legal entity gets into hot water, financial backup from the retail bank would no doubt continue, but would be capped under EU rules governing excessive risk.
Other Liikanen Group recommendations cover measures currently being adopted at EU level, like the drawing up of living wills for banks that the Commission has included in the draft bank restructuring rules (see EUROPE 10628), and bail-in rules for bailing out banks by writing down its shares and forcing junior lenders to chip in (or converting debt into shares). The Liikanen Group firmly backs the introduction of bail-in mechanisms so that investors are clear what would happen to their assets if a bank is broken up. Other ideas include stronger bank governance with the emphasis on risk management.
The Liikanen Report sends a message to the Basel Committee (responsible for international banking rules), stating that there is too much heterogeneity in the way risky assets appear on the balance sheet, as Liikanen explained, urging the Commission to ensure that the outcome of the Basel Committee's work on bank capital requirements for the trading portfolio properly covers the risks to which European banks are exposed. (MB/transl.fl)